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China’s real sin is not ‘currency manipulation’

WSJ editorial: China's real problem is not currency manipulation, it's sterilization. The U.S. should assist the Chinese in facilitating monetary reforms such as increased yuan convertibility by offering technical support and forming a currency swap arrangement to stabilize the yuan in the event of exchange-rate overshooting.

This piece did not mention who's the author, but I can smell Bob Mundell, the "father of Euro".  Some real good economics there.

A bipartisan swarm pounded Treasury Secretary Timothy Geithner on Capitol Hill yesterday for not doing enough to stop China's supposed money mischief. The sessions made clear that pressure is building to impose punitive tariffs on Chinese goods if the yuan doesn't appreciate in value. While it's true that China's monetary policy is causing problems, the yuan is the wrong target and protectionism is the wrong tool to get Beijing to cooperate.


First off, pegging the yuan to the dollar is not "currency manipulation" or "stealing American jobs." Hong Kong, Estonia and Bulgaria have fixed exchange rates and no one accuses them of underhanded tactics. But under their currency-board systems, inflows of foreign exchange directly lead to an increase in the money supply, and hence rising prices. That tends to constrain trade imbalances.

China's real sin is sterilization, which insulates its domestic economy from the money-creating effect of a currency board. When a company like GE invests in a Chinese factory, or a retailer like Wal-Mart buys Chinese-made goods, they exchange dollars for yuan. The Chinese government then buys those dollars with yuan. But instead of adding to the money supply, it removes those yuan from circulation by selling bonds and raising reserve requirements. Without a rise in the general price level, China's trade surplus with the world persists and grows as productivity rises.

Other emerging economic powers have used this approach—including the U.S. Milton Friedman's "A Monetary History of the United States" notes that from 1921-29, when the world used gold instead of dollars for monetary reserves, the nation's gold stock grew by about 50%, reflecting its trade surplus. Initially Washington was content to allow the money supply to rise. But from 1923 on, a policy of sterilization caused the level of high-powered money to remain stable, and wholesale prices fell 8% from 1925-29.

This short-circuited the self-correcting mechanism inherent in the gold standard, which is akin to a universal currency board since all currencies are pegged to gold. The U.S. should have seen an increase in the money supply, causing higher prices and over the long term tending to restore trade balance.

Instead the Federal Reserve wreaked havoc on countries trying to stay on or rejoin the gold standard, especially Britain, which was hemorrhaging gold. It was forced into a period of deflation and couldn't compete with the American export juggernaut. London responded with protectionism in the form of Imperial Preference, which contributed to the Great Depression, and the gold-standard system collapsed.

Likewise, Japan's use of sterilization in the late 1960s hastened the end of the Bretton Woods monetary system, while the East Asian tiger economies came a cropper in 1997 after overinvestment in their export industries annihilated profits.

China's growth potential means its share of world trade could get much bigger, and the distortions that much more damaging. Like the U.S. in the 1920s, China's rapid development without a sustainable monetary policy could topple the dollar system, especially since many countries in East Asia are also sterilizing their buildup of reserves to stay competitive with China.

There are interesting parallels between the 1920s and the 2000s. In 2003, China's dollar reserves began to grow like Topsy, Beijing stepped up its sterilization and the U.S. trade deficit burst its usual bounds of about 2% to 3% of GDP. As the provider of the world's reserve currency, the U.S. should naturally run a deficit in this neighborhood, but when the gap passed 5% alarm bells began to ring.

The challenges posed to central bankers have also been similar. China's purchases of U.S. Treasurys drove down bond yields in the West, lulling the Federal Reserve into a belief in the last decade that it did not need to tighten. While the prices of goods remained relatively stable, asset markets spiralled as misallocated capital cascaded through the world economy. Inflation appeared as stock market and real-estate bubbles, which created deflationary pressures after they burst.

So far, commitments to the World Trade Organization have prevented a post-crisis slide into protectionism. But the readjustment to long-run equilibrium that might have occurred under a better monetary system is still being thwarted. Washington is using fiscal stimulus to promote consumption rather than investment, while China has spent 15% of GDP on new investment instead of boosting consumption. Imbalances have only worsened.

The U.S. Treasury and the IMF think revaluation of the yuan is the fix. But this would carry significant costs, and without reform of monetary policy it would be ineffective. As Beijing discovered from 2005-08, a rising yuan only attracts more "hot money" to be sterilized.

The better option is for the People's Bank of China to curtail sterilization and allow the price level to rise moderately. Such inflation is a natural and benign phenomenon in a developing economy as productivity rises. And because it is growing faster than its trading partners, Beijing should not fear running a trade deficit as it attracts investment and imports capital goods. It is not in China's interest to keep storing up monetary pressure that eventually creates a crisis.

There are signs that Beijing understands this. Reform to rebalance the economy is rumored to be on the agenda of the Communist Party's annual plenum meeting in the next few weeks. And the 12th Five Year Plan to be unveiled next month is supposed to focus on boosting household income, which has been suppressed in favor of industry, in order to encourage consumption.


This is where U.S. leadership is essential. The U.S. should assist the Chinese in facilitating monetary reforms such as increased yuan convertibility by offering technical support and forming a currency swap arrangement to stabilize the yuan in the event of exchange-rate overshooting. More urgently, President Obama and Secretary Geithner need to damp down protectionist pressures, promising vetoes and refraining from new antidumping and other tariffs while working with Beijing to phase out sterilization.

The fragile world economy needs greater monetary coordination and reform, not protectionist ultimatums. The moment is ripe for leaders to cooperate to produce a more stable monetary system, if they—and Mr. Obama especially—have the wit to seize it.

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