Is China better at monetary policy than the US?

W.hen china’s Leaders reappointed Li Gang as the country’s central bank governor in March, a pleasant surprise.in economics ptimed Li, an American-born teacher, is something of a reform-minded, well-traveled technocrat who is disappearing from China’s policy-making system.

His impression of a welcome anachronism was made on April 15 at the Peterson Institute for International Economics, a Washington think tank, when he gave a recorded speech in English before accepting unscripted questions from the audience. Enhanced. In his speech, he paid tribute to market power and economic freedom. “We have to believe that the market correction is largely reasonable,” he said. As a policy maker, he has pushed for giving households and private companies “maximum freedom” to buy foreign exchange without completely abandoning capital controls. His one reason for his stance is personal. As a student and professor abroad, he remembers finding it difficult to convert even small amounts of yuan into dollars. “I hate it,” he said.

Chinese officials have even jokingly claimed that they are reluctant to intervene in the currency market. One of his reasons is that traders at hedge funds, brokerage firms and commercial banks are much better paid and therefore probably smarter than he and his hardworking employees. central bank team. When asked if he thought China’s foreign exchange reserves were still safe after Western financial sanctions against Russia, he expressed an almost moving confidence in the “structure” (remember?) of the global economy. bottom.

This was music to the ears of the Washington crowd. But some of Lee’s claims were frowned upon. He contrasted China’s interest rate stability with the US Federal Reserve’s activism. For example, after the covid-19 outbreak, the Fed cut interest rates by his 1.5 percentage points to almost zero. People’s Bank of China (Pock) by just 0.2 percentage points. Conversely, since early 2022, the Fed has raised interest rates by 4.75 points from his Pock We have lowered interest rates by another 0.2 points.

Li also explained that the central bank is trying to keep real interest rates a little below China’s “potential” growth rate — the pace at which the economy can grow without increasing inflation. One of the charts he showed suggested that real interest rates have averaged almost 2 percentage points below potential growth since his tenure began in 2018.

Such guidelines raise many thorny issues. Let’s start with the theory behind it. In 1961, future Nobel Prize winner Edmund Phelps laid out the “Golden Rule” of saving and investing. An economy that follows this rule accumulates capital until its marginal product (the profit from adding more) equals the underlying growth rate of the economy. In such a situation the interest rate (which is closely related to the marginal product of capital) also agrees.

But this theoretical lesson is a rather strange guide to monetary policy decisions. After all, central bankers do not control the marginal product of capital, they only have a very distant influence on it by dictating the pace of investment. Furthermore, why would a central bank aim to keep interest rates below, rather than at, growth potential? Only if you lower it will interest rates fall below the growth rate. Such an economy sacrifices consumption for excess savings and investment, which does not produce offsetting satisfaction in the future.

Of course, China is regularly accused of this very kind of overinvestment. So it was a little strange to hear a Chinese central banker describe one of its symptoms as a policy goal. But in a speech in Beijing earlier this month, Li made it clear that he was trying to follow the golden rule. When making policy decisions, he aims to stay slightly below the glorious growth rate, because it is very difficult to calculate potential growth accurately (and perhaps he prefers to overshoot it). also prefers to undershoot).

Uncertainty also explains Yi’s reluctance to set interest rates. To justify this approach, he cited the “attenuation” principle formalized by William Brainard at Yale University in his 1967. This principle states that when policy makers are uncertain about the effectiveness of their policies, they should act less than they would otherwise. In other words, if you are not sure about the potency of the drug, reduce the dose. This sounds reasonable. A former Fed official once said:

But in monetary policy making, this principle can backfire. As argued in a 2020 paper by Stéphane Dupraz, Sophie Guiraud-Neufsi and Adrien Pennalvers of the Banque de France, smart and highly paid traders in financial markets are responsible for setting wages and prices in the broader economy. is a person. You learn to anticipate this dullness and adjust your behavior accordingly. If inflation runs wild, they expect a muted reaction, and as a result, expect a more sustained imbalance in inflation. They may act on this expectation and set prices and wages in ways that exacerbate the problem.

Underattenuation

After Yi’s speech, Adam Posen of the Peterson Institute noted that other central bankers would be very pleased with China’s policymakers’ inflation record, especially now. Inflation in China was just 2%. But cautious and restrained policymaking is unlikely to be the reason for this exceptional price stability. Thanks to aggressive containment of the 2020 pandemic, the central bank didn’t have to cut interest rates as much as the Fed to save the economy. So the central bank didn’t have to raise interest rates to keep inflation down, as the Fed belatedly did. The success of China’s weakened monetary policy is due to its apparently unweakened covid policy. ■

Read more about our column on economics, Free exchange.
How the State Can Control the Banking System (April 12)
Why Economics Doesn’t Understand Business (April 4)
China is now an unlikely safe haven (March 30)

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