Nominal exchange rates, real exchange rates and protectionism
By Scott Sumner
The three concepts mentioned in the title of the post are completely unrelated to each other. So unrelated that the subjects ought not even be taught in the same course. The nominal exchange rate is a monetary concept. Real exchange rates belong in course on the real side of macro, perhaps including public finance. And protectionism belongs in a (micro) trade course.
The nominal exchange rate is the relative price of two monies. It’s determined by the monetary policies of the two countries in question. It plays no role in trade.
Protectionism is a set of policies (such as tariffs and quotas) that drives a wedge between domestic and foreign prices. Protectionist policies reduce both imports and exports. They might also slightly affect the current account balance, but that’s a second order effect.
Real exchange rates influence the trade balance. When there is a change in either domestic saving or domestic investment, the real exchange rate must adjust to produce an equivalent change in the current account balance. A policy aimed at a bigger current account surplus is not “protectionist”, as it does not generally reduce imports and exports, nor does it drive a wedge between domestic and foreign prices. It affects the gap between imports and exports. Here are some policies that can lead to a lower real exchange rate and a bigger current account surplus:
1. The central bank can accumulate lots of foreign assets, increasing national saving.
2. The government can run a budget surplus.
3. The government can create a sovereign wealth fund.
4. The government can encourage private savings, via a pay as you go retirement system.
[Update: I meant fully funded pension system, not pay as you go.]
5. The government can switch from an income tax to a consumption tax.
None of these are protectionist. A low real exchange rate is sometimes called a “competitive advantage”, although the concept has absolutely nothing to do with either competition or advantages. It’s simply a reflection of an imbalance between domestic saving and domestic investment. These imbalances also occur within countries, and no one ever worries about regional “deficits”. But for some odd reason at the national level they become a cause for concern. Some of this is based on the mercantilist fallacy that exports are good and imports are bad.
Here’s David Glasner:
Currency manipulation has become a favorite bugbear of critics of both monetary policy and trade policy. Some claim that countries depress their exchange rates to give their exporters an unfair advantage in foreign markets and to insulate their domestic producers from foreign competition. Others claim that using monetary policy as a way to stimulate aggregate demand is necessarily a form of currency manipulation, because monetary expansion causes the currency whose supply is being expanded to depreciate against other currencies, making monetary expansion, ipso facto, a form of currency manipulation.
As I have already explained in a number of posts (e.g., here, here, and here) a theoretically respectable case can be made for the possibility that currency manipulation can be used as a form of covert protectionism without imposing either tariffs, quotas or obviously protectionist measures to favor the producers of one country against their foreign competitors.
I disagree with this. There is no theoretically respectable case for the argument that currency manipulation can be used as protectionism. But I would go much further; there is no intellectually respectable definition of currency manipulation.
And the most egregious recent example of currency manipulation was undertaken by the Chinese central bank when it effectively pegged the yuan to the dollar at a fixed rate. Keeping its exchange rate fixed against the dollar was precisely the offense that the currency-manipulation police accused the Chinese of committing.
Because currency manipulation does not exist as a coherent concept, I don’t see any evidence that the Chinese did it. But if I am wrong and it does exist, then it surely refers to the real exchange rate, not the nominal rate. Thus the fact that the nominal value of the Chinese yuan was pegged for a period of time has no relevance to whether the currency was being “manipulated”. The real value of the yuan was appreciating.
The dollar was pegged to gold from 1879 to 1933, and yet I don’t think the US government was “manipulating” the exchange rate. And if it was, it was not by fixing the gold price peg, it would have been by depreciating the real value of the dollar via policies that increased national saving, or reduced national investment, in order to run a current account surplus. In my view it is misleading to call policies that promote national saving “currency manipulation”, and even more so to put that label on just a subset of pro-saving policies.
If economists want to use the term ‘currency manipulation’, then they first need to define the term. I have not seen any definitions that make any sense.
Here’s China’s real exchange rate, which has been appreciating over time.