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What Do Chinese Exchange Rates and German Wages Have in Common?

Jamus Lim's picture

They have both been blamed for being the primary mechanism that prevents the adjustment of their trade imbalances, of course.

What this (admittedly crude) caricature papers over, however, is the ultimate necessity for any proximate adjustment mechanism to operate on one of the levers that constitutes the real exchange rate. Recall, this real exchange rate (q) is defined as

q = ep*/p,

with e being the nominal exchange rate, and p and p* representing prices at home and abroad, respectively. So given that the real exchange rate conditions the flow of net exports (and thus the current account balance), the definition above necessitates that the burden of any external adjustment must fall on either nominal exchange rates (e) or domestic prices (p), of which wages to labor are the major component (we generally take foreign prices as given).

For a country such as China, then, current account adjustments vis-a-vis a major export partner (such as the U.S.) will be induced by either changes in the exchange rate or domestic prices. The clamor for China to revalue the yuan stems from a focus on the first of these two levers. By extension, this also means that the effects of any revaluation could be potentially undone if prices in China were to fall in an equiproportionate fashion; conversely, if wages in China were to rise, adjustment could occur without any direct change in the nominal exchange rate.

For Germany, in contrast, these two levers will only be operative for trading partners outside of the EMU. Relative to Greece, then, any adjustment must come from prices. This is essentially why "low" German wages have been blamed for impeding intra-Eurozone rebalancing. But Germany, by and large, operates as a capitalist democracy, and so it is unclear how higher wages could possibly be mandated by fiat. 

Undoubtedly, this discussion of channels does not impute causality in either direction. As others have argued, the claim that German current account surpluses cause deficits in the Euromed countries is not supported by evidence. In a similar fashion, any claim that Chinese surpluses, in and of themselves, lead to U.S. deficits is misguided. This is where the so-called saving glut hypothesis comes dangerously close to misattribution of causality. Claims that excess saving abroad is responsible for the corresponding deficits at home (since deficit countries are forced to "absorb" this excess saving), rather than being symptomatic of underlying fundamentals, often cater more to the politics of blame, rather than illustrating real economic processes.

In any case, recent research (gated technical version here) has cast further doubt on whether the hypothesis jives with reality. The bottom line for policymakers seems to be the need to better understand how imbalances can be prevented from getting too out of whack. Unfortunately, this may require focus on structural mechanisms that are much more poorly understood than proximate factors, such as the exchange rate.

Update: And as usual, the Economist is totally on the ball when it comes to current issues on the global agenda; this week their online debate topic asks whether Germany is too export-dependent.