Politics & Policy

Tied & Tested

China and the U.S. are linked . . . a good thing.

Columnist Tom Friedman of the New York Times wrote that “When Chinese authorities told banks last week to cut back their wild lending, commodity prices and stock markets tumbled all over the world.” The always clever Friedman then conjured up a prayer that concluded, “May China’s leaders live to 120, and may they enjoy 9 percent GDP growth every year of their lives. Thank you, Father. Amen.”

#ad#While it’s good to see Friedman appealing to a higher power, his prayer has already been answered over the past ten years. Since China’s 1994 currency stabilization reform, which firmly linked the yuan to the dollar, real economic growth in the country has averaged 8.9 percent per year — with no recessions. Call this the post-Tiananmen Square modern era of Chinese growth.

Most important to the continuing health of China’s rapidly emerging economy have been pro-growth measures to reduce tariffs, market-liberalization steps to reform and modernize the Chinese economy, agriculture reforms going back to the late 1970s, and, in particular, the currency reform to stabilize the yuan — which has been crucial to attracting deep-pocketed international investors. These measures set the stage for the decade-long durable economic boom which shows absolutely no signs of stalling.

China has become one of the world’s primary growth engines. Almost single-handedly China has pulled Japan into an export-led recovery, ending a fifteen-year Japanese downturn. In fact, China has anchored an economic revival throughout the Asian-Pacific rim. Its huge industrial demand has contributed mightily to a revival of the U.S. commodity and manufacturing sectors and has had a boom-triggering impact on world shipping.

In short, the global economy needs China.

In recent weeks China has taken a few modest steps to slow its allegedly overheated economy. It raised bank-reserve requirements, clamped down on cement, steel, and aluminum projects to curb excess development, and implemented some land-use rules to slow industrial growth.

Amidst the current growth wave, government-reported Chinese inflation has picked up. In mid-2002 China was deflating at a 1.3 percent pace, but recent consumer-price-index readings have hovered around 3 percent. The corporate-goods index, a proxy for wholesale prices, was deflating at a 4 percent clip in 2002. Now it’s rising at a 6½ percent rate.

Look familiar?

In effect, China’s price trends mirror and magnify U.S. price trends. This is because the yuan is tied to the dollar. So it is really the U.S. Federal Reserve calling the tune for Chinese money.

As the Fed reflated its way out of deflation in recent years by lowering interest rates and expanding the money supply, China’s economy benefited enormously (as did emerging country economies worldwide). And as China’s economy is not nearly as diverse, flexible, or developed as America’s, price swings up and down tend to be more exaggerated than those in the U.S.

Still, there is no inflation crisis occurring in either country.

The Greenspan Fed undoubtedly overshot liquidity additions to the U.S. economy in fighting deflation in 2000-02. Some of this spilled over to China. Yet while core inflation (excluding food and energy) is creeping up in the U.S., it is only 1.4 percent over the past twelve months — nothing to panic over. Still, it is noteworthy that the overall Consumer Price Index did rise 5.1 percent annually in this year’s first quarter.

Here are some other telling parallels: As U.S. Treasury bond rates have increased recently from 3.6 percent to 4.5 percent, China’s government bond yield has turned up from 4 to 5 percent. In recent weeks the U.S. dollar has reversed a two-year decline and appreciated by roughly 6.5 percent. This means the dollar-linked Chinese yuan has also appreciated in lockstep with the greenback.

Currency appreciation amounts to a de facto tightening of monetary policy in both countries. As currency values rise, increased consumer and business purchasing power will slow price increases. In response to this restraint, U.S. dollar-denominated commodity prices — such as gold, copper, steel scrap, and wheat — have corrected sharply lower with stock markets also losing some of their steam of late. But these are overreactions to a very mild dose of monetary restraint in both China and the U.S.

Today’s Federal Open Market Committee meeting will lay the rhetorical groundwork for an overdue increase in the federal funds policy rate. Most market mavens expect a rate hike in June or August. Really, the central bank should act today. Global stock, bond, currency, and commodity markets have already built in about a 75-basis-point Fed move. Why wait? The sooner the Fed acts, the less action it will have to take later on.

That said, Federal Reserve policy will remain relatively accommodative for quite some time. The boom in the U.S. and China will not end. Instead, with a bit of stimulus removal — actually nothing more than a lightening up on the monetary accelerator — rising inflation expectations can be stopped dead in their tracks. This would prolong bull-market prosperity cycles in both countries. Once again, Mr. Tom Friedman’s prayer would be answered.

— Larry Kudlow, NRO’s Economics Editor, is CEO of Kudlow & Co. and host with Jim Cramer of CNBC’s Kudlow & Cramer.

Larry Kudlow is the author of JFK and the Reagan Revolution: A Secret History of American Prosperity, written with Brian Domitrovic.

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