The yuan and the US economy
Gerard Jackson
There are strident calls for the US to do something about the yuan. According to these voices China's currency is overvalued and this is causing the US economy to become less competitive vis-à-vis Chinese companies. But is this so?
What is being overlooked here is that trade is driven by differences in prices. The retort is that China has deliberately undervalued the yuan against the dollar to give itself an unfair price advantage.
It's indisputable that when a country runs an undervalued currency this will artificially lower the prices of its goods relative to other currencies. What is not understood is that the damaging effects of this policy will make itself felt throughout its own economy. And the longer the currency manipulation continues the greater the damage.
If the yuan has been undervalued relative to the dollar this would open the door to arbitrage. It will now pay Americans to buy yuans which will then be used to buy Chinese goods. The goods will be imported into America and exchanged for dollars which will then be used to buy more yuan, and so on.
The effect of this process will be to exert an upward pressure on the Chinese currency.
It will also pay Chinese businesses to offer more goods for dollars, exchange these dollars for undervalued yuans and then use them to buy more goods which are then offered for dollars.
This process is very similar to the previous one and also works to bring the yuan into line with its market value. To counter the upward pressure of the yuan China would have to buy more dollars. This is simply done by manufacturing more yuans.
There must, however, come a point when this process will be halted and the necessary exchange rate adjustment takes place.
Unfortunately this adjustment will also involve further adjustments in the pattern of production that could prove severely disruptive.
Let us assume that the Yuan is severely undervalued with respect to the dollar and has been for sometime. This would have caused part of China's production structure to become excessively export oriented.
Capital would have been attracted into lines of production that are expanding in response to the increased demand for exports from the US.
What this means is that capital and savings are being misdirected into less valued lines of production to the detriment of the economy. This process raises the cost of capital goods and savings for other lines of production and thus restricts their expansion.
This process cuts both ways. US companies will have been misled by the exchange rate into thinking that it is more profitable to produce for the US market by shifting operations to China, thus adding to the imbalances in the capital structure in both countries.
There is nothing new in this analysis. Samuel Brittan who was a highly respected economics writer for The Financial Times and who was certainly no Austrian had this to say on the subject:
"...If an imbalance is allowed to persist too long, a deficit country acquires an excessively home-based industrial and commercial structure, while the surplus country becomes excessively export-oriented. . . . This makes adjustments needlessly painful and difficult when it does come. And there is a risk of high transitional unemployment while resources are being transferred. Shop assistants in Britain cannot be transferred overnight engineering establishments which do not yet exist, while Volkswagen workers [or Chinese assembly workers] cannot move straight away into the German social services. These very facts themselves become ammunition for those who oppose parity changes and the eventual adjustments are all the more sudden and severe, when at last they come." (The Price of Economic Freedom: A Guide to Flexible Rates, London MacMillan and Co., 1970, p. 18).
It ought to be clear that the so-called exchange rate problem has been produced by people who have no idea about the consequences of trying to manipulate currencies to gain an economic advantage. Additionally, the link between currency crises and loose monetary policies is something that many in the economics profession have apparently lost sight off.
When severe exchange rates adjustments are eventually made free market economics is always blamed for the results, never those who actually caused them.
Gerard Jackson is Brookes' economics editor
BrookesNews.Com
Monday 29 November 2004