This article explains the real story behind the commonly espoused explanations regarding the taming of China’s inflation. It also breaks down many of the peripheral issues on the topic that are regularly discussed in the press, and exposes the false theories associated with these issues.

Currencies and Prices

In explaining how a rising currency will help tame inflation, most pundits relay that revaluing a currency to a higher price will cause import prices to be cheaper, thereby lowering domestic prices. For example, Credit Agricole CIB economist Dariusz Kowalczyk stated:

“Policymakers have sent a clear message that currency appreciation will be used as a tool to counter imported inflation [due to near-record global prices for oil and other commodities].”

Similarly, Bloomberg News reported…

“Chinese officials may also seek to speed up gains in the currency, also known as the renminbi, to fight inflation, lowering the cost of imported U.S. goods such as Boeing Co. aircraft and Microsoft Corp. software.”

The truth is that there is no such thing as importing or exporting inflation, because each country or currency area has its own individual currency, which is separate from another region’s currency. Prices within a particular currency area can rise only when that particular currency is inflated. (A rare exception is when other currencies also circulate within the same currency area, and an increase in the quantity of the other currencies causes prices to rise in that currency. But even in this case, the depreciating currency will likely soon stop circulating, as it will be shunned for the stronger currency.)

But currency changes can indeed affect prices by way of changes in the supply of goods. A country whose currency is artificially undervalued — such as China — will artificially export more and import less. If the currency is allowed to rise toward the market exchange rate, it will begin to export less and import more.

All else being equal, a higher-priced currency will indeed result in a lowered price of imported goods. When imported goods cost less, consumers have more money to spend on domestic goods; purchasing power increases. Or if the amount saved from spending less on imports is spent on acquiring greater amounts of the imported goods, there will be less demand for domestic goods, causing domestic prices to be lower. In either case, what has lowered prices is a stronger currency.

The previous explanation applies only to cases where “all else remains equal.” But a currency that rises with all else remaining equal is one that was previously artificially weak, for the purpose of exporting as much as possible and is, thus, being revalued by the marketplace to its true market price. Otherwise, excluding short-term fluctuations, one currency moves against another because of changes in the relative supply of currency units, and corresponding changes in relative consumer prices between the two currency regions in question. Currency movements absent these fundamental changes are due to government manipulation of the currencies.

The flip side of the rise in the price and purchasing power of a currency is that goods in that currency are then more expensive in terms of foreign currencies, resulting in fewer goods exported. Exporting less is economically beneficial, as it leaves more goods remaining inside the country, increasing the supply and lowering the price of domestic goods.

Therefore, it would seem that higher-priced currencies are better, since they result in cheaper imports and lower domestic prices. But if the currency is too expensive and artificially overvalued, fewer goods are exported, causing less foreign exchange to enter the country. An artificially high currency will, eventually, cause the country to run out of foreign exchange. This, and goods too expensive from the view of other countries, will cause trade to cease, resulting in lower standards of living.

The essence of the trade-off is that a country can have a weak currency and increase exports so as to obtain more foreign currency, or it can have a strong currency and increase imports so as to obtain more goods.

So what is the optimal level of a currency’s price? Does a country want a stronger currency or a weaker one? Does it want more cash or more goods? The fact is that a country is not an “it.” A country consists of millions or tens of millions of individuals, each having different goals and different valuations. Government bureaucrats cannot set an ideal currency price that is optimal for everyone. Thus, the only optimal currency price is that which is set by all market participants jointly, by way of their supplying and demanding both goods and currency based on their needs and desires.

And in reality, the optimal currency price they, the market, will settle on will be the price that, adjusting for transportation costs, causes domestic prices of internationally traded goods to approximate the price of those same goods in other countries. In other words, they will make relative prices equilibrate across countries, just as individuals do within a country. Otherwise, arbitrage opportunities would exist, and the result would be a leveling of relative prices and real currency valuations. That optimal currency price will also result in the country exporting about the same amount as it imports; the balance of payments will tend toward zero. Trade surpluses and deficits derive from mispriced currencies arising from government manipulation.

The Real Relation Between China’s Rising Currency and Inflation

A manipulated currency can cause domestic prices to be artificially higher or lower than they would otherwise be, but it cannot cause prices to rise on a sustained basis; it cannot cause price inflation. Aside from rising prices due to a continual reduction of goods produced and existing in a country, the only thing that can cause price inflation is that country’s expansion of the money supply, which results in increases in demand. Aggregate prices rise only with reduced supply or increased (monetary) demand. Thus, contrary to the popular perception displayed in the quotes above, China’s re-pricing of its currency — alone — will not reduce price inflation.

[Ed note: Our currency expert, Abe Kaufman, weighs in with his insight on the Chinese/U.S. currency war discussion.

"We need China to keep buying our bonds, so politically, it's really risky to escalate the tensions. Still, the uncertainty regarding China -- whether we have a trade war or not -- will cause sentiment swings in the markets. Then add China's real problem…not the trade war, but whether China's economic slowdown will be controlled or severe. As fears ebb and flow, we could see the effects in several currencies, such as the Australian dollar, the Brazilian real and more.

"Luckily, all that volatility is the perfect environment for the sphere I operate inside -- a relatively new way to play currency moves easily and inexpensively.

"Unlike the mainstream currency markets, this new market gives you a chance to turn 2% moves in currencies into potential 150% gains in less than a week. And as China worries continue, we could continue seeing those kinds of gains again and again."

Check out Abe's most recent report here.]

What will reduce China’s price inflation is ceasing the activity that is holding its currency artificially low: money printing. As Figure 1 shows, it is doing just that.

In general, China can keep its exchange rate even with the dollar only by creating new money at as fast of a rate as the Federal Reserve creates dollars. In addition to the rate of creation of one currency versus another, the amount of currency actually on the market available for exchange makes a difference as well. In this respect, China reinvests the dollar reserves it obtains from its trade surplus — which come about from an artificially low yuan and an artificially high dollar — into U.S. Treasuries, instead of selling them in the foreign exchange market, so as to prevent the dollar from falling (and yuan rising) from the increased supply.

But additionally, in order to keep the yuan artificially lower against the dollar than it would otherwise be — given the market supply and demand for each currency — the Chinese central bank, the Peoples Bank of China (PBOC), actively buys dollars and sells yuan in the marketplace. It pays for the dollars by creating yuan with which to buy them.

When the PBOC creates yuan, it expands the money supply. It is, therefore, this expansion in the money supply, not an artificially low currency per se, that is creating price inflation in China.

Exchange Rate vs. Money Supply as the True Cause of Inflation

When one has knowledge of the true nature of China’s currency and inflation situation, it can be very frustrating to hear mainstream economists focus on the currency as a cause and solution for inflation, instead of focusing on the originating cause of money creation. Even the World Bank misstates the problem:

“‘Strengthening the exchange rate can help reduce inflationary pressures and rebalance the economy,’ the World Bank said in its latest quarterly update on the world’s third-largest economy.”

But to its credit, it also separately said:

“Inflation expectations can be contained by a tighter monetary policy stance and a stronger exchange rate.”

While the comment is still vague in terms of giving the real link between monetary policy and the exchange rate, it at least notes the monetary-policy issue.

Regards,

Kel Kelly

The China Bust: Tic Toc Part I was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

By 1930, China and Mexico were the two notable countries that still employed a silver standard. (There is a long history of silver standards. The pound sterling is one legacy. By the late 19th century, though, most countries had attached themselves to the gold standard.) Silver traded more like a commodity than it might have if it still circulated as money. In step with most raw materials, the price of silver fell 52% between 1928-1932.

That was an unpleasant period in the United States, but not so much in China. This is a relative comparison. China had not escaped the worldwide Depression. Between the high of 1929 and September 1931, wholesale prices had fallen 29.5% in the U.S., roughly the same across Europe, but only 20% in China. In the words of Roy Jastram, author of Silver: The Restless Metal: “The Senate Foreign Relations Committee wanted to raise the price of silver so that China could buy foreign goods.” The motivation is no different today. Substitute “Senate Finance Committee” and the match today is exact.

A higher silver price — in theory — would increase the Chinese capacity to buy more American goods and pull the U.S. out of the Depression. Economists buttressed the politicians’ yearnings. John Maynard Keynes wrote a letter to a House of Representatives’ committee. Keynes believed there “was good reason to suppose that higher silver prices would boost Chinese imports and diminish exports by raising costs of production in world terms. This would cause China to stop buying silver and to export it instead, to make up for her unfavorable balance of trade.”

The reader of Jastram’s history can almost feel the good professor’s blood boiling at this hallucination: “What China really needed was a stabilized price of silver, because rapidly fluctuating exchange rates could do real harm. Predictability of exchange rates was what the businessman needed. The prospect of silver prices rising arbitrarily at the hands of the United States meant further instability — the last thing the commercial world needed to add to its internal turmoil from war, flood, and famine.”

“War, flood, and famine” ravaged China for a quarter century or more, culminating in the Communist Party’s acquisition of national control in 1949. It is true the post-1928 slide allowed the Chinese to buy silver cheaply, thus, in greater quantities. In professor Jastram’s words: “[China] could then apply [the greater quantity of silver] to her purchase of other goods and commodities. As a nation with an unfavorable balance of trade, mainly due to internal catastrophes, a low price of silver was important to her.” A low price of silver was exactly what the United States would banish. (Under a silver standard, China’s business expanded with a greater quantity of silver reserves. Today, we have elevated the Fed to a godlike status since the means of expanding business is to print more dollars, which become bank reserves. Godlike figures always crash and burn, but that is another story.)

This analysis describes only the public debate and, regrettably, the more high-minded motivations. The man most responsible for currency manipulation was Sen. Key Pittman of Nevada. He was not in the least bit interested in the China trade but had long been an advocate of higher silver prices. Lyric Hale, CEO and publisher of the indispensable China Online, describes the motivations of the peoples’ representative thusly: “Sen. Key Pittman of Nevada supported a bill to require the U.S. Treasury to purchase silver, in order to raise prices and ‘do something’ for the silver industry. Need I mention that Sen. Pittman was a major investor in silver mines? By 1934, he got his way, since FDR needed votes for his New Deal.”

Pittman rode the fiat train as it gathered steam. (He had played an instrumental role in the decision to sell silver reserves on the open market and to replace them with Federal Reserve Notes during World War I.) In the confusion following the passage of the Gold Reserve Act in 1934 (which transferred title of gold from the Federal Reserve to the United States government) and the frantic pace of New Deal legislation, Pittman was able to remonetize silver, in a manner of speaking. His attachment to Roosevelt’s Agricultural Adjustment Act (under the Thomas Amendment) required the U.S. government to buy silver on the world market until the price reached one-sixteenth that of gold: $1.29 per ounce. This was more than double the world’s market price. In Charles Kindleberger’s estimation, “Silver purchases abroad provide a brilliant example of world economic irresponsibility on the part of the United States.”

Kindleberger continues: “[The silver program] represented a beggar-thy-neighbor policy, where the hurt to the neighbor was wanton and provided no domestic economic and little political benefit.” It also ignored reality. American trade with China was the best thing going. Between 1930-1931, when the silver price declined 25%, the United States increased its exports to China by 1.2%, a period when American trade with all other countries fell by 38%. But Washington operated under a veil of ignorance. After driving up the price of silver, American exports to China collapsed.

The Chinese minister of finance, T.V. Soong, warned the rising prices of silver drained China of money. (There is no funny-money paper printing with a metal standard. The silver is either there or not. If the money has been sold and left the country, it simply does not exist. Borrowing contracts. Then, business and jobs contract.) Soong’s sober warning went unheeded. Jastram laments, “It is sad to be reminded of popular American comments at the time. These seldom went beyond reiterating the conviction that doubling the world price of silver would double the exchange value of China’s stocks of silver and thereby allow her to buy the United States out of the Depression. What it did was to drag China in…” The American-led program of purchasing silver (other countries bought upon American insistence) “added the final destructive touch in 1933…It could not have made the Chinese feel any happier to hear the American proposals advanced as a means of saving [China].” Following the 1934 Thomas Amendment, when the Mexicans and Chinese pleaded for relief, Secretary of the Treasury Henry Morgenthau reacted much as the bombastic political class today: He blamed the Mexicans and Chinese for creating difficulties. For good measure, Morgenthau cast doubt on their “standards of personal and public morality.”

By the latter half of 1934, “Depression in China deepened as [silver appreciated] with American buying. Dislocation became severe with the great drain of silver from the country. This forced a contraction of credit leading to business failures everywhere, including some major banks.” Unlike the U.S., China did not have a Federal Reserve System. It was a hard-money country. When bank reserves fell, and without the stimulus of fiat money printing, banks failed. (These explanations of the different money systems may look repetitive, but we are so far removed from a hard-money standard today, the redundancy may be useful.)

Silver continued to flee China since Pittman’s handiwork bid prices above what the production from his Nevada silver mines would have earned, if not for mindless government buying. (Corn and ethanol might be a current parallel.) In Jastram’s eulogy: “In [October] 1934, a record volume of silver left China in legal form. In an attempt to stem this vital outflow, a heavy export tax was put on the metal.”

Order was disintegrating. Mao’s Long March started the same month. Japan was encircling China. The Chinese people were starving to death. “At the close of October in 1935, the Chinese had reached their limit of patience — even endurance. They proposed the sale of a huge amount of silver in preparation for putting their money on a paper basis. On Nov. 3 they nationalized all domestic silver and ordered it exchanged for paper notes. China was the last major nation to abandon the silver standard.” In Lyric Hale’s words, “China was truly an accidental communist county.”

In a sad re-enactment, the U.S. Senate drafted legislation in July 2007 to “boost pressure on China to let its currency rise in value.” If passed, this will include heavy tariffs on imported goods. Wal-Mart shoppers may be surprised to see prices rise 30%. In a sad recreation of Morgenthau, current U.S. Treasury Secretary Henry Paulson flew to China the following week “to warn top Chinese leaders that Congress will move ahead with legislation unless the yuan appreciates in value.” Paulson’s mind seems to be a muddle. When he departed on an April trip to Beijing: “U.S. Treasury Secretary Henry Paulson said…he is ‘a big believer in a strong dollar,’ but reiterated that China’s currency needs to appreciate more against the greenback. ‘As I think you know, I believe very strongly that a strong dollar is in our nation’s interest, and I’m a big believer in currencies being set in a competitive, open marketplace.’” The Chinese negotiators may be left asking themselves, “If the head money-changer from Goldman Sachs thinks you can appreciate and depreciate a currency at the same time, what do Americans want?”

It only grows less comprehensible. The politicians want to devalue the dollar, yet it is on the verge of a collapse. In such circumstances it is a noble sentiment of presidential candidate Hillary Clinton to campaign for a bulletproof dollar. According to The Daily Telegraph: “[She] has called for restrictive legislation to prevent America being ‘held hostage to economic decisions being made in Beijing, Shanghai, or Tokyo.’ She said foreign control of over 44% of the U.S. national debt had left America acutely vulnerable.” The second sentence is true; the first sentence is preposterous. A practical application of Clinton’s proposal might ban the Chinese from buying American securities or demand all Americans pay off their mortgages immediately (thus retiring the billions of dollars worth of American mortgages the Chinese government was kind enough to mop up.)

The Communist Party of China has enough domestic woes of its own without this nonsensical blustering: The fragility of the Chinese banking system is comparable to that of 1934; the millions of unemployed Chinese might whip up their own Long March. Perhaps this is why the authorities issued their “nuclear option” on Aug. 8, 2007. He Fan, a government official, reminded the world’s greatest spendthrift to bother someone else: “China has accumulated a large sum of U.S. dollars. Such a big sum, of which a considerable portion is in U.S. Treasury bonds, contributes a great deal to maintaining the position of the dollar as a reserve currency…China is unlikely to [sell dollars] as long as the yuan’s exchange rate is stable against the dollar.” If not, “The Chinese central bank will be forced to sell dollars once the yuan appreciates dramatically, which might lead to a mass depreciation of the dollar.”

In response, Sen. Graham warned the Chinese “to work with us to achieve meaningful currency reform, rather than issuing draconian threats. Congress has been incredibly patient on this issue, and the consequences of inaction without real reform are too great to many sectors of our economy.” This is populist rambling with no substance. Just how would the U.S. close the trade gap if the dollar were devalued by 30-50%? Ship 200 tons of socks to Shanghai Harbor?

In the wake of Graham’s warning, President Bush told the Chinese they would be “foolhardy” to sell U.S. dollars. Hank Paulson told CNBC such action by China would be “absurd.” Possibly so, but the debtor is not in a position for its head of state and chief currency negotiator to mock its primary dealer. Even the most arrogant, highly leveraged, insolvent hedge fund manager knows that. Well, maybe not.

Samuel Johnson best described the past 75 years of nonsense: “Knowledge without integrity is dangerous and dreadful.”

Regards,
Fred Sheehan

August 15, 2007

America’s Beggar-Thy-Neighbor Policy was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.