• Is China being bad?

    The answer is going to be yes and the forex peg is the reason, but it won’t be for anything they’re doing to the US.  My last three posts have been a lead up to this one.

    This post is also a response to Nick Rowe who asked on my last post

    Let’s switch to a slightly different thought-experiment. Suppose I, as an individual, tried to create 0% inflation in Canada, because I didn’t like the Bank of Canada’s 2% inflation target. Could I do it? If not, what’s the difference between me and China?

    The answer to that question is connected to the answer to the question of whether or not China is being bad.

    Size Matters

    First Nick’s question, clearly the answer is no Nick can’t personally change Canada’s inflation rate but why not?  Well in a perfectly competitive market Nick is a price taker so can’t really effect the price of anything.  The usual intuition is that Nick is too small a part of the market.

    If we move to monopolistic competition then Nick has pricing power in his own output and maybe he can do something to change Canada’s inflation rate.  Of course, in the international market for manufactured goods if we identify countries as the competing units then we’re pretty clearly talking oligopolistic competition where countries can exert substantial price effects.

    To take an example, suppose Nick and I were the only two people providing blogging services to Canadians, that there was a paying market for this service and that this sector was, say, 10% of all economic output in Canada and 10% of the CPI basket of goods.  Further suppose our two blogs are perfect substitutes for one another (clearly fantasy since I have about 5-10 readers as best I can guess, but humor me).  So actually it’s not actually monopolistic competition it’s straight oligopoly but the argument will carry over.  If Nick decided to compete with me by undercutting my prices by say, 20%, then I’d have to match him or lose the whole market.

    If this happened then the CPI basket’s price would be reduced by 2%, enough to bring down Canada’s inflation rate to zero in the absence of a response from the BoC.  Essentially China is undercutting  US prices in manufactures, a sector that is probably something like 10% of the US economy (I don’t know but for this it doesn’t matter what the right number is).  This puts downward pressure on US inflation.

    Now, presumably the BoC would respond by easing so Nick would have to continue lowering his prices to offset this.  This is basically what China is doing when they match each Fed easing with a local tightening, the pegged exchange rate means Fed easing is also Chinese easing but also Chinese tightening is US tightening.  Notice I haven’t mentioned the tradeable vs non-tradeable distinction yet, this will appear soon.

    So what rules out this behaviour of Nick in the usual sort of models?  Well, optimizing behaviour.  In the example Nick and I have some sort of marginal cost of producing the service and to keep Canada’s inflation at zero he’d have to very quickly reduce his price below his costs.  If the story had an initial condition that was equilibrium then Nick was optimizing and his 20% price reduction was therefore, by construction, suboptimal for him.  Nick would not be acting in his own best interest.

    China’s badness

    This leads naturally to the question of China and the connection to my previous posts.  China is not acting in their own best interests.  So why do they do it?  Well, there’s only one Nick but lots of Chinese.  In particular some Chinese work in the tradeables sector and some in the non-tradeables.  China is acting in the interests of those Chinese that work and own capital in the tradeables sector at the the expense of those that work in the non-tradeables sector.

    Basically the combination of the forex peg and keeping domestic inflation low has the effect, through the mechanism describe here, of keeping the REAL wages of the workers in the non-tradeables sector below their free market levels.  This creates a surplus which accrues to those in the tradeables sector, particularly the capital owners I’d imagine.

    This is wrong, it’s basically exploitation and it is why I so intensely dislike the Chinese exchange rate peg and their disingenuous wining about Fed policy.

    Adam Purzitsky
    Adam Purzitsky
    Senior Quantitative Portfolio Manager, Co-Fund Manager
    Feb 13, 2011 at 8:37am

3 Comments in total
  • You do not need a pegged exchange rate to engineer domestic income redistribution. Too much writing for nothing.

    Posted by: Anonymous
    Feb 14, 2011 at 6:46 am

  • It wasn't that much writing.

    Posted by: Adam P
    Feb 14, 2011 at 7:21 am

  • If I had a nickel for each time a western economist complained that the peg was not in the interest of China, I would be rich.

    Obviously they don't agree.

    Look at it this way: cheap credit for state owned enterprises. The liberalization you tell the apparatchiks to want would undercut their access to cheap credit and empower consumers. It is not in their interest.

    Won't happen.

    Posted by: Anonymous
    Mar 3, 2011 at 10:36 pm

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