Conventional Wisdom, Conventionally Wrong

I was struck by a WSJ editorial I came across yesterday. The piece, published in 2007 by Matthew Slaughter of Dartmouth's Tuck School of Business (hi, John G.) sheds light on China's alleged trade advantage, commonly attributed to its currency manipulation.

The argument made by Hank Paulson (and a slew of Rust Belt Congressmen) goes something like this: by intervening and aggressively purchasing dollars, China is keeping its currency -- the renminbi -- below the equilibrium price a competitive market would establish. This in turn makes Chinese goods less expensive than American equivalents. Thus, the hollowing of America's manufacturing core (or an equivalent politically-charged metaphor).

Seems fairly straightforward. So much so, I'd posit this concept has become common knowledge, conventional wisdom. Of course, we all know the correlation between conventional wisdom and reality isn't all that high -- remember, the world was flat up until the 15th century (despite what Thomas Friedman might have you believe).

The key to debunking this myth lies in basic economic theory, as articulated by Slaughter.

The exchange rate that matters for trade flows is the real exchange rate -- the nominal exchange rate adjusted for local-currency output prices in both countries. Supply-and-demand pressures in international markets can, and do, alter not just nominal exchange rates, but also nominal prices for goods and services. And these pressures driving the real exchange rate, in turn, reflect the deep forces of comparative advantage such as cross-country differences in technology, tastes and endowments of labor and capital.

If an under-valued currency makes Chinese goods more affordable for Americans, it does so for all (American) market participants. In other words, the weak renminbi increases total demand for Chinese wares, putting upward price pressure on these products in terms of their local currency. Your dollar might fetch too many renminbi than it ought to, but thanks to market dynamics those renminbi will buy fewer goods.

While the issue of China's currency policy is far from moot, it certainly doesn't deserve the attention it receives from Hank, Congress and the media.

I'd like to spend more time contemplating the roll China's large stash of USD-denominated assets plays in this story. If they're sitting on north of $1 trillion in US Treasuries (not to mention the equity in Morgan Stanley, suckers) how powerful is China's incentive to keep the dollar nominally strong and does this compulsion create real inefficiencies?