Roubini on Global Rebalancing

Great post highlighting that while there is a growing consensus that the U.S. deficits (Current Account and Fiscal) need to be addressed, there is less agreement over whether the U.S. should continue urging China to revalue the Yuan. After reading the arguments for and against, it really is hard to imagine how rebalancing can take place if China does NOT revalue the Yuan:

So, McKinnon and Roach are correct in stressing the important role that US fiscal adjustment can play in supporting an orderly global rebalancing. But their view that such rebalancing does not require any exchange rate adjustment in China is at odd with over thirty years experience with flexible exchange rates where exchange rate flexibility has helped undoing exchange rate misalignments that do occur from time to time. Adjusting relative prices via nominal exchange rate movements is less costly that trying to adjust such relative price via costly deflation or inflation.

One can also point out that the risks of a deflationary spiral in China are minimal. Currently, in China inflation risks are increasing - not decreasing - (as Goldman Sachs has recently pointed out) and the actual inflation rate is artificially kept low via various administrative freezes on the price of energy and the price of many public services. So, the risk of deflation via a currency appreciation is minimal. If anything, by appreciating its currency China could successfully control inflationary pressures - such as those deriving from the skilled labor shortages pressures on wages in the high growth regions of China - while providing to its citizens an increase in terms of trade or purchasing power over foreign goods.

Also, the McKinnon concern about the deflationary effect of a Chinese and Asian appreciation on their economies can be turned on its head as a failure to flexibilize the Chinese and Asian currencies may lead to deflation in the US, Europe and Japan. Indeed, if the Chinese/Asian appreciation does not occur via a nominal appreciation and it does not occur via higher inflation in China (as slow growth of Chinese real wages may keep such inflation under control), then the only way in which such real appreciation can occur is through the fall in the price of traded goods in the rest of the world (i.e. a fall in prices in the US, Europe and Japan). Thus, while McKinnon worries about Chinese deflation, he does not consider the possibility that the needed real exchange rate adjustment could - in principle - occur through a destabilizing deflation in advanced economies. And, as the experience of Japan in the last decade suggests, such deflationary pressure would have severe consequences on the productive sector of the advanced economies.

Thus, a US fiscal adjustment without a change in relative prices (the Chinese/Asian nominal and real exchange rate) will not trigger enough of an expenditure switching effect that is required to reduce the global imbalances. Both are required to have an orderly global rebalancing. Unfortunately, however, the U.S. has very little legitimacy in brow-beating China to do its part of the global rebalancing via an RMB reval as the U.S. is doing nothing to address its fiscal deficit problem that is an important source of such imbalances.