Like much of the blogosphere I was puzzled over Paul’s China criticisms. However, as a general rule of thumb, when you disagree with a Nobel Laureate on an area closely related to the one in which is received his prize, assume that the misunderstanding is on your part – not his. So, I have been quiet and kept reading.

Now, I think I get and it comes in a few lines

China isn’t fighting deflation — it’s fighting inflation, so the undervaluation of the yuan has to be accompanied by restrictive credit policies domestically. (China can separate exchange rate policy from domestic monetary policy because it has capital controls)

The problem is not that Chinese monetary policy is too loose, it is that it is too tight. Paul is saying it has to be tight because of the way in which the Yuan to Dollar peg is maintained.

When we generally think of pegging currencies, we think of monetary policies moving in tandem. China wants a cheap Yuan so when the Federal Reserve prints dollars, the Bank of China has to print Yuan. Saying the Yuan is too cheap is the same as saying the dollar is too expensive and of course we have a cure for that – print more dollars.

However – and this is where I am primarily giving a Paul a chance to step in and really clear things up – when the Chinese government prints Yuan, it trades them for dollars but doesn’t allow those Yuan back into the country.

In order to invest in China you need state permission and the state limits how much money comes in. It essentially has an import quota on Yuan.

This means that while Yuan are loose in the international market and therefore cheap, they are actually tight at home and therefore expensive. Because China is controlling the flow on money across the border it can have a loose international monetary policy but a tight domestic monetary policy.

Indeed, it goes deeper than that. A loose international Yuan bids up foreign demand for Chinese goods. This in turn both increase the quantity of goods China produces and their domestic price. Essentially, foreign consumers are given a price advantage relative to domestic consumers.

However, China doesn’t want domestic consumers to face higher prices. So, it has to tighten the domestic Yuan even tighter. It has too push down domestic demand so that the sum of international demand plus domestic demand are not so high that they produce domestic inflation.

The tight domestic Yuan, therefore, is driving down Chinese consumption at precisely the time in which the world could use more consumption. The loose international Yuan also gives foreigners a price advantage when buying Chinese goods and so it is driving down inflation in the US at precisely the time the Fed is trying to dive it up.

However, the story still gets worse from there – I am really riffing here, half of this is just occurring to me as I type. The loose international Yuan can only be used to produce manufactured goods. Manufacturing requires commodities both as the feed stock for the actual goods and to be used in the construction of new manufacturing facilities.

What does that mean. It should mean that when the Fed loosens policy, that China responds by loosening the International Yuan which in turn gets shunted towards commodities. Thus rather than boosting the consumer price level as we hope, Fed easing actually winds up boosting commodities.

This is because China is offsetting the total increase in worldwide consumer demand by tightening the Yuan at home, and boosting the total increase in commodity demand by loosening the Yuan abroad.

Thus this Yuan policy does all the wrong things.

This is my best shot at understanding the issue. Hopefully, Paul will swoop in to set things straight.