This will be a long post, as Paul Krugman’s recent piece on the yuan raises all sorts of different questions. Let’s start with his assertion that an overvalued Chinese currency is restricting our ability to reflate our economy:
But given our economy’s desperate need for more jobs, a weaker dollar is very much in our national interest — and we can and should take action against countries that are keeping their currencies undervalued, and thereby standing in the way of a much-needed decline in our trade deficit.
That, above all, means China.
But how do we know the yuan is undervalued? Its current value is not out of line with predictions of the Balassa-Samuelson Theorem, which predicts that countries with higher per capita GDPs will have higher real exchange rates. Krugman points to the huge Chinese trade surplus. But is their surplus actually all that large? After all, China is a very big country. As I pointed out earlier, the Germanic/Nordic current account surplus is vastly larger, despite the fact that the countries lying between Switzerland and Norway have a combined population only a tenth as large as China’s. The smaller East Asian countries also have vastly bigger surpluses on a per capita basis. So why focus on China?
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