Tuesday, October 26, 2004

China Before the Fall

I get this economic newsletter. It is politically stupid Libertarian. They do understand economics very well.

Since it is unavailable on line I'm reprinting the whole thing. It is very good.


Issue 390 October 26, 2004


Currency traders have to live with this question
continually. He who is on the wrong side of that trade will get
hammered, the way that those who were short the dollar and long
the peso got hammered when the Mexican government floated the
peso in the summer of 1976. I can remember one hard-money
investment advisor who had touted investing in pesos in early
1976, because you could make a safe, guaranteed 200% per annum on
your money. I also remember his "Sell!" notice, sent by first
class mail, mailed a day after his clients lost up to $35,000 per
futures contract. Too late, of course, as he knew when he sent

The Chinese central bank's floating of the yuan -- or more
likely, controlled ("dirty") floating -- will have repercussions
on us when we shop at Wal-Mart or other retail outlets that sell
Chinese-made products. These products will get more expensive,
assuming the yuan moves up, which all commentators assume,
including me.

The question is: How soon?


Fixed currency exchange rates are price controls. But,
unlike most price controls, fixed rates are controls on products
produced by government-licensed monopolies: central banks and
commercial banks.

Price controls produce gluts of those products whose prices
are set above the free market price, i.e., price floors. Price
controls produce shortages of products whose prices are set below
the free market price, i.e., price ceilings.

A price control on currencies is simultaneously a price
floor (the overpriced currency) and a price ceiling (the
underpriced currency).

The Chinese central bank, operating at the discretion of the
Chinese government, has established a price ceiling for the yuan
and a price floor for the United States dollar: 8.3 to one. This
has produced heavy demand for the yuan in terms of the dollar.

To avoid a shortage of yuan -- "Sorry, no yuan for sale at
the official price" -- the Bank of China keeps expanding the
monetary base. It creates yuan, and then uses some of the newly
created yuan to purchase dollars in the open market, with which
it then purchases U.S. Treasury debt.

The alternatives to this policy are these: (1) float the
yuan -- i.e., abolish the price controls -- which will raise its
price in terms of dollars; or (2) allocate access to yuan on a
basis other than open market purchase. In other words, either
"high bid wins" or "stand in line." Currencies are like other
scarce commodities. They are allocated either by price or by
favoritism, i.e., "Get to the front of the line by doing things
my way."

There was a time, prior to August 15, 1971, the day Nixon
(1) unilaterally told the Treasury to stop selling gold, (2)
floated the dollar, and (3) imposed price ceilings on everything
except raw agricultural products, when conservatives argued for
fixed exchange rates "to stabilize the currency markets and
reduce risk." In other words, they argued for price controls on
currencies, even though they also argued for free market pricing
on all other items offered for sale. Today, there are few
economists outside of China's central bank who call for fixed
exchange rates. They have learned their lesson. The free market
works. It lets buyers and sellers set prices, thereby avoiding
gluts and shortages.

Fixed exchange rates never did stabilize the currency
markets. They stabilized the official price of currencies in
relation to each other, but always created gluts and shortages in
the currency markets. Then, from time to time, a central bank
would devalue its currency in an overnight change of policy,
which inflicted huge losses on currency traders on one side of
the transaction and huge profits for those on the other side. It
was official price stability for a while, and then instability on
a massive scale without much warning, other than official
assurances that the change was not being contemplated.

I remember Treasury Secretary John Connally's press
conference on Monday, August 16. He was asked by some reporter
why he had assured everyone that the government was not
contemplating such a policy. He gave an honest answer. If he
had told the truth, he said, the run on the dollar by foreign
central banks to buy gold from the Treasury at $35/oz would have
been even greater.

The Dow rose almost 33 points that day -- a huge increase in
those days.

The Chamber of Commerce and the National Association of
Manufacturers issued positive press releases. No more inflation!

Within a year, shortages were everywhere: the inevitable
effect of price and wage controls. There had been a gasoline war
going on that weekend in California. I can remember prices at 21
cents a gallon. Normally, prices were around 30 cents. Gas
stations ran out of gas and then went out of business. But it
was great for 7-11 franchises. That was the era in which gas
stations set up convenience stores.

Nixon's price/wage control program was abandoned in late
April, 1974, after it had disrupted American markets. The system
had never been enforced vigorously or else the disruptions would
have been worse. Nixon resigned in August.

Treasury gold sales were never restored. In January, 1980,
gold was selling for over $800/oz -- briefly.

The dollar was permanently floated in December, 1973,
although the float has been "dirty" for much of the time: some
central bank intervention by one or another central bank. Today,
only China enforces a fixed rate.


From time to time, I read about "exported deflation" into
the United States and "exported inflation" from the United
States. A recent example of this line of reasoning appeared in
"The Asia Times." The author wrote:

Dollar hegemony emerged after 1971 from the peculiar
phenomenon of a fiat dollar not backed by gold or any
other species of value, continuing to assume the status
of the world's main reserve currency because of the
US's geopolitical supremacy.

This is nonsense. Dollar hegemony emerged after 1945
because the United States was the world's strongest economy. The
Bretton Woods international monetary agreement of 1944 assured
dollar hegemony. When Nixon broke the terms of Bretton Woods by
closing the gold window, he did not undermine dollar hegemony.
There was no other central bank/nation willing to re-establish
gold convertibility. So, the dollar has won by default.
Such currency hegemony has become a key
dysfunctionality in the international finance
architecture driving the unregulated global financial
markets in the past two decades.

This is true enough, but without the cooperation of other
national governments and central banks, this hegemony could not
be maintained. The hegemon is not in a position to force other
central banks from re-establishing the gold standard.

This may be overstated. Because most countries store their
gold in the vault of the Federal Reserve Bank of New York, there
may be some pressure: a threat by Washington to confiscate a
nation's gold. If this threat has been made, it has been made
very quietly. If the U.S. ever did this, foreign nations could
torpedo the dollar by selling T-bills in one retaliatory move.
Tit for tat is a well-respected policy internationally.


Our author continues:
China's overheated economy is the result of hot money
inflow caused by dollar hegemony.

This is nonsense. The Federal Reserve System has no
authority in China. The FED has been increasing the U.S.
adjusted monetary base at a mid-single-digit rate. The Bank of
China has been increasing its money supply at rates much higher.
The hot-money inflow of dollars into China has to do exclusively
with China's policy of making available cheap money at a fixed
rate. The old economic rule holds up: "At a low price, more is
demanded." The Chinese central bank is subsidizing the creation
of demand for its own currency by fixing the rate below the
market. Then, in order to meet world demand of yuan in dollars,
it creates fiat money. To blame the FED is ridiculous. Blame
the Bank of China.

By the way, "dollars" do not "flow into" China. They move
from some accounts in large multinational banks into other
accounts. Jones buys yuan with dollars and transfers this money
to Wong, whose account rises. Jones bought yuan from Chen, who
may buy T-bills. Or, more likely these days, Jones bought yuan
from the Bank of China, which now buys T-bills.

While paper dollars do circulate in third-world nations
whose nationals have moved to the U.S. and mail home dollars, the
number of paper dollars in China is minimal, as far as anyone
knows. If they do circulate, they came from Chinese residents in
the U.S. who sent money home to their families. Federal Reserve
Notes do not circulate in China's capital markets.
China's developing economy should be able to absorb
huge amounts of capital inflow, but dollar hegemony
limits foreign investment to only the Chinese export
sector, where dollar revenue can be earned to repay
capital denominated in dollars. Since China's export
sector cannot grow faster than the import demands of
other nations, excessive dollar capital inflow
overheats the export and exported-related sectors,
while other sectors of the Chinese economy suffer acute
capital shortage.

This is also nonsense. Dollar hegemony has nothing to do
with which sector of the Chinese economy is favored by investors.
Investors with dollars in their bank accounts are buying yuan in
order to get in on China's economic boom, which is being
sustained by the Chinese central bank's policy of monetary
inflation. China's economy is a bubble economy. Investors are
willing to buy in to any sector where they can find Chinese
"cousins" to expedite deals.
Overheated economies produce growth-inhibiting
inflation through excessive import of money and sudden
rises in prices for imported commodities and energy.

He has it exactly backward. Central bank inflation of a
nation is what creates an overheated domestic economy. Central
bank inflation can also create a boom in a foreign nation's
economy. How? By lowering foreign interest rates. How? By
purchasing that nation's treasury debt. This is taking place in
the United States today. It is the inflow of capital from the
Bank of China that is subsidizing the U.S. boom, not the other
way around. China is running a $100 billion trade surplus with
the United States. It is buying U.S. assets, mainly T-bills,
with this excess $100 billion.

It is not the excessive import of foreign capital that
causes economic overheating in China. It is the boom created by
monetary inflation, coupled with China's fixed exchange rate
policy, that sucks in foreign investment capital. Investors love
to invest in bubbles.
The imported inflation is then re-exported, causing
inflation in other parts of the global economy.

This man does not understand economic cause and effect.
Imported inflation is not re-exported. What is exported are
cheap products made in China. While it is wrong to speak of
"exported deflation," because deflation is accurately defined as
"a decrease in the money supply," it is legitimate to speak of
price competition. China is surely price competitive. Capital
flowing into China makes Chinese producers even more productive.
Prices fall, or else fail to rise as rapidly as they otherwise
would have, in nations that import Chinese-made products.
Inflation causes interest rates to rise, which in turn
causes unemployment and recession in all economies that
are plagued by it.

But China is price competitive. It is pressuring consumer
goods prices in foreign nations to fall. This causes interest
rates to fall: a lower rate for the price inflation premium that
is built into in long-term loans by lenders who demand
compensation for the threat of depreciating money.

Add to this factor the demand for U.S. T-bills by the
Chinese central bank. It causes American short-term rates to
fall. Rising demand for T-bills from China lowers the rate of
interest because the Treasury can sell T-bills at a lower price.
It is China's central bank, not the FED, that is the main source
on the supply side for today's low interest rates in the United
Dollar hegemony enables the US to be the only exception
from macroeconomic penalties of unsynchronized exchange
rates and interest rates. The US, because of dollar
hegemony, is the only country that can claim that a
strong currency that leads to trade deficits is in its
national interest in a global economy dominated by
international trade. This is because a strong dollar
backed by high interest rates helps produce a US
capital account surplus to finance its trade deficit.

High interest rates? In the United States? Have you
checked your rate of return from your passbook savings account or
money market fund? What has this guy been smoking?

Having misunderstood economics, and having perceived low
interest rates in the U.S. as high interest rates -- i.e.,
imposing bad economic theory on existing economic facts -- the
author then does something remarkable. He draws a correct
The issue is not whether Asian central banks will
continue to have confidence in the dollar, but why
Asian central banks should see their mandate as
supporting the continuous expansion of the dollar
economy at the expense of their own non-dollar
economies. Why should Asian economies send real wealth
in the form of goods to the US for foreign paper
instead of selling their goods in their own economy?
Without dollar hegemony, Asian economies can finance
their own economic development with sovereign credit in
their own currencies and not be addicted to export for
fiat dollars. As for Americans, is it a good deal to
exchange your job for lower prices at Wal-Mart?

The Asia Times has more.

There is one answer to all of these questions: mercantilism.


Asian politicians are the victims of a false economic theory
that was refuted by Adam Smith in 1776. They have been
hypnotized by the success of the post-war Asian tigers in
building their economies through exports to the West, especially
the United States. That legendary success was based mainly on
the increased productivity of Asian industry through the creation
of domestic capitalist markets.

Yet, even here, there was a mercantilist element. Asian
exporters were governed by domestic government bureaucracies.
Only certain products were allowed to be exported. The most well
known of these bureaucracies is Japan's MITI: the Ministry of
International Trade & Industry.

Like mercantilists in the seventeenth century, today's
mercantilists draw a false conclusion. Instead of working to
reduce the control of government over the domestic economy,
especially central bank control, Asian politicians conclude that
government control is the basis of the success of the export
sector. Also like seventeenth-century mercantilism, the
political benefit from catering to a minority sector of the
economy -- exports -- is high. Exporters know where their bread
is buttered: in Parliament. They and the politicians can justify
Parliament's splendid pay-off -- pressuring the central bank to
lower the international value of the currency by inflating it --
by arguing that "exports are good for the economy."

The hegemony of the dollar is indeed one factor in the Asian
governments' willingness to subsidize exports to the U.S. OPEC
governments that control the export of oil -- socialist ownership
-- demand payments in dollars. This is an American payoff to
Middle Eastern sheiks for promised support against domestic
revolution: American-made weapons and training. This is the
hegemon in action.

Nevertheless, the main reason for Asian governments' policy
of subsidizing American consumers through currency depreciation
is domestic mercantilism. There is a sweetheart deal between
Asian exporters, politicians, bureaucrats, and central bankers.
We Americans are the beneficiaries at the expense of Asian

Grab it while you can. The gravy train won't last forever.


There is no question that the Chinese economy is overheated.
This is the exclusive fault of the Bank of China.

The central bank's policy of monetary inflation has created
the boom phase of what Austrian School economists describe as the
boom-bust cycle. Austrian economists blame central bank
inflation for booms and busts. In this sense, Austrian
economists are unique. Their view is not popular.

China has a tiger by the tail, to quote the title of a 1972
collection of articles written by Austrian economist F. A. Hayek.
China's central bank has created the boom phase of the economy.
If it does not cease inflating, there will be a crack-up boom, as
Ludwig von Mises called it: the destruction of China's currency
in mass inflation. On the other hand, if the bank slows the rate
of monetary inflation, there will be a recession or worse. The
bubble will pop.

Bad macro!

Economic causes and effects are not racial. They are not
national. They operate in China, just as they operate everywhere
else. The Bank of China has created a boom that is as artificial
as the yuan's fixed exchange rate with the dollar. This boom
cannot be sustained without negative consequences. It also
cannot be ended without negative consequences.

Politics dominates China. The Communist Party of China is
no longer Marxist in economic theory, but it surely is Leninist
in political power. These aging leaders are not going to risk
losing their power by calling a halt to the boom -- not unless
domestic inflation escalates. The pain of such economic
pressures on politicians will determine the timing of any change
in Chinese monetary policy.

Consider the political pressure of unemployed workers in
huge cities where jobs have disappeared. This pressure is very
different from, and more excruciating than, recessionary
pressures on self-sufficient family farms in distant rural
regions. We are watching 200 million people streaming into
Chinese cities in one decade. There has never been a population
move like this one. These uprooted newcomers are now
concentrated in tight geographical areas. Take away their jobs
and their dreams overnight, and you have a truly revolutionary
situation on your hands. What's a little price inflation
compared to this? What's a whole lot of price inflation compared
to this?

Terry Easton thinks that the Chinese government will keep
fixed exchange rates until after the 2008 Olympics, which will be
held in Beijing. That's as good a political guess as any. Of
course, serious economic pressures can surface before then.

Saving face is higher on most Asians' value scales than
saving money. Capitalism is a new import there. The fear of
shame is deep-rooted. Chinese society is a shame society. This
will add political pressure to maintain the fixed rate. China
wants lots of visitors, and keeping the yuan low will encourage
these visitors to come. Urban discontent in the streets is not
favorable to foreign tourism.

But there are other considerations. China is now running a
small trade deficit with most of the world, even including the
$100 billion trade surplus with the United States. Capital is
flowing into China, and not just dollar-denominated capital. If
domestic prices start rising rapidly, exports will be reduced.
There will be pressure on the Bank of China to slow the rate of
monetary inflation. If the central bankers have not read
Austrian School economics -- this seems likely -- they may not
understand the size of the tiger they have by the tail or how
fast he can turn. The bankers may risk a slowdown, not expecting
a depression.


The political prestige of the Olympic games is high.
China's rulers want to share in the glory of the games, which
will mark China's entry into the world's ruling nations. But
four years of price inflation can add up. So can shortages of
price-controlled items, such as water and electricity, which are
already being rationed politically.

Political power is not democratic in China. The power elite
in China is in a strong position to pursue bad monetary policy.
I do not think most Westerners understand China's political
rulers and the pressures they feel.

I think Chinese politicians understand power better than
American politicians do. Power has been a life-and-death matter
in Communist nations. These men grew up during Mao's cultural
revolution. They survived.

An American retreat from Iraq will motivate China's rulers
to abandon the dollar if they think there will be a switch to the
euro or other currencies by OPEC. It is not losing face to
abandon a sinking ship.

Let us not be naive. China's politicians set central bank
policy. The political dog wags the central bank tail in China,
unlike in the United States.

I expect an end to fixed rates in China within a year after
the United States pulls out of Iraq. If U.S. troops are still
there in 2008, then I would expect floating rates before 2009.
But I don't think we will have to wait that long.


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Joe Katzman at Winds of Change looks at some of China's future possibilities. Nice mention of this piece.


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