Geithner, Summers, Bernanke, and Co. should be careful what they wish for.
By Ambrose Evans-Pritchard
The Telegraph, 20 Jun 2010
Global markets are braced for a possible sell-off in US Treasury bonds after China said over the weekend that it will allow the yuan exchange rate to adjust against the dollar, ending a two-year currency freeze that has led to trade clashes with Washington and Brussels.
China's Central Bank said the economic recovery had opened the way for a return to "flexibility" but ruled out an immediate one-off rise in the yuan. The currency will be allowed to fluctuate within a widened band of 0.5pc each day against a basket of currencies.
The yuan is now expected to rise slowly against the dollar, although it may fall if the euro weakens further. "There is at present no basis for major fluctuation or change in the exchange rate," said the bank.
The policy shift is a goodwill gesture towards the US and Europe before next week's G20 meeting in Canada as a rising yuan helps Western industries compete against Chinese imports. US Treasury Secretary Tim Geithner welcomed the step but said "the test will be how far and how fast they let the currency appreciate."
For a long time now, Washington has been labeling China a wicked “currency manipulator,” and forecasters have followed with regular predictions that this will be the year that Beijing finally ends its peg and allows the yuan to float upwards. It's apparently now happening, and Washington is excited about the prospect of getting its turn at having a relatively weak currency and expects that such a move will rescue American manufacturers and exporters.
As the theory goes, if a country’s currency is just weak enough, then its products will be relatively cheap, and the country will gain a comparative advantage. (Rarely mentioned is the implication that prudent savers will be destroyed.)
But in the typical Washington-Keynesian fashion, the critics of “currency manipulation” have it all backwards and mistake an effect for a cause. A country has a strong currency because its government doesn’t debase it and the world wants to buy its products. A country has a weak one for the opposite reasons.
Sure, when a country’s products (and thus its currency) are in demand, other countries have an opportunity to undersell it (the same, of course, happens in private business). Such a process is natural and mutually beneficial when it occurs through market-equilibrium and the division of labor. Terrible distortions and wealth destruction occur, however, when this process is perverted by treasury and central bank officials who decide that inflation is the best way to boost exports.
When Washington claims that a weak dollar will help manufacturing, one should first ask why this hasn’t worked in the past. Under the Bush administration, the dollar declined against the Euro by some seven percent per year (!), and yet America’s trade deficits with Europe (most importantly, Germany) only increased. Over the past 10 years, the Fed and Treasury essentially took the dollar out behind the woodshed and shot it -- the price of an ounce of gold increased by $1000 over that period (!) -- and yet trade imbalances continued to explode.
One should also ask who these American manufacturers are exactly who will benefit from the great debasement. Little industrial production remains in the country, and no new manufactures are going to want to set up shop in the U.S. and deal with its regulations, a pro-union administration, and a coming cap-and-trade policy.
And there is another factor to all this. Comparisons are often made between the average Chinese worker -- who saves 40 percent of his income and lives in Spartan austerity -- and the average American one -- who indulges in cheap credit, HD TVs and McMansions with marble counter tops. The asymmetry has much to do with laudable Chinese diligence -- and a vulgar American sense of entitlement -- but it is also related to the simple fact that, because Beijing suppresses its currency, its people can’t buy the stuff they make. (This is yet one more inconvenient consequence of debasement that Geithner & co. might want to consider.)
If the yuan goes up, this will all change. The “decoupling thesis” (which is probably overdone at this moment) is based on the notion that in the future, the Chinese will stop sending their products to America -- and financing the consumption of them to boot -- and instead start enjoying the fruits of their labor. America, on the other hand, seems to be headed towards a state in which it lacks both manufacturing capacity as well as the wealth to consume anything.
When China allowed the yuan to rise in July 2005 the move triggered a slide in US Treasury bonds, with knock-on effects on US mortgage and corporate debt. Investors will be watching closely to gauge response to sales of $108bn of US notes this week.
China has become the biggest force in global bond markets with holdings of $900bn (£600bn) of US government debt. Yuan revaluation is likely to dampen China's export growth and slow the pace of reserve accumulation, reducing the need to recycle money into foreign bonds. Hans Redeker of BNP Paribas said a rising yuan may have the effect of draining liquidity from global asset markets.
One of the usually Kudlow-Cramer-Panglossian responses to America’s massive trade deficits is to say that all the dollars that go overseas to purchase Chinese goods are reinvested back in America in the form of capital inflows and Treasury bond purchases. This is true. However, such commentators -- most of whom are now praising the end of "manipulation" -- fail to grasp that the “Chimerica” arrangement will come to an abrupt end the moment Beijing removes its currency peg.
Pegging the yuan to the dollar always meant "suppression,” that is, inflation at the same rate as the greenback. This was accomplished, to a large extent, by Beijing’s purchase of treasury bills with yuan. The currency peg was, in this way, the origin of Beijing’s holding of close to a trillion in U.S. debt.
Can it be that Geithner, Bernanke & co. don’t recognize that in demanding an end to Chinese currency manipulation, they are risking the financing of the federal government?
The first day's comments to this piece were uniformly excellent, and so I've decided to go into a few issues raised in this update.
1) When we speak of “inflation,” we’re really referring to a number of different variables that need to be isolated. (And rising prices on retail items -- the man-on-the-street definition of “inflation” -- is a secondary factor.)
- In predicting “deflation” in 2007 and 2008, what MISH, and Robert Prechter and a few others, correctly identified was massive credit contraction: that is, loans being recalled, or not given at all, defaults, bankruptcies, etc. This is still happening, and since credit is money (when you get a loan from a bank, you’re going to spend it), many price levels have fallen.
- But then there’s monetary inflation -- the creation of paper and digital currency -- and that’s something all together different. It's self-evident that the Fed's buying of toxic assets and intervention in the mortgage markets -- or Bernanke's fantasy of dropping dollar bills out of helicopters -- will debase the value of the dollar and eventually cause prices to rise, as all of these things amount to creating new dollars out of thin air.
Again, credit contraction and monetary expansion are two different, and sometimes countervailing, forces; the credit-expansion “inflation” occurs in the roaring boom years; the monetary-expansion “inflation” usually comes as a last ditch efforts by the government to reinflate the popped bubble. At the moment, credit contraction is offsetting the monetary expansion. But monetary expansion is ultimately the more powerful phenomenon, and I imagine that at some point we’ll experience it taking over. And this won't be pretty...
It’s worth pointing out that instances of hyperinflation have never coincided with the boom years of credit expansion. They've instead occurred during sever economic breakdowns and instances when people have lost all confidence in the government, the banks, and the currency (think Weimar or contemporary Iceland or Zimbabwe). People want to get rid of bad money as quickly as possible -- they'll buy anything, food, gold, stocks -- just so long as they don't hold onto rotting paper or digits.
Apropos China, we should remember that this kind of inflation can also have political causes… Imagine Washington clashing with Beijing over, say, an Israeli attack on Iran. Beijing might dump the dollar over night and create a catastrophe in the U.S.
2) JKR makes a provocative suggestion -- that a de-pegged yuan might actually fall relative to the dollar (!). I must say that I’ve never even considered this possibility (which doesn’t mean that it’s wrong, of course), and it’s been boggling my mind for about an hour now…
The reasons why I never considered this are two: 1) China has been suppressing the yuan -- i.e. keeping it from going up -- since the peg began; 2) this would go against the intentions of those who support the depeg option, all of whom (I think, at least) expect the dollar to become cheap and the yuan, dear.
This hypothetical dollar-up/yuan-down situation might occur if there’s a precipitous crash in, say, foreign stock markets, and, just as in 2008, everyone jumps into the dollar. Then again, one can imagine an analogous situation that argues against the idea of the yuan falling: if -- or rather when -- China’s real estate and stock bubbles burst, demand for the yuan, even if its only domestic, might send it soaring in value.