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Monday, April 05, 2010 2:49 AM

Why Repegging the Yuan and Other Non-Free-Market Solutions to Trade Imbalances With China Will Fail

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In spite of much yapping by economists, especially Paul Krugman, I strongly doubt a currency repeg by China would do much (if indeed anything at all) to cure any global imbalances.

As a starting point in understanding why, please consider this statement made by Michael Pettis in response to a comments on his post How will US savings rate rise if you don’t penalize consumption?

"...to use a controversial example, if the US were able to force up the value of the dollar by 20% or more against all other currencies, it would become far more profitable to produce cars domestically, it would revive the aluminum and chemical industries, and it might cause a significant divergence of electronics assembly to the US."

Ironically, if that is the case, then it would appear the solution to the global trade imbalance is for a stronger dollar not a weaker one. Yet nearly everyone except China is clamoring for a weaker dollar.

Correction From Pettis:

Mish, sorry, I meant force “down”, not up. The point is that if the dollar were devalued by 20%, the immediate impact would that US manufacturers would become much more profitable and foreign much less so. That would shift US and foreign consumption of cars from foreign producers to US producers, and would of course have a positive impact on US employment.

Now over the longer term that advantage would disappear as inflationary pressures in the US eroded the initial price advantage, but assume that the US closed its capital account and engaged in very heavy sterilization and financial repression — as China and the other “Asian development model” countries do and did. This would permit the relative price advantage of US cars to persist indefinitely, until enough capital misallocation in the US eventually created its own distortions.
Who Is The Manipulator?

Stepping back for a moment, why is it manipulation for China to peg its currency where it wants, yet it is not manipulation when the Fed pegs short-term interest rates where it wants, and openly monetizes treasuries and agencies on top up it?

Supposedly the Fed's monetization ended in March, but we will see.

Regardless, the pot is clearly calling the kettle black when it comes to blatant manipulation.

Yet, Krugman screams "manipulation" at the top of his lungs and wants massive tariffs if China will not do something about its supposedly undervalued Renmimbi.

I expressed some thoughts on China and balance of trade issues on March 22 in China Not As Simple As Krugman Thinks; The Coming Trade War With China.

Finding a cure to global imbalances is far more complex than currency. Yet most are focused on the "currency manipulation" aspect of China's peg, hoping to force China to revalue the RMB.

Is The Trade Deficit Even A Problem?

According to Rothbard in Money and Its Purchasing Power "More nonsense has been written about balances of payments than about virtually any other aspect of economics."

Economist Frank Shostak explains what Rothbard meant in Does the widening US trade deficit pose a threat to the economy?'.
Most economists are of the view that the ever-growing US trade deficit and the subsequent expanding foreign debt pose a threat to the well-being of Americans. What is then required, so it is held, is to set in motion policies that will help curtail the widening trade imbalances between the United States and the rest of the world. Focusing on the trade deficit as the supposedly major problem of the US economy only diverts the attention from the real culprit, which is the US central bank.

What matters for the process of wealth formation is the flow of real savings. The balance of payments statement doesn't provide such information. Consequently, it is not possible to determine the implications of a given state of the current account on the well-being of Americans without information regarding the state of the flow of real savings. Therefore various pessimistic assessments regarding the US economy, which are based on the state of the balance of payments, are likely to be without much foundation.
I agree with Shostak that the Fed is the problem, not the trade deficit per se. However, does anyone believe the flow of real savings in the US has been positive? Likewise, does anyone think the trade deficit is not a symptom of a negative flow of real savings?

Looking At Solutions In Isolation Is A Mistake

One problem I see is that everyone looks at various "solutions" in isolation, without considering alternative market reactions.

For example ...

The Fed and many others believe a weaker dollar will stimulate exports. In practice however, a weaker dollar might stimulate more speculation than exports, just as it did from 2002-2007.

If the US wants to encourage savings, a higher interest rate and stronger dollar would sure do it. However, the Fed does not want to raise rates with unemployment so high.

In regards to manufacturing: Wages certainly enter into play, so much so, that wages (not currency exchange rates) are likely the determining factor as to where manufacturing takes place.

In regards to agricultural exports: weather, soil, rainfall, and land are likely to be the determining factors.

In theory, energy prices could rise so high on account of peak oil, that shipping costs could become a major determining factor for all goods and services.

In regards to the RMB: Given that 99% of economists think the RMB would soar if China floated it, I am not convinced it would.

When have 99% of economists ever been right? Bear in mind, I am making up a number, but sentiment is overwhelming for sure.

What if the RMB fell? Heck what if it just stayed flat? Or what if it rose and then hot hedge-fund money rapidly exited China, profit in hand?

Note too, the recession did more to reduce US trade deficits than a collapsing dollar did.

That is just a start of this intertwined mess. Thus, things are sure a lot more complicated than Krugman makes them out to be.

Let's back up a second and ask a seemingly simple question: Exactly what problem are we trying to solve?

It should not take much reflection to realize that is not such a simple question, and problems go well beyond trade.

Major Global Problems

  • Trade Imbalances
  • Massive consumer debt and leverage especially in the Western world
  • Huge wage differentials between developing and developed countries
  • Public unions contribute to wage imbalances and savings internally
  • Unfunded liabilities such as Social Security
  • Unsustainable pension promises in the US, Europe, and Canada.
  • High US unemployment
  • Commercial Real Estate Bubble in the US
  • Real estate bubbles in China, Canada, Australia, and the UK that have not popped but most assuredly will
  • Demographic nightmare in Japan
  • Interest rates artificially low in the US, UK, and EU
  • The PIIGS
  • Stock market bubbles reinflated
  • Carry trade speculation

I am certainly in favor of letting the free market solve all of those. Indeed many of them are so intertwined, that only the free market has a chance in hell of solving them.

Non-Free-Market Solutions Failed Miserably

Central banker actions, Congressional actions, and SEC sponsored non-free-market ideas all failed miserably. Proof of that statement is easy enough to find.

Example number one: What does Japan have to show for fighting deflation for 20 years but the largest debt to GDP ratio in the world? Yet the Fed is back at it with monetarist policies and Congress is following up with Keynesian stimulus efforts that wrecked Japan.

Example number two: A massive housing bubble was a direct result of the Fed's attempt to stimulate its way out of the 2001 recession.

Example number three: The SEC sponsored the big three rating agencies by changing the rating agency model from quality to quantity. Please see Time To Break Up The Credit Rating Cartel for details.

Example number four: Fannie Mae and Freddie Mac

What about Tax Policy and Tariffs?

US corporate tax policy certainly encourages corporations to produce and hold profits overseas. What if tax policy allowed deferral of profits in the US instead of overseas?

If the US imposed tariffs, what if China were to say in response "OK we will buy planes from Airbus instead of Boeing"?

Indeed, it would not surprise me one bit if a threat like that from China (or fear of a threat like that from China) is the reason we have not yet seen the Treasury department label China a currency manipulator.

Through China's Eyes

Looking at things from China's point of view, what happens if China slows and there is social unrest?

Property Bubbles

The property bubbles in Canada, Australia, and China have reached spectacular heights.

Please see Email from a Chinese on China's Real Estate Bubble for one person's view.

Things That Need To Happen

  • China needs to float the RMB.
  • The US and the rest of the world need to let the market set interest rates.
  • Globally, bad banks need to fail instead of being propped up.
  • Housing prices need to fall to the point where they are affordable.
  • The US needs to encourage savings.
  • China and the US need to stop insane levels of fiscal stimulus
  • The US needs to stop being the worlds policeman.

Currency Peg Cannot Possibly Work

Attempting to solve global trade imbalances by forcing China to repeg the Renminbi is like attempting to put out a house fire by turning on the air conditioner.

If there is a perfect number to peg to, only the free market can find it, because the number will constantly change.

Likewise, no central banker knows what short term interest rates should be. Yet they all manipulate rates, often with conflicting goals. For example, does any central bank want a strong currency now?

Certainly, insane stimulus needs to stop across the board, and that especially includes China and the US. Indeed, it was massive stimulus and excessively low interest rates following the 2001 recession that fueled the global debt and housing bubbles. Excessive stimulus is fueling commodity speculation and the property bubbles in China, Canada, and Australia right now.

The irony is no country (especially the US and China) wants to give the free market a chance, even though regulation (Fannie, Freddie, and the rating agencies) together with preposterously low interest rates from the Fed and central bankers in general is exactly what created this mess.

Instead, the US and China (along with Europe and Japan) are all involved in mutual finger pointing, with no country willing to do what really needs to be done: trust the free market to fix these problems.

Mike "Mish" Shedlock
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