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2010-03-16

Fallacy in mechanically applying conventional economic wisdoms

Second comments on Yiping Huang “Krugman’s Chinese renminbi fallacy”, 15/03/2010, http://www.eastasiaforum.org/2010/03/15/krugmans-chinese-renminbi-fallacy/

I think this article has generated useful and interesting debates. Some of those are related to conventional wisdoms of economic theories.

For example, the point made by some about China’s exchange rate regime is implicitly based on the assumption that a flexible exchange rate regime is superior or better, so China should move to that or restore that mechanism.

The implicit problem with some of conventional economic theories that most people accept or use as truth nothing but the whole truth can be very inappropriate and indeed very dangerous at times. Further, it is often ignored by many people that the whole context of a particular regime is operating.

For example, many economists, based on some conventional economic theories, had thought GFC had been over and would not happen. What has happened in the last couple of years or so?

Many economists, based on some conventional economic theories, did not have a clue how to tackle the GFC, but to have the government stay out of any interventions. An example was the Fed has used and probably still using so called non-conventional method of quantitative easing, as opposed to what many economists had been used to and content with.

Shouldn’t governments intervene at all in the face of the GFC? Isn’t that dangerous?

Now let me turn back to the exchange rate regimes. Undoubtedly, many if not most economists would probably assume that the flexible regime is better. OK, let’s assume that they are right for the moment. What about Japan’s lost decade of the 1990s? Was Japan using a flexible or fixed exchange rate regime? Did it help Japan? Or from another viewpoint, did it solve Japan’s trade surplus, or for that matter the US trade deficits? I assume they both had a flexible exchange rate regime when very large trade imbalances could still have occurred.

Another point, while a flexible exchange rate regime is said to allow the monetary authority to pursue a free monetary policy of its own. However, we have seen wild fluctuations in some exchange rates, say even the $US and the Euro, for example. Do those wild fluctuations in exchange rates not have a destructive effect on the economies or businesses? When people talk about the freedom of monetary policies, did they have an idea of the potential costs to businesses or the economies in mind? Have they done a cost and benefit analysis as such?

Further, many economists have been talking about allowing currency to appreciate and its effect to dampen inflation. I am not arguing they are wrong. But have they thought about how the Chinese monetary authority conducts its monetary policies and how that can deal with a fixed exchange rate regime and effective monetary policies?

While I am not an academia and am very rusty in economic theories and policies, are many economists really having rational expectations, in the sense that they have a correct model of the real economies and how they work?

I have no answers to that, but sometimes it pays to be a little suspicious, or a bit diligent, and not be blind-sided and simple accepting what some people are saying, no matter how elegant they may be. After all, history has proved that many people can be wrong, and sometimes serious wrong, in both their theories and their beliefs.

The fact that there are serious disagreements among the best minds and most bright and great economists on so many issues is a proof that a particular economic theory or conventional economic wisdom is not necessarily always sacrosanct. It can be dangerous to use them mechanically.

To me, that acts as common sense and simple risk management.

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