Let's Ease Up On China About the Yuan

"A currency, to be perfect, should be absolutely invariable in value." David Ricardo, in Proposals for an Economical and Sound Currency, 1816, sec. ii.

A past Wall Street Journal headline tells the tale of what passes for acceptable commentary when it comes to China and its currency policy. The headline was "Zoellick Sees Yuan Too Low," the Zoellick in this case being 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 not long ago decried China's "mercantilist policy" that works "by subsidizing foreign consumers who buy Chinese goods."

In truth, Zoellick, Geithner, the Financial Times, and the rest of the economic commentariat who decry the "cheap" yuan reveal an impressive misunderstanding of what capital actually is, the purpose of currencies, and how free exchange really works. This form of economic illiteracy extends to the highest reaches of government. Larry Summers, for example, director of the National Economic Council in the White House, showed it when he explained to the Financial Times that "exchange rates ... are the relative price of domestic and foreign goods ..." Sadly for China and the rest of the world economy, we all stand to suffer from these false notions about money and price determination.

Capital, money and wealth. To see why, it's important to cover certain basics. First off, capital is decidedly not money, and money is not wealth.

Capital solely constitutes access to the human and physical inputs which enable producers to innovate or create. Money's role is to provide producers with a measuring stick with which they can assign a value to the human and physical inputs they're accessing. Money isn't wealth; it can't be eaten and it can't open up markets. It's quite simply the best benchmark for measuring the assets that producers and investors exchange.

Much as a homebuilder can rely on the foot always being 12 inches, producers are most able to invest rationally 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 a vital distinction so often missed by pundits.

And just as stable money provides producers with the measuring rod most conducive to rational investment decisions, so does stable money foster the highest volume of trade.

When individuals engage in trade the purpose is not to exchange money but to trade 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 currencies are stable, long-term contracts can be entered into more readily because each side knows that the value of that which will be received in the trade will not vary. When money changes unpredictably in value, the process of contracting is in effect converted into a form of gambling.

Currencies. The modern view is that currencies 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 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 as 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 principal plus interest, he's also paying back money more expensive than that which he borrowed.

Money must be stable so that producers can sell, and lenders can lend without price distortions. Applied to China, or any country for that matter, money of uncertain value would and does retard the natural process that leads to economic growth as the debtor/creditor relationship is violated.

Almost as problematic, when currencies fluctuate, so do the prices of investments and goods. Considered in light of the last four decades in the US, 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" would make it more difficult for chefs to cook, or a "floating foot" would make it more difficult for builders to build houses, currency fluctuations confuse investors, producers and traders. They distort 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. That on its face is false. More realistically, when money is devalued investment flows into the proverbial ground, and away from the entrepreneur. Inflation, put more simply, is anti-growth.

China's yuan/dollar policy. When a country pegs its currency to that of a historically more stable currency regime, far from currency manipulation, the country in question is moving one step short of currency union. Much as the EU member countries aren't charged with manipulation for adopting the euro, the Chinese monetary authorities shouldn't face criticism for seeking a closer monetary relationship with the United States.

China 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 something more credible. This makes sense because in the $3.2 trillion currency market, the dollar is still the world's currency. Ninety percent of the time the dollar is the unit of account on the other side of any currency trade. It's natural that many countries logically want to maintain a tight currency relationship with the dollar.

As past H.C. Wainwright Economics publications have argued, every sovereign country has the right - indeed the obligation to its own people - to aggressively seek currency stability. Along these lines, it should be said that pursuit of a floating currency value would constitute an absence of policy whereby money's sole purpose is compromised.

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 much damage the debased dollar has done to the US economy this decade. But that's been covered in myriad Wainwright Economics publications.

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 US manipulations of the greenback.

So despite currency weakness that no doubt weighs on economic growth in both China and the US, 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 US exports to China from 1999 to 2008 alongside a 312 percent increase of Chinese exports to the US 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. Currency fluctuations foster "money illusion" such that bad decisions are camouflaged by changes in the money prices of goods.

Perhaps most important of all, it can't be forgotten that as recently as the 1970s, China was seen by Washington as both a military and economic enemy. With its leaders presently seeking China's place in the world as a free market engine of growth, one that compliments our production here, we must ask how US efforts meant to destabilize a growing economic relationship aid either world peace or economic growth.

Considering the very real possibility that an undefined yuan could collapse in value, we must also ask ourselves how a Chinese government might respond both militarily and economically to a currency crisis created by us. The situation we're dealing with is potentially combustible given the unrest that can result from currency uncertainty, and sadly it is the US monetary authorities who are presently holding the lit match.

For its own sake China should strengthen the yuan. China could and probably should strengthen the yuan versus the dollar. But this decision should not be entered into based on the commonly held belief that the yuan is artificially cheap. China's monetary authorities should adjust their currency upward in order to escape inflationary US cheap-dollar policies.

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 US 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 US have skyrocketed. Yes, the yen was more expensive versus the dollar, but the cost of production in yen fell. Money is a veil. As Adam Smith himself observed, "The sole use of money is to circulate consumable goods."

There's no reason to assume things would be any different for Chinese producers. To repeat, money is nothing more than a measuring stick, or a "veil." 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.

Conclusion. Changes in currencies do not change the real value of the goods which they are used to price. Currencies cancel out. Individuals 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. It doesn't take long.

What would be compromised, however, is US economic growth. Indeed, our jawboning of the Chinese is signaling that Treasury policy is to keep the dollar weak, and as we continue to devalue, investment will continue to flow to other countries where inflation will erode returns less than in the US. To put it very simply, if it seems as though we're weak relative to China now, the true shock about our relative weakness will surely reveal itself if monetary authorities take the advice of Zoellick, Geithner, and the Financial Times.

Policy toward China today is driven by a sad misunderstanding of the purpose of money. Neither a commodity nor wealth, money should be insignificant except for its seminal role in helping us to attach value to goods we want to exchange or productive opportunities in which we want to invest.

Trade is solely about products, and money is the lubricant. To ascribe to money magical powers, as establishment thinkers do, is to falsify its meaning. The result is devaluationist policy of the US variety that weighs on our economy more than any other policy in existence today.