Rebalancing Up or Down?

Ryan Avent on the latest Yuan fighting:

China will argue, with some support from economists, that the currency is less important than people think. American and Chinese imbalances are rooted in structural factors. China’s surplus grew from 2005 to 2008 while the currency appreciated by 20%, and Japan’s previous efforts to push up the yen under pressure from American leaders contributed to a weak Japanese economy — but not to an end to Japanese trade surpluses.

I think it’s important to understand the currency issue in a broader monetary policy context. You don’t want the Japan scenario where currency revaluation amounts to tighter money in China, with a big Chinese contraction and only a small impact on America. What we’re looking for is a modest cooldown of the Chinese economy (which is having inflation/bubble issues) and a substantial bump in American output. That would mean pairing currency revaluation with expansionary monetary policy. Instead of China buying-up dollar-denominated financial assets to keep the exchange rate in check, the Federal Reserve could buy them up.

But the good thing about this is that expansionary monetary policy is something we can do unilaterally. We don’t need to threaten China. Or bargain with them. Or do anything. We just need to set a price level target and say we’re going to have some modestly elevated inflation until we hit it. At that point the Chinese will either have to start importing even more American inflation or else (more sensibly) let the currencies readjust.