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.

Mr. Obama fired the opening salvo last week, urging Chinese Premier Wen Jiabao “to speed up the revaluation of the yuan, telling him in a two-hour meeting at the United Nations that the slow pace of reforms was affecting both global and U.S. economies.”

I’m going to give you a lot of quotes in this article because they are simply too hilarious to pass up. According to CNNMoney, “Lawmakers say China’s currency is unfairly cheap and passed a measure Wednesday that opens the door to tariffs that aim to help U.S. companies compete. The legislation, which authorizes the Commerce Department to impose duties on imports from countries with undervalued currencies, passed the House of Representatives by a vote of 348 to 79. The Senate, however, is not expected to take up the issue until later this year.” The article continues with a jibe at Republicans: “The bill got support from both sides of the aisle, a rarity in recent sessions, with Democrats framing the legislation as a jobs issue,” and follows immediately with a magnificent bit of economic insight from Representative Xavier Becerra, Democrat, of California: “We can talk, or we can act. International trade is a high stakes, cut-throat business, and every time we simply talk, the other side acts, and every time they act, an American loses a job.” Perhaps he should simply stop talking?

Honestly, I had no idea how incredibly funny left wing fiscal policy can be. Consider this gem: “China said this year it would allow its currency, the yuan, to trade in a wider range against the dollar. But the currency has scarcely appreciated since then, inflaming critics who charge the undervalued yuan helps steal U.S. manufacturing jobs.” No explanation is given for how the Peterson Institute of International Economics came up with a figure of a 24% discrepancy in the relationship between the two currencies, but the gang on the Hill believes it. Funny me…I thought foreign exchange rates were set by a bidding process on the FOREX. If all we have to do is declare the value of our currencies, what’s the problem? A simple Congressional resolution would do it. “Resolved: henceforth the US$ shall trade against the yuan at a ratio of 3:1 instead of 4:1, Sincerely yours, Congress. P.S. We really mean it.”

Let’s make it even simpler: how many dollars does it take to buy a barrel of oil? How many yuan are required? That shows us the Arab world’s opinion on the relative values of the currencies, if no one wants to believe world currency exchange rates. Obama’s position is claiming “undervaluation” drives up the price of our goods in China and makes Chinese products cheaper in the USA than they would be if a “fair” exchange rate were used. Okay, back to my complex economic model, compare the price of any Chinese export to America and the same item sold in any two other countries chosen at random. Do the Chinese price items differently according to the market or the currency used? Could the same sum not buy an identical amount of the third parties’ currencies? If so, then, yeah, the Chinese are probably playing dirty pool and our choice is to stop buying from them. If not, then this is just another ploy to raise revenue and stand up nobly declaring Demmies are the “working man’s” friend. CNN proceeds to this gem: “The House vote caps years of frustration for lawmakers as the United States has continued to shed manufacturing jobs, and promises of reform from the Chinese have failed to result in policy changes.” Wait a moment…didn’t we just read that China promised this year to reevaluate? Has anyone other than the current crop of solons carped about this? Seems to us that Reagan, Bush, and Clinton were all in favor of increased trade with China. We’ve been working on this since the time of RMN. Other than one on one I simply do not see how China can change the perceptions of currency traders and foreign nations concerning the value of the yuan.

Here is a real prize from Tim Ryan, D-Ohio, demonstrating a terrific grasp of the politics of envy and pipe dreams: “If this risks upsetting the People’s Republic of China, so be it…Whether you’re a Democrat or a Republican, a liberal or a conservative — millions of good-paying jobs have been lost and hundreds of thousands of families across this country have suffered as a result of China’s unlawful trade policies.” No, Tim, we cannot risk upsetting China lightly, partially because we owe them three-quarters of a trillion dollars. Far more to the point, those millions of good-paying jobs were not stolen by China, they were driven out of America by increasing taxes, regulation, and legislation. The current economic mess stems from those and government interference in banking, devastating “green” demands, and Bernanke’s policies.

The Senate will not consider the issue until later in the year, which isn’t going to keep China from reacting quickly. That great economist, Charles Schumer, D-NY, pontificated, “We must take decisive action against China’s currency manipulation and other economically injurious behavior. (Ed. Note: unspecified) China is merely pretending to take significant steps on its currency,” Schumer said. “This sucker’s game is never going to stop unless we finally call their bluff.” In my experience, that is the sort of rhetoric heard on school grounds and probably between Crips and Bloods with vocabulary adjusted suitably to include “diss” and references to the opponents mothers. It is not the language of diplomacy or economics, but it is pre-election posturing. The proponents are hoping to make some money (the government keeps tariffs), but this is politics, not so pure, but simple. You have been told that you cannot judge a book by its cover, but in very large part you can make a quick decision on the advisability of any given bit of legislation by seeing who supports it. Don’t agree if the answer is “…trade groups and unions cheered the bill’s passage. AFL-CIO President Richard Trumka issued a statement of support and Scott Paul, the director of the Alliance for American Manufacturing echoed the message. “This is one of the most pleasantly lopsided trade votes in recent history,” Paul. “Voters are mad and Congress is finally responding.” I particularly like Mr. Paul’s statement. The Statists have finally figured out what the TEA Party is all about. Voters aren’t mad about runaway spending, higher taxes, higher costs of living, socialized medicine, and increasing regulation, by golly, we’re feeling menaced by the Yellow Peril, and it’s about time Congress did something about it. I feel that way every time I walk into my friendly “Everything $1.09″ store. Dirty bunch of commies, taking advantage of me that way.

I’ll close this preliminary discussion with another quote from the entrepreneur in the White House: “The reason I’m pushing China about their currency is because their currency is undervalued,” Mr Obama orated. “…people generally think they are managing their currency in a way that makes our goods more expensive to sell there and their goods cheaper to sell here.” He added, further, that “the resulting imbalance is a major factor contributing to the U.S. trade deficit.” I stopped at this point to take dear Charles to task, chastising him fiercely for having become a bore who drones on endlessly about how the Chinese are manipulating the currency exchange, threatening working class Americans, and destroying our way of life by offering four dollar bathrobes. Charles just grinned, of course, knowing full well that neither one of us had discussed China other than to speculate on the possibilities of collapsing bubbles and whiffs of rebellion in the air.

I’ve started with the light side because all of this is funny as indicative of what passes for thinking amongst Statists. Want more money? Pass another tax. Election prospects looking grim? Whip up the populace over an outside threat. Next time we’ll get into psychology and the real effects declaiming to the fans will have on the world you and I live in. They aren’t pretty, and it is a lot easier to start a war than it is to stop one. Mr. Obama is in dire need of a swift, victorious war, but this isn’t it.

It doesn’t help that China is overreacting, too, starting with accusing us already of “dumping product” on the Chinese market, in particular auto parts and chicken parts. I was under the impression that our primary poultry export to that portion of the world is the feet of chicken, which are considered a delicacy there and good for nothing other than grinding up for pet food after simmering to get a little coloring for chicken broth in the USA.

When the Chinese fling chicken feet on the table, I think they’re serious.

Regards,
Linda Brady Traynham
Whiskey & Gunpowder

October 6, 2010

P.S.: If you really can’t wait until next time and/or do not know why we do not wish to engage in trade wars, it seems to me that my discussion of the tire fiasco is archived under “Smoot Hawley Must Ride Again.” The reasons haven’t changed.

Asiatic Adventurism, Part I was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

The end of the long-standing United States policy of nonintervention in the currency markets.

America has declared war on the Chinese yuan. Depending on whether you go with the House or Senate figures, the yuan is undervalued by anywhere from 15% to more than 40%. That’s a pretty big spread. You’d think they would shore up that minor detail first before proceeding…

Instead, full of rhetoric, bolstered by the cries of the AFL-CIO, Congress put forth two Senate bills this summer, paving a new path to combat “currency manipulators.” Read: China, make your yuan appreciate faster.

The Senate Finance Committee gave its gung-ho approval of 20-1 on July 27. On Aug. 2, the Banking Committee seconded that with a hearty 17-4 in favor of a similar measure.

In a nutshell, Congress wants a stricter definition of currency manipulation. Then, it wants to be able to “punish” the manipulator with anti-dumping tariffs until it changes its tune. That’s the goal of the Fair Currency Act of 2007.

But this currency war is another war we’re unlikely to win.

You see, the earliest we could win this one is 2010. That’s how long it will take to get all the ducks in a row: the International Monetary Fund, the World Trade Organization, and the rest of the world.

By that time, we’ll have a new president. And a lot of manufacturing jobs will already have vanished. And in fact, if we do absolutely nothing and the yuan appreciates just 5% a year, we’ll already be up to 25% appreciation by 2010. So why all the bluster?

Maybe we should give Bush & Co. some credit. Here’s one conflict they’re willing to “talk out.”

Instead of legislation, the IMF, or the WTO, they’re putting the burden on Treasury Secretary Hank Paulson’s “strategic dialogue.” So far, that’s yielded a big fat “NO” from the People’s Bank of China about the yuan. But they did add a few airline routes and cut some export tax rebates.

And they promise more talk. Hank Paulson is forced to make America a two-faced Janus god of currency. Paulson “urges the Chinese President Hu Jintao and Vice Premier Wu Yi to allow the yuan to rise more quickly, arguing it would boost China’s stability and modernization.” Essentially, that’s like telling Bush to tell Bernanke what to do. And of course, it’s not as if Paulson gets to paint the U.S. as the poster child of stability and modernization, else we’d not be having this “strategic dialogue” in the first place.

But that’s not his concern… Hank is too busy telling China how he and President Bush are NOT behind the Congressional push to penalize China for its yuan management.

Surely, we should not expect China to take seriously this “house divided” method of currency critique. And just how long has this tomfoolery been going on?”

Shot off the Bow: the China Currency Coalition

Back before July 2005, the yuan was pegged to the dollar. In steps a business interest group called the China Currency Coalition. These concerned denizens of the trade union world filed a petition with the U.S. Treasury representative demanding an investigation of China. According to member and secretary-treasurer of the AFL-CIO Richard Trumka, here’s what happened:

“The Bush administration summarily rejected the petition within a few hours of its filing — apparently without taking the time to read the several hundred pages of analysis, documentation, statistics, and tables.”

Similar petitions were filed by Congress — and rejected.

Trumka goes on to say: “This administration makes me feel like Bill Murray in the movie Groundhog Day. We show how the Chinese government manipulates their currency. Over and over, they send back a procession of Treasury secretaries, undersecretaries, deputy secretaries, and the USTR to give speeches, issue press statements, and testify before Congress…”

The first time the yuan controversy graced your Whiskey’s pages was back in April 2005 . At that time, the bipartisan brotherhood against China, honorable Sens. Schumer and Graham, were spouting the virtues of a hefty 27.5% tariff on Chinese exports.

What do you know? These guys never expected it to pass. They just hoped it would be a loud trumpet call. Bush personally appealed for them to withdraw the bill, with a sort of wink. Try again next year. And try they have.

Smoot-Hawley Redux: China 01.01.2008

For a quick history review, let’s jump back to 1930. Sen. Reed Smoot and Rep. Willis Chatman Hawley birthed what became the highest tariff in U.S. history.

Historically, Republicans love a high tariff. And Smoot, from Utah, a beet sugar growing and wool producing state, was no exception. Over 1,000 economists petitioned President Hoover to say nay. (Just like today, when 1,028 economists signed an anti-protectionist petition over the China currency war.)

Yet Smoot-Hawley went off without a hitch. The maximum 53% tariff hit 900 manufactured items and 70 agricultural products. The result was so dastardly that even today’s State Department history page chalks it up as a failed enterprise.

Smoot-Hawley outraged foreign nations. Historian Richard Hofstadter labeled Smoot-Hawley "a virtual declaration of economic war on the rest of the world." It’s easy to see why.

In just two years time, 25 countries fought back by raising their duties, decimating U.S. foreign trade. America had exported $5.24 billion in goods in 1929. By 1932, the total was just $1.6 billion. Total global trade declined 66%.

Believe it or not, in the depths of the Depression, Smoot only argued that the tariffs were probably not high enough. In 1932, Hawley didn’t manage to get re-elected. Nor did Smoot, who was edged out by a Democrat. Yes, this was the high-water mark of U.S. protectionism.

So perhaps Congress is suffering from a bad case of amnesia… Thus, today’s Smoot-Hawley: the Fair Currency Act of 2007.

Handing Down Judgment From the Land of Deficit

In deconstructing the Senate bills that comprise this so-called Fair Currency Act, I was troubled by three things:

a) What right do we have to determine the true value of someone else’s currency?
b) With what mechanism can we enforce that right?
c) With what knowledge do we act to ensure the “right” outcome?

Here are the salient developments from Senate Committee bill S.1607:

It’s up to the secretary of the Treasury to identify these rouge currencies that are in “fundamental misalignment.” The identification checklist includes:

• A current account surplus (viz., trade surplus) compared with U.S. deficit
• Same outrageous surplus scenario with other trading partners
• Level of foreign direct investment
• Huge foreign currency reserves.

And there’s this gem of a clause: “Pursuing any other policy or action that, in the view of the secretary, warrants designation for priority action.”

Now of course, the objective methodology for computing this misalignment has actually yet to be established.

But the “punishment” will be adding a tariff on top of the export price — adjusting it to the “natural” price. But in order to get that process off the ground, the U.S. would have to get the IMF’s director on its side.

The director would have to establish that Article IV of the IMF Articles of Agreement was indeed violated. This means proving China is manipulating exchange rates to gain unfair advantage. Of course, that same Article IV also insists that members foster “a monetary system that does not tend to produce erratic disruptions” …this might impact the level of our own bargaining chips a bit, eh?

But going back to that checklist:

• Yes, China’s $233 billion trade surplus with the U.S. in 2006 was the biggest ever recorded with a single country (at least until this year)
• China’s surplus is rising against Europe and Japan, but it does have deficits with some countries, making the global surplus $177.5 billion last year
• China has focused its foreign direct investment on energy/raw materials…meaning it imports at internal production prices, rather than that of global demand
• China is sitting on $1.33 trillion greenbacks in currency reserves.

So OK, we have a currency manipulator, but what can we really do about it?

Forgive me for stopping, but let’s make this a double-barreled shot.

The reality of this yuan controversy is almost too laughable to press on without a pause for good reflection.

Catch you tomorrow, dear reader,
Samantha Buker

August 23, 2007

The Chinese-American Currency Wars of 2007-2010 was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.