COMMENTARY
HONG KONG -- As the audience at the Asia Society's May gala dinner here sips their coffee, the moderator allows one more question from the audience for Nobel economics laureate Robert Mundell. A Chinese gentleman stands to ask how much longer the U.S. dollar would remain the world's reserve currency. The query seems like the perfect set-up for the world's foremost expert on monetary policy and a well-known "friend of China" to predict the rise to pre-eminence of China's currency.
Instead, Mr. Mundell says that China is still far behind the U.S. in economic strength and stability. "I think the dollar era is going to last a long time . . . perhaps another hundred years."
His answer is a fitting end to an evening in which the conventional wisdom has been set on its ear. The high U.S. trade deficit, widely supposed to be unsustainable, is not only sustainable, Mr. Mundell says, it is necessary to the functioning of the global economy.
Yes, China's high balance of payments surplus, and the pressure on the yuan, could be resolved quite easily if the central bank stopped the practice of "sterilization" -- that is, the practice of following up its interventions in the foreign-currency market by issuing bonds, thereby preventing the domestic money supply from increasing too fast. And no, he says, this would not lead to a big jump in inflation.
On this last score, Mr. Mundell has a few economists in the audience scratching their heads. Is the economist known as the "father of the euro" for his work on optimal currency areas just being provocative? After all, he has a bit of a reputation as what the Chinese would call a lao wan tong, a playful old child.
So the next day I meet with Mr. Mundell to try to get to the bottom of this last point. According to standard economic theory, if the money supply increases, so should inflation. So what gives?
First a brief explanation. Without sterilization, China would essentially be running a currency-board system, much like in Hong Kong. When people want to convert more foreign currency into Hong Kong dollars than the other way around, the government makes the trade, creating new Hong Kong dollars and depositing the foreign currency into reserves. The money supply increases, and if this outstrips the growth in the economy, the usual outcome is too much money chasing too few goods -- inflation. For instance, in the mid-1990s inflation in Hong Kong ran much higher than in the U.S.
Mr. Mundell himself pioneered the explanation for the so-called "impossible trinity." In its simplest form: No economy can have free capital flows, a fixed exchange rate and control over its own monetary policy, i.e. stable interest rates or stable prices, all at the same time. Economies with a currency board like Hong Kong enjoy the first two, but can't regulate the local economy separately from the one they have pegged to, and so may suffer bouts of inflation and deflation.
But, Mr. Mundell asks, what if extra yuan did not send consumption of Chinese goods into overdrive, but merely satisfied the desire to hold yuan and yuan-denominated assets? China's domestic economy is becoming wealthier and its citizens are saving in record amounts. The savings cannot easily go abroad because of capital controls, so it is invested in production capacity far beyond the needs of domestic consumption. Meanwhile, the largest portion of the increase in reserves is driven not by the trade surplus but by inward investment. "If you create money in an equilibrium situation," he says, "the additional money makes disequilibrium, and people spend more and that involves more imports, and potentially inflation. But if you print money to fill an excess demand for money, there is no inflation that comes from that."
By sterilizing, the central bank prevents the supply from rising fast enough to satisfy the demand, perpetuating the imbalance. Raising the required reserve ratio of the banks has the same effect. Ease off the sterilization and monetary tightening, Mr. Mundell predicts, and the demand for yuan will soon be sated. One result would be increased domestic demand and imports, reducing the trade deficit. But it's unlikely that domestic prices would rise across the board, and prices of some goods might actually decrease as companies achieve greater economies of scale. Since the trade surplus will decline, political tension with the U.S. will also ease.
In the early 1980s, Mr. Mundell explains -- after Paul Volcker's Federal Reserve tightened interest rates and vanquished the runaway inflation of the 1970s -- the U.S. economy passed through a sharp recession. When it began to recover and the value of the dollar was restored, the desire of Americans and foreigners to hold the currency increased. The money supply began to grow at a phenomenal rate, and some, including Milton Friedman, predicted inflation would reappear. It didn't: "What was happening was the expectation of disinflation was increasing the demand for money," Mr. Mundell says. In fact, disinflation continued through the 1980s.
Today, the money supply in China (M2) is growing at 17%, compared to GDP growth of about 11%, yet inflation remains very low. This fact is obscured by a lot of blather about the Chinese economy "overheating." Yet the hallmark of overheating, as Mr. Mundell observes, is an excess of demand leading to bottlenecks in many markets. If anything, China still suffers from weak domestic demand. And while there are a few isolated bottlenecks in the economy, in general there are plenty of inputs available to increase production.
The experience of developed countries is misapplied to China, with a resulting confusion. In the U.S., for example, the Federal Reserve usually regulates the economy largely by setting the interest rate at which banks lend to each other, and through the buying and selling of bonds -- practically never by administrative means or intervening in the foreign-currency markets. In China, the management of the exchange rate is the central bank's chief way to regulate the economy. Setting interest rates is mostly for show.
China could include asset prices in its index of prices if it wanted to target price stability. But as long as the international monetary environment is stable, pegging the yuan to the dollar offers the opportunity to target the broadest possible index of prices, effectively the goods of the whole world. It's difficult to improve on that, even if China had its own Alan Greenspan.
Full convertibility of the yuan to the dollar is not on the cards as long as the primary objective of the Communist Party is maintaining power, not the welfare of China's citizens, Mr. Mundell admits. But he advises the Party bosses to progressively relax the controls to help take the pressure off the balance of payments.
However, in the unlikely event that the yuan were suddenly made fully convertible, Mr. Mundell predicts that the value of the currency would fall, not rise. Many Chinese savers would want the security of keeping at least some portion of their wealth in foreign currency and would convert quickly, worried that the government might slam the door shut. This might become a self-fulfilling prophecy. In the U.K. in 1947, the Bank of England saw its reserves evaporate in a matter of weeks, and reinstated capital controls. The movement to full convertibility is fraught with danger and must be approached cautiously.
Mr. Mundell says that abandoning the sterilization policy would have to be done gradually to avoid scaring the markets: "I wouldn't suddenly change what they are doing, just slow it down and phase it out over a year or so period."
Mr. Mundell is on the same wavelength as China's leadership as to keeping the value of the yuan stable and appears to have some influence with it; he was even given a "green card" by the government two years ago, giving him the permanent right to live and work in the country. Still, he is skeptical of the quality of China's top economists, choosing to focus more on the next generation. He has lent his name to a business school in the capital, as well as a financial magazine.
One senses that, even though he helped found the supply-side school that informed the policies of Ronald Reagan, Mr. Mundell is too much of an independent mind to ever become a government's go-to economist. He's having too much fun as a lao wan tong.
Mr. Restall is the editor of the Far Eastern Economic Review, from which this article is adapted.
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