Twenty-two years ago the top treasury officials of the G5 countries met at New York’s Plaza Hotel to realign the major currencies amidst worries, particularly at home, that weak foreign currencies were negatively impacting the ability of U.S. companies to export. The Plaza Accord communiqué specifically stated that “some further orderly appreciation of the main non-dollar currencies against the dollar is desirable.”
Japan, in particular, complied. Prior to that meeting, the yen traded at 240 yen per dollar, but strengthened to as much as 80 yen per dollar by 1994, an appreciation of 200 percent. It’s now well known, however, that this substantial appreciation led to a severe monetary deflation in Japan during the 1990s, and to a recession from which the country has only recently recovered.
It was a lost decade for Japan, and one would think we had learned from the episode. But apparently not.
Before the August congressional recess, the Senate Banking and Finance committees approved bills intended to force China to appreciate its yuan nearly 40 percent or face increased duties on Chinese goods entering the United States. The House Ways & Means Committee will be considering its own version this fall. If a compromise bill between the House and Senate is formed, and passed into law, the result would be a competitive devaluation of the dollar against the yuan. The legislation also would officially repudiate the use of fixed-exchange-rate regimes, which China employs today, and demonstrate to the world that the U.S. now embraces an archaic, mercantilist, zero-sum economic framework.
Congress’s belief that it can balance the trade deficit between the U.S. and China by devaluing the dollar is highly suspect. Think of the pending anti-China legislation this way: California and Nevada have a common currency and a fixed exchange rate (one dollar for one dollar). These states also run significant trade imbalances with one another. No reasonable person would want these states to establish a floating currency arrangement in order to balance their current accounts. Yet this is exactly what many legislators have in mind with China.
A more ominous development in the current movement to revalue the yuan is the underlying desire of U.S. officials that China float its currency, enabling markets to determine the value of the yuan. In other words, just as markets judge the Federal Reserve’s management of the dollar, legislators would have investors trade the Bank of China’s administration of the yuan. But forgotten here is the trouble our own Fed had managing the floating dollar after 1971, following the breakdown of the Bretton Woods monetary arrangement, and the potential reality that China’s central bankers will prove even less up to the task.
For now China merely imports the monetary successes and failures of our highly experienced central bankers. Were China to abandon its credible dollar link, it is a safe assumption that Beijing’s rookie central bankers would soon be tested by decidedly more seasoned currency speculators.
Despite its gradual and cautious approach to its currency, China has come to embrace global capitalism and free trade with the U.S. since it became a WTO member six years ago. But the yuan-dollar disagreement now commandeered by Congress threatens to spark potentially devastating retaliatory responses. The result could be the destruction of good will between economically vibrant nations, and the disruption of a key dynamic in the present global expansion.
In response to the proceedings on Capitol Hill, some Chinese officials have already suggested that China threaten to liquidate $1.3 trillion worth of dollar holdings. To some, this would be considered China’s “nuclear option.” Indeed, such retaliation would evoke memories of the tariff barriers erected around the world in the early 1930s in response to the Smoot-Hawley tariffs, which helped spark the 1929 stock market crash.
Chinese threats of a dollar liquidation, however, are not far off the mark. If Congress passed a bill into law effectively forcing the Chinese to appreciate the yuan against the dollar, the Chinese could be forced to sell their vast dollar holdings in exchange for yuan as a way of significantly revaluing the yuan.
This could realistically threaten the dollar and the American economy. As for China, such a rapid and excessive appreciation of the yuan could spark severe deflationary pressures in the rural economy and lead to increased unemployment for an already vulnerable constituency. Potentially, it could threaten the broader Chinese economic expansion and politically destabilize the central government.
Chinese officials do acknowledge the need to appreciate the yuan against the dollar and undo some of the inflation being imported into China by virtue of the yuan-dollar link. But they prefer a gradual approach that would minimize the deflationary impact to the Chinese economy. Legislators stateside should respect China’s gradualism, even embrace it, all while remembering that trade does not occur between countries, but between individuals who exchange surpluses for the excess goods created by others.
A yuan completely unhinged from the more credible dollar would retard beneficial trading arrangements. And since money is, in the end, a veil, a weaker dollar will not open foreign markets in the way reckless legislation working its way through Congress assumes.
– Paul Hoffmeister is chief economist at Bretton Woods Research, and can be reached at phoffmeister@brettonwoodsresearch.com. John Tamny is editor of RealClearMarkets, and can be reached at jtamny@realclearmarkets.com.