China and the Floating Dollar Jude Wanniski November 17, 2004

With gold jumping almost to $441 yesterday morning following the surprise report that producer prices jumped 1.7% last month, we are now in danger of stepping into a vicious inflation cycle that we hoped could be avoided. Back in March, remember, the Federal Reserve first signaled that its monetary accommodation would be ending, without specifying when. Because gold had come down from $430 to as low as $380, we thought there might be a chance that the inflation the Fed was beginning to worry about might be nipped in the bud by the economy’s increasing demand for liquidity. It thus might not show up in the statistics later in the year, and the Fed could then hold the funds rate down to 1% for the balance of the year.

On June 30 this hope ended when the funds rate went up, the first of four quarter-point moves that have brought the rate to 2% even though inflation stats were behaving themselves. Oil has come off its dizzy peak and will nibble away at this month’s producer prices when the index is reported next month, but other commodity prices are still lagging gold and should offset oil’s drop. In other words, the Fed will be under pressure to push funds at least to 2 ¼% before Christmas and there will be howling from market analysts for the Fed to become more aggressive in its measured-pace policy. The futures market now expects funds at 2.75% by late spring and unless very good things are happening to push up the demand for dollars in the real economy, futures will be pricing in 3.75% by year’s end and gold will be climbing toward $500. That’s the scenario that occurs to us.

Now bring China into the picture. Last spring, we also hoped the $50 drop in gold would bring relief to China, which was already feeling the inflation, and end talk of Beijing’s need to float the yuan. That happened and at least until October the internal and external pressure on Beijing to float died down. But with gold running up as fast as it has, China is back in the crosshairs. This time there is the added argument that the dollar is weakening against the euro, the yen, sterling, the Canadian dollar, etc., because of the $160 billion bilateral U.S. trade deficit with China, and that only a floating yuan will reverse the trade flows and strengthen the currency.

I was surprised in yesterday’s Financial Times to find Glenn Hubbard, recently President Bush’s CEA chairman, teamed up with Bill Dudley of Goldman Sachs, writing about China’s need to float the yuan in order to develop its nascent capital markets. Hmmm. Bloomberg’s Andy Mukherjee then e-mailed me from Singapore: “Why don`t Americans start saving and Asians start spending? Why don`t Asian central bankers let the dollar go? What will make them want to dump the dollar -- runaway inflation in China?” Then came Paul Craig Roberts in his syndicated column warning that when China does finally float, in order to comply with demands of the World Trade Organization, it will cause a shock to the U.S. economy as prices of Chinese produced goods soar! He goes so far as to argue that “China`s currency peg to the U.S. dollar prevents correction of the U.S. trade imbalance and imperils the U.S. dollar`s role as reserve currency.”

Hold on now. Currency exchange rates have almost nothing to do with trade flows, no matter how many times you read that they do or how much common sense it seems to be that they do. It is a classical theorem, which I learned from Mundell and Laffer 30 years ago, that you cannot change the terms of trade by changing the value of the unit of account. There may be temporary changes in the composition of trade flows, but the aggregates will not change. We’ve watched trade flows for almost three decades at Polyconomics and the theorem has never been dented.

China’s current account surplus with the U.S., now about $160 billion per year, is entirely due to the fact that the U.S. is the biggest, wide-open market for Chinese goods in the world. The rest of the mercantilist world is happy to sell to China, but they put up resistance to imports from China. The net effect is that China is now running a trade deficit with the world as it imports capital to feed its rapid growth. Its acquisition of U.S. financial assets is slowing down as it dips into its dollar earnings to import from the rest of the world, which has what it needs that we don’t have at competitive prices.

Why doesn’t the U.S. save more and Asians spend more? As long as the real value of U.S. wealth is expanding, as it has been in recent years, there is less need to save. When my stock portfolio grows along with the value of my real property, I don’t have to squirrel away a portion of my paycheck for a rainy day. I can spend it all. That’s why savings rates go up in recessions and why trade deficits turn into surpluses.

As for Craig Roberts’ concern that the dollar’s role as a reserve currency is imperiled? That may be true but not for the reasons he cites. China and Japan still see value in keeping their currencies tight to the dollar, to limit the hedging costs that would eat into profits by floating their currencies. As the Fed continues to mismanage the dollar -- causing inflation while believing it is fighting it, the costs to China and Japan rise and the value of using the dollar as their accounting unit declines. Japan’s aggregate trade has already shifted slightly to China from the U.S. At some point, both could find themselves in a de facto currency trade bloc that would support a yuan/yen accounting unit. All of Asia would link into such a system if it had the promise of stability against gold and all other commodities, oil included.

The countries with the best money will eventually have the best and biggest banks. Japan’s banks have suffered terribly in the last decade because of Tokyo’s need to keep Uncle Sam happy with its yen policies. China and Hong Kong were badly hurt during the dollar deflation of 1997-2001, but struggled through with their dollar peg intact. If they are as smart as they seem to be, the Chinese and Japanese will figure enough is enough and pool their experience in their own little Asian Bretton Woods, which Bloomberg’s Mukherjee has been writing about recently. China’s in a great spot. It isn’t being bled white in Afghanistan and Iraq. It has reserves galore and a 9% growth rate while the U.S. economy hesitates while contemplating more Fed rate hikes. Eventually, maybe someone in the Bush administration will take notice and make the right connections. And give Alan Greenspan a call, asking if he’s sure the Fed is on the right track.