Monday, September 25, 2006

Hume vs Schumer and Graham

Here is a good question for an exam in international economics:

"One of the fundamental tenets of free trade is that currencies should float -- or at the very least, move along with market forces." True or False? Explain.
The quotation is from an op-ed in today's Wall Street Journal by Senators Charles Schumer and Lindsey Graham, writing about their plan to slap tariffs on Chinese goods unless the Chinese let the yuan move in foreign-exchange markets.

My answer would start by saying that the quoted statement is false. There is nothing inconsistent between free trade and fixed exchange rates.

My explanation would emphasize David Hume's price-specie flow mechanism. Back in the 18th century, Hume studied how the world economy reaches equilibrium under the fixed exchange rates established by a world gold standard. In such a system, adjustments in the price levels at home and abroad were the mechanism that brought trade flows into equilibrium. As a result of automatic adjustments in money supplies and prices, fixed exchange rates between currencies can coincide with free trade in goods and services.

Here is a question for the Senators to ponder: How do New York and South Carolina manage to have free trade between them? There is no floating exchange rate to bring interstate trade flows into equilibrium. By using a common currency, the two states effectively have a fixed exchange rate, and somehow everything works out just fine. David Hume explained why.

Or maybe the Senators want to slap tariffs on interstate purchases until each of their states adopts its own freely floating currency. There's a topic for their next op-ed.

For previous posts on the Chinese exchange rate, click here and here.