China and the 'Cheap Yuan' Myth
"The sole use of money is to circulate consumable goods." Adam Smith, The Wealth of Nations, p. 370
A recent Wall Street Journal headline told the tale of what passes for "knowledgeable" commentary when it comes to China and its currency policy. The headline was "Zoellick Sees Yuan Too Low", the Zoellick in this case Robert Zoellick, President of the World Bank.
Zoellick can of course claim a lot of establishment compatriots when it comes to his views on the yuan, including Treasury Secretary Tim Geithner, and the editorial board at the Financial Times. Fearful that the value of China's currency is driving what are mythical "global imbalances", the FT's editorialists recently decried China's "mercantilist policy" that works "by subsidizing foreign consumers who buy Chinese goods." Horrors!
In truth, Zoellick, Geithner, the Financial Times, and the rest of the economic commentariat who decry the "cheap" yuan reveal a shocking misunderstanding of what capital actually is, the purpose of currencies, and how free exchange really works. Sadly for China and the rest of the world economy, we all stand to suffer their false notions about money.
To see why, it's important to cover the basics. First off, capital is decidedly not money, and money is not wealth.
Instead, capital solely constitutes access to the human and physical inputs which enable producers to innovate or create. Money's role concerning capital is that it provides producers with a measuring stick of sorts so that they can assign a value to the human and physical inputs they're accessing. Money isn't wealth, it can't be eaten or open up foreign markets, it's quite simply the best way to measure the true wealth that producers and investors exchange.
Much as a homebuilder is able to build houses thanks to the foot always being 12 inches, producers are most able to rationally invest in the growth of their businesses when the dollar, euro, yen or yuan are unchanging in value. That's why gold was for so long used to define currencies, because gold is historically so stable in real terms. When we see the price of gold change, we're not seeing the price of the yellow metal moving up or down as much as we're seeing the currency in which it's priced vary in value. That's an important distinction.
And just as stable money values provide producers with the measuring rod most conducive to rational investment decisions, so does stable money foster the most amount of trade. Indeed, when individuals exchange goods they're not exchanging money so much as they're trading products for products; money ideally the stable "ruler" which allows the baker to assign a value to the bread he's exchanging for the vintner's wine. When money values are stable, long-term contracts can be entered into more readily because each side knows the value of that which will be received in the trade will not vary over long timeframes.
Moving to currencies themselves, contrary to the modern view suggesting that they should rise and fall based on a country's underlying economic outlook, for the above reasons it becomes apparent that this widely held supposition is false. Currencies are not commodities, instead they're merely concepts along the lines of an inch being an inch. If managed properly, their value once again shouldn't change.
To see why, we have to remember that the debtor/creditor relationship underlies all economic activity. Entrepreneurs can't innovate without credit, and if money values float, credit is either hard to find, or it's not worth accessing.
The reason for this is basic. When money is devalued, as in when we inflate, the creditor necessarily loses out for dollars, euros, yen or yuan being paid back that are worth less than those lent out. Conversely, if money moves upward in value, the entrepreneur is by definition not just paying principle plus interest, he's also paying back money more expensive than that which he borrowed.
Money must be stable so that producers can produce, and lenders to that production can lend without monetary distortions. Applied to China or any country for that matter, money of indeterminate value would and does retard the natural process that leads to economic growth for the debtor/creditor relationship being violated.
Almost as problematic, when money prices fluctuate, so do the prices of investments and goods fluctuate. Considered in light of the last four decades in the U.S., it's no surprise that hard, unproductive assets such as gold and housing thrived in the weak-dollar ‘70s and the decade just passed, while equities of the technological variety did so well in the ‘80s and ‘90s.
Just as a floating "minute" or "foot" would make it more difficult for chefs to cook, and builders to build houses, monetary fluctuations confuse investors, producers and traders for distorting the nominal prices of all assets, particularly commodities. When money is cheap the unproductive and easily taxable assets of the earth win out over the assets and economy of the mind.
Implicit in the arguments made by Zoellick et al is that a weak currency aids a country's economic growth, which on its face is false. More realistically, when money is devalued investment flows into the proverbial ground, and away from the entrepreneur. Inflation is anti-growth.
Regarding China, it has no modern central banking history, and since it doesn't, its monetary authorities have done what numerous countries do around the world, which is to define the yuan in terms of dollar. This makes sense because in the $3.2 trillion currency market, the dollar is 90% of the time the unit of account on the other side of any currency trade. The dollar is the world's currency, which means many countries logically want to maintain a tight currency relationship with the dollar.
Looking at the yuan/dollar specifically, since the former is pegged to the latter, if the yuan is cheap then so must be the dollar. Of course since the yuan has risen over 20% against the dollar since July of 2005, if there's a cheap currency to speak of, it's the dollar. In that case, it's rarely mentioned how little the debased dollar has done for the U.S. economy this decade, but that's a subject for another opinion piece.
For now though, to put it very simply, the yuan is tied to the dollar and it is inexpensive because the dollar is. Simple as that. If the dollar were strong, so would the yuan be strong. Far from a currency manipulator, China's monetary authorities are merely mimicking U.S. manipulations of the greenback.
So despite currency weakness that no doubt weighs on economic growth in both China and the U.S., China's dollar peg is still in place owing to the sole reason that we have currencies to begin with: money is what allows us to most easily circulate goods. In that sense, the yuan's peg to the dollar has been a smashing success judging by a 446 percent increase in U.S. exports to China from 1999 to 2008 alongside a 312 percent increase of Chinese exports to the U.S. over the same period.
Dual currency stability is most useful for enabling trade, which is the lone reason we produce. And when currencies are stable in real terms - ideally measured in gold - the debtor/creditor relationship is elevated in concert with marginally more rational investment and trade decisions thanks to currency fluctuations not fostering "money illusion" such that bad decisions are camouflaged by changes in the money prices of certain goods.
In China's case, it could and probably should strengthen the yuan versus the dollar. Importantly, this decision should not be entered into based on the commonly held belief that the yuan is artificially cheap (remember, the yuan is defined in dollar terms) as much as China's monetary authorities should allow the country's currency to float upward in order to escape inflationary U.S. monetary policy.
Indeed, one reason Japan's economy didn't weaken as much as ours did in the ‘70s has to do with the fact that the Bank of Japan chose not to mimic our dollar devaluation. Great Britain of course did, and the ‘70s were a disastrous economic decade for our foremost ally.
Assuming a much stronger yuan, this would no doubt redound to China's economy, and it wouldn't crimp the ability of Chinese producers to export to the U.S. one iota. For evidence supporting this claim, we need only reference Japan once again. The yen has appreciated over 250% against the dollar since 1971, and in concert with the yen's rise, Japanese exports to the U.S. have skyrocketed. Yes, the yen was more expensive versus the dollar, but the cost of production in yen fell. Money is a veil.
There's no reason to assume things would be any different for Chinese producers. Money is of course nothing more than a measuring stick, or a "veil", and if the yuan were to strengthen, it would mean that the myriad imported inputs Chinese producers rely on to create exports would become a great deal cheaper in yuan terms, or the yuan would buy far more dollars that would buy more imported inputs. So while the yuan would be more expensive versus the dollar in a reflation scenario, it would take much less in the way of yuan for Chinese companies to produce exportable goods.
The above scenario reminds us that changes in the value of currencies do not change the real value of the goods in which they're priced. We once again trade products for products, so while a stronger yuan would make the dollar look even limper by comparison, prices would adjust to the changing currency values in such a way that the ability of Chinese producers to export wouldn't be compromised.
What would be compromised, however, is U.S. economic growth. Indeed, our jawboning of the Chinese signals that Treasury policy is in favor of a weak dollar, and as we continue to devalue, investment will continue to flow to other countries like China where inflation won't erode returns. To put it very simply, if you think we're weak relative to China now, you'll be shocked how weak we look if monetary authorities take the advice of Zoellick, Geithner, and the Financial Times.
Policy toward China today is sadly driven by a misunderstanding of the purpose of money. Neither a commodity nor wealth, money is insignificant excepting its seminal role in helping us to attach value to goods we want to exchange, and productive ideas we want to invest in.
Trade is solely about products, and money the lubricant. To ascribe to money greater, more magical powers as establishment thinkers do, is to retard its meaning on the way to devaluationist policy of the U.S. variety which weighs on our economy unlike any other policy in existence today.