Mystery-blogger knzn packs an avalanche of insights into a very brief discussion of why China's policy of puchasing dollars to peg its nominal exchange rate has not led to real appreciation via inflation in China. knzn is quite critical of Charles Schumer and Lindsey Graham, who've written an op-ed in the Wall Street Journal (via Mark Thoma) today in defense of a proposal that amounts to a faint and distant threat of tariffs on Chinese goods. I am broadly sympathetic to Schumer and Graham's proposal, despite considering myself a staunch free-trader, and I think their point largely stands, despite problems that knzn and Greg Mankiw highlight. I hope he will forgive me for abusing his insights in support of a position he may not much like. Here's knzn:

China today is a special case for several reasons. First, there is a rapid flow of workers into the industrial sector, and this flow is helping to prevent the inflation that might ordinarily attend an undervalued currency. Second, much of China's foreign exchange intervention is sterilized, which is to say, China is making attempts to slow down domestic sources of demand to compensate for the foreign demand occasioned by its weak currency. Third, China's government is effectively running a very large surplus, which also tends to slow down domestic demand. Fourth, arguably, China is following policies that encourage a high level of private saving, which also tends to slow domestic demand.

knzn whizzes through this like it was nothing, but there's a ton of interesting stuff here. knzn's first reason is conventional wisdom, fine as far as it goes, and as the vowelless one notes, "if China has a lot of workers available to do these jobs, whereas the US has only a few (relatively speaking), why shouldn't trade be set up to create jobs in China rather than the US?"

But knzn's second point left me standing naked on the shoreline in wonder. Countries that manage their exchange rates are supposed to sterilize their interventions. It's like Central Banking 101. If China's central bank prints Yuan to buy dollars, it's got to borrow some of those Yuan back to avoid flooding the market with newly printed Chinese bills, right? knzn is having none of it, and of course he's absolutely right to note that sterilization is just a fancy word for what central banks do when they want to restrain domestic demand to avoid inflation. What I considered central bank prudence, knzn considers cheating, "[S]terilized intervention, might reasonably be considered an unfair trade practice (and probably a foolish practice as well)." Central banks may "naturally" want to prevent their exchange rate policy from causing inflation, but doing so in effect pegs the real, rather than nominal exchange rate. While pegging nominal exchange rates need not impede trade balance adjustments (because those adjustments can occur via changes in the price level), pegging real exchange rates blocks trade adjustment entirely.

knzn's third point is also a shocker. He notes that China is "effectively" running a large surplus. But hold the phone. Isn't China running a significant fiscal deficit? Well, yes, if you consider only tax revenues. But, if you consider a consolidated income statement that includes China's central bank, China's deficit would be dwarfed by the piles of foreign currency flying into the vaults, net of sterilization costs (and even net of significant presumed valuation losses). So is knzn is right to refer to this as "a very large surplus, which also tends to slow down domestic demand"? I think he's only half right, in a very subtle way.

Imagine that China did no sterilization, and purchased dollars with freshly printed Yuan to maintain its peg. This would maximize the surplus achieved by China's government (including central bank). But it would also be a very loose, a stimulative monetary policy that might provoke inflation, as China's central bank would be increasing the money supply dramatically. An unsterilized peg then has two paradoxical and countervailing effects, amounting to a stimulus and tax at the same time. It taxes holders of domestic currency, by increasing the cost in local money of forign goods (an upward shift in the supply curve for imports). But it stimulates domestic demand for all goods. The net effect is almost certain inflation of the price of imported goods (relative to the price that would prevail without intervention), but a mix of real GDP growth (to the degree that there is "slack" in the economy ) and inflation in the domestic economy.

Now let's put all this together. If China were simply pegging its currency without sterilizing, it would stimulate demand for nonimported goods and services, but it might also stimulate inflation, permitting real exchange rate adjustment. But, by adjusting the degree of sterilization, it can seek a sweet spot that grows unsterilized money at a level chosen to maximize real GDP without provoking inflation, preventing real adjustment. The net effect is a synthetic tariff, raising the price of foreign goods while stimulating the domestic economy and providing revenue to the state. It's no wonder that China's trade partners object.