By Karl Smith
I think genuine concerns about this issue are getting mixed up with traditional protectionist rhetoric and causing confusion.
Matthew Perry writes
Here are the details of that consensus, as I understand it:
1. China manipulates its currency by keeping the dollar overvalued and the yuan undervalued.
2. That currency manipulation gives China an economic advantage that harms the U.S.
3. The U.S. and other countries should individually or collectively take steps to persuade or force China to stop its manipulation.
4. Solutions to China’s currency manipulation range from direct legislation like the bill passed in the Senate that will impose stiff tariffs on Chinese goods if the Treasury finds evidence of currency manipulation, to other forms of indirect pressure on China to persuade it to stop manipulating its currency.
Let me break from that consensus and present an alternative position:
He goes on to point out that Chinese currency manipulation is an implicit subsidy on Chinese goods which benefits the consumers of those goods – Americans.
That is, of course correct.
However, I think the easiest way to see why currency manipulation is a problem is to first ignore the role of international trade and just think about what’s going on in the money markets.
China – for whatever reason – wants to raise the value of the US dollar.
Now, I think everyone intuits that if the Federal Reserve printed lots of money it would lower the value of the dollar. Conversely, if the Federal Reserve contracted the money supply it would raise the value of the dollar.
So, if China wants to raise the value of the dollar it needs to effectively destroy lots of dollars.
How would it accomplish this?
It would print a lot Yuan. Then use those Yuan to buy dollars. Then take those dollars and buy US Treasury Bills.
When China buys lots of T-Bills that will tend to lower the interest rate on T-Bills. In response US banks will sell T-Bills and lend the proceeds in the Federal Funds Market. This will tend to lower the Federal Funds rate.
However, the Federal Funds rate is targeted by the US Federal Reserve. As it begins to fall the Federal Reserve will contract the money supply in order to drive up the Federal Funds rate.
Thus China has accomplished its goal of contracting the US money supply and driving up the value of the dollar.
However, this contraction of the money supply causes an economic contraction within the United States.
In normal times the Federal Reserve would observe falling prices and increasing unemployment as a result of these actions and so it would simply lower its interest rate target.
This would result in an expansion of the US money supply and an increase in US output. The result would be that China has shifted the mix of US production away from tradable goods and towards structures.
In effect China is performing what Austrian Business Cycle theorists predict would be the result of “artificially” increasing US savings. This shouldn’t be that odd to ABCT because if the US Central Bank can disrupt the allocation of resources in the US, shouldn’t the Chinese Central Bank also be able to do this if it trades in USD.
Mainstream economics would say that we don’t really have much of a problem here though as the US economy would simply adjust. The problem comes when there is a shock like the US subprime bust.
In response the Fed pushes rates to zero but it can’t go any lower. However, the Chinese government is still contracting the US money supply. The Federal Reserve cannot easily offset this because interest rates are already zero.
So Chinese currency manipulation contracts the US economy.
Notice we haven’t said anything at all about trade flows. We are solely talking about what happens to the monetary economy.
That’s because this would hold even if the US was running a trade surplus. Its just that to make the balances settle the dollar would rise and the US trade surplus would shrink, rather than the trade deficit rising which is what we have today.
It also doesn’t actually matter what the balance of trade is with China. The effects of the manipulation will manifest themselves among some trading relationship.
It could be that the US and China had no bilateral trade at all. However, Chinese manipulation made Chinese products in Brazil less expensive relative to American products. The same effect would occur.
That’s because it’s the manipulation, not the trade that matters.