Trade With China Explains Dollar Weakness

As the dollar falls against the euro, yen and other major currencies, China and other emerging economic powers holding lots of dollars and U.S. securities are crying foul, and for an end to the dollar's central status in global commerce.

If they are truly disgusted, they should look to themselves for answers.

Since the end of World War II, the dollar has largely replaced gold as the reserve asset central banks hold to back up national currencies. The supply of mineable gold is too limited, and efforts to back up currency with gold would result in chronic shortages of liquidity and global deflation.

When a merchant moves goods, for example, from Thailand to Mexico, the market for pesos into bahts is thin or nonexistent, and the merchant sells pesos for dollars to buy bahts. Similarly, many other cross-boarder trades, financial contracts and debts are denominated in dollars, although the euro is coming into greater use.

Over the years, governments and traders gravitated to the dollar, because the United States has the largest and most diversified economy. Virtually anything made or grown around the world is made or traded in the United States, and money invested in dollars is secure from political upheaval and state confiscation.

Until recently, the dollar has been a well managed currency. The U.S. government resisted the temptation to borrow too much and flood the world with too many dollars and Treasury securities, which provide liquidity the same as do dollars.

The current market determined system of exchange rates emerged by default in the early 1970s, when the Bretton Woods system of government-enforced fixed exchange rates failed, and the United States ended the convertibility of the dollar into gold.

This system has no rules or effective governing structure. Consequently, some governments seized opportunities to manipulate the system to gain competitive advantages in trade. For example, since 1995 China has maintained an undervalued currency by selling huge amounts of yuan for dollars to merchants and currency traders.

The undervalued yuan makes Chinese exports artificially cheap and foreign products too expensive in Chinese markets. China enjoys huge trade surpluses that create millions of jobs and double-digit growth in China. Japan and others have pursued similar strategies.

These policies impose huge trade deficits and unemployment on the United States, create enormous imbalances in the global economy, and contribute importantly to the Great Recession.

The U.S. trade deficit grew from about one percent of GDP in 2001 to more than five percent from 2005 to 2008, and this should have created a shortage of demand for U.S. goods and services and a recession.

However, China invested the dollars obtained suppressing the value of the yuan to purchase U.S. securities. U.S. consumers borrowed those dollars, against their homes and on credit cards, and kept the U.S. economy going.

Finally, the credit bubble burst and an even bigger recession resulted. Huge federal borrowing is now required to finance massive U.S. stimulus spending, bailout banks and otherwise rescue the U.S. economy.

All this borrowing floods capital markets with Treasury securities, which provide the same liquidity as dollars, and pushes down exchange rates for the dollar against every major currency except the Chinese yuan. This reduces the value of the dollars, as expressed in euro and yen, held by China, Russia, Saudi Arabia and others.

Hoisted on the consequences of their own mercantilism, China and others would like to see the dollar replaced by a basket of currencies.

A global currency poses enormous diplomatic and technical challenges, including creating an international body to control its supply and persuading governments to issue debt denominated in this global currency. Without those, private merchants and financiers would still seek a central national currency to facilitate trade and denominate private cross-border contracts and debts.

Even with a global currency, China could still buy dollars with yuan to keep its value suppressed against the dollar and boost exports into the United States. The United States would still have to run large federal deficits to avoid economic meltdown.

China would still be stuck holding dollars that chronically fall in value against other currencies.

If China and others want that problem fixed, they need to abandon currency manipulation and let their populations purchase more U.S. goods and services.

The U.S. economy would grow robustly, federal borrowing would subside and the threat of too many dollars compromising the dollar's role in international finance would vanish.