Must-read: Ben Bernanke: “China’s Trilemma—and a Possible Solution”

Must-Read: The extremely-sharp Ben Bernanke continues to make the argument that the Washington-Consensus Great-Moderation division of labor between technocratic central banks and directly-elected governments–central banks tasked with macroeconomic stabilization, and directly-elected governments focused on rightsizing a public sector funded by an appropriately-prudent debt management system–is simply wrong and inadequate, as we have learned to our great cost. Here he addresses the problem of macroeconomic balancing in China, and says smart things:

Ben Bernanke: China’s Trilemma—and a Possible Solution: “Is the no-devaluation strategy a good one for China?…

…If it is, what does China need to do to make its exchange-rate commitments credible?… China’s ability to avoid a significant devaluation in the medium term will depend on a number of factors, including the country’s other policy choices. China… cannot simultaneously have more than two of the following three: (1) a fixed exchange rate; (2) independent monetary policy; and (3) free international capital flows….

Start with four premises…. 1. China is undergoing a difficult but necessary transition… to [a growth model] that focuses on… services and… consumer demand… accompanied by a slowdown in Chinese GDP growth…. 2. China’s growth appears to have slowed recently by more than the leadership expected or wanted…. 3. To support economic growth… China has eased monetary policy…. 4. At the same time, China has continued a process of reforming and opening up its capital markets. Notably, private Chinese citizens are allowed to invest some of their savings abroad, to a limit of $50,000 per person. Points #3 and #4 are the sources of China’s trilemma…. Chinese households and firms who are able to do so are spurning yuan-denominated investments and looking abroad for higher returns. However, increased private capital outflows also constitute a flight from the yuan toward the dollar and other currencies; that, in turn, puts downward pressure on China’s exchange rate.

In the short run, the PBOC can offset this pressure by selling some of its enormous stocks of dollar-denominated securities and buying yuan…. [But] here is the trilemma in action: If China wants to use monetary policy to manage domestic demand and to simultaneously free up international capital flows, it may not be able to fix the exchange rate at current levels…. One approach would be to devalue now and get it over with. (A series of small devaluations wouldn’t work, as expectations of future devaluations would just accelerate capital outflows.)… [But] a big yuan devaluation would likely be deflationary for the rest of the world… [and] would work against the goal of promoting services over exports. A second possibility… would be to stop or reverse the process of liberalizing capital flows…. This strategy… would sacrifice some of the progress that China has made in opening up its financial system…. Moreover, the horse may be out of the proverbial barn, in that the effectiveness of new capital controls in China would be uncertain…. A third option is to wait and hope…. However, hope is not a plan.

So what to do? An alternative worth exploring is targeted fiscal policy, by which I mean government spending and tax measures aimed specifically at aiding the transition…. Fiscal policies aimed at increasing income security, such as strengthening the pension system, would help to promote consumer confidence and consumer spending. Likewise, tax cuts or credits could be used to enhance households’ disposable income, and government-financed training and relocation programs could help workers transition from slowing to expanding sectors…. Targeted fiscal action has a lot to recommend it, given China’s trilemma. Unlike monetary easing, which works by lowering domestic interest rates, fiscal policy can support aggregate demand and near-term growth without creating an incentive for capital to flow out…


Brad DeLong


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