The notion that the renminbi is dangerously undervalued and that China is exporting deflation got legs during the May 1, 2002, hearings on the Treasury’s Report to Congress on International Economic and Exchange Rate Policy. Those hearings were chaired and carefully choreographed by Senator Paul Sarbanes (D-Md.). The assembled panelists (except me) embraced the idea that China was exporting deflation. To use one of Frank Knight’s favorite words, this is ‘nonsense.’ Deflation is always and everywhere a monetary phenomenon, and in this day and age it is a monetary area-specific problem.
China is exporting manufactured goods. Indeed, in the past 20 years, its share of world exports has increased from 1 percent of the total to 5 percent. In consequence, sector-specific or relative prices — not overall price levels — have been affected. This explains, in part, why the prices of services are increasing much more rapidly than those for goods — even in Japan. For example, the price changes for sector-specific categories in December 2002 (YoY) were: U.S. Durables -3.2 percent and Services +3.3 percent; Eurozone Goods +1.8 percent and Services +3.3 percent; and Japanese Durables -4.4 percent and Services +0.1 percent.
Changes in relative prices require no policy response. After all, relative price changes are an indispensable guide that gives a coherent direction to economic activity.
Unfortunately, U.S. Treasury Secretary John Snow has already fallen into the trap set by those who wrongly assert that China is exporting deflation — read: China is a super-competitive exporter of manufactured goods, one that’s robbing its U.S. counterparts of pricing power. In written responses to members of the Senate Finance Committee, prior to his confirmation, Snow indicated that he might put pressure on China to revalue its currency. This represented the first of Snow’s missteps in the exchange-rate sphere. Indeed, the evidence to date suggests that he, like his predecessor, is ill-equipped to handle these matters properly.