For a variety of reasons, Chinese economic policy makers resist pressures to allow the yuan (or renminbi) to rise against the dollar.  On this side of the great pond (i.e., the Pacific Ocean), politicians (see H.R. 2378 Ryan-Murphy bill) and many economists clamor for explicit pressure that “forces” the Chinese to allow the yuan to appreciate.  What would happen if the yuan were to rise markedly against the dollar?  Several observations are worth making.

1.  Much of the trade deficit that exists between the US and China arises from the sale of final goods.  The value added by Chinese firms in these goods, however, is rather small.  So what?  If the yuan rises, it means that Chinese firms will be able to purchase intermediate goods more cheaply than at present; thus, the decrease in the cost of Chinese goods in yuan terms will counter the rise in the exchange rate and limit the change in prices to American consumers.

2.  It’s not clear that changes in the nominal exchange rate drive large changes in purchasing.  For example,  the Japanese yen was forced to appreciate against the dollar in the late 1980s.  Such a rise has had limited impact on trade with Japan.  The U.S. runs trade deficits with virtually all of its major trading partners.  This is a natural outgrowth of diminishing savings relative to (tangible) investment over past three decades.

3.  On a related point, Gillian Tett, in today’s Financial Times argues that the Japanese experience with a rising yuan could be replicated in China.  Unless China reforms its banking and financial system in a way that decentralizes the allocation of capital, it may suffer the economic stagnation that Japan has suffered for the past two decades.  Cheap capital, centrally allocated, tends to yield excess capacity in politically sensitive industries.  I have heard this argument on many occasions in China.  If China’s economy were to suffer a long period of weakness, demand for US, European, and Asia goods would diminish, not rise.

4.  The iron triangle or impossible trilogy restricts countries from having a) open capital markets, b) a fixed exchange rate, and c) independent monetary policy at the same time.  Different countries, based on the depth and breadth of their domestic capital markets and their social time preferences, as well as their desire to attract capital, make different choices.  China chooses some combination of capital controls and limited monetary independence along with a fixed exchange rate.  The US and Europe, with much more developed capital markets, choose to allow exchange rates to float.  Small countries, dependent on world trade and world interest rates, such as Hong Kong and Estonia, forgo independent monetary policy.  There is no right choice.  Each country manipulates the tools it believes give it the highest level of economic welfare.

My advice to US policy makers:  be careful what you ask for.

In today’s New York Times Economix Blog, Uwe Reinhardt poses the central question: “Is ‘More Efficient” Always Better?” In answer to the question he provides the basic definitions one would confront in an introductory economics course – including appropriate references to  Pareto – and proceeds to point out that some efficient points, such as R and U, are not necessarily better than some inefficient ones (any in the region bounded by X, Y, and Z).

He then proceeds to link efficiency with optimality, which becomes his point of contention.

“One suspects that the term optimal came into widespread use among economists as a marketing device to promote their normative propositions based on efficiency. But as Professor Arrow warns his colleagues on this point:

A definition is just a definition, but when the definiendum is a word already in common use with highly favorable connotations, it is clear that we are really trying to be persuasive; we are implicitly recommending the achievement of optimal states.

Alas, it gets worse. Astute readers will have figured out by now that literally every point falling on the entire solid curve in the graph must be “Pareto optimal” by the economist’s definition of that term, not only those falling on line segment Y-Z. That circumstance makes the economist’s use of the word optimal even more dubious.”

In my view, Reinhardt stops in the wrong place.  Rather than “dis” the term efficiency,  he could differentiate between Pareto efficient (all points on the concave curve bounded by the two axes and called in this case the Happiness Possibility Frontier or HPF) and Pareto optimality (which employs Pareto’s notion that, at these points, to make someone better off, another person must be made worse off.)   So what’s the point?  Actually, there are two points to be made.

1.  For any point (or allocation) below the HPF, that is any Pareto inefficient allocation, there exist Pareto improvement possibilities, and economists should encourage taking advantage of such.

2. Once on the HPF, Pareto optimal allocations depend upon social preferences, about which economists have no unique judgment to contribute; however, each such social choice judgment does yield consequences with opportunity costs (foregone choices) that can be identified.  Stated differently, all Pareto efficient points are candidate points to be Pareto optimal under some set (of sometimes very curious) social preferences.

To conclude, the notion of efficiency is not a vague term, and it does reflect a value free standard.  In my view, one can claim that for any Pareto inefficient allocation, Pareto improvements exist.  Efficiency, however, says nothing about the optimal choice until preferences – in this case comparison of A’s vs. B’s happiness – is made.  Furthermore, economists should encourage those making such social preferences to be transparent rather than hide them in 2000 pages of legislation.