Ideas as sound as “the world is flat” pervade the economics profession. Take, for example, the notion that rising budget deficits force interest rates higher because government borrowing “crowds out” private borrowing. This is pure myth, dispelled by the huge U.S. budget deficits of the early 2000s that were congruent with falling interest rates. People, nonetheless, adhere to this theory as gospel. A lesser-known myth in the profession has to do with the concept of fixed exchange rates, whereby one country links the value of its currency to another. There are numerous examples where this linkage has benefited all parties involved, leading some people to defend the concept in all cases. But I argue that fixes only sometimes work, while at other times “floats” would be best. China’s yuan-dollar policy is the latest case in point.
The idea of fixed exchange rates derives from the desire of nations to maintain the purchasing power of their currencies. The “gold standard” had been the traditional fixing method — a country would back its currency by fixing it to the gold price — but this fell on hard times in the 20th century when some countries felt the need to print money to finance wars. To maintain some assurance of the value of a currency, countries began to tie their currencies to another that was considered as “good as gold.” It’s in this way that the U.S. dollar, in the decades after World War II, became the world’s reserve currency, with countries periodically tying their currencies to the dollar in hopes that such price stability would aid in the conduct of trade.
Unfortunately, the history of fixed currencies has been mixed. Bad economic policy has often overcome the value of a fixed exchange rate, with speculators ultimately breaking the banks of countries that could not or would not follow the disciplines needed to keep a currency’s value intact. But as long as politicians of reserve-currency countries avoided resorting to the printing press, global stability could be enhanced. Hong Kong tied its currency to the dollar in 1981, after which it experienced strong economic growth and low inflation. On the other hand, Argentina’s experiments with tying the peso to the dollar failed when its fiscal and monetary policies conflicted with the idea of a stable currency.
Fixed exchange rates typically have received little attention from politicians in Washington since such decisions seldom have had an impact on the U.S. economy. And to the extent that the linkage would stabilize another country’s economy, all was for the good. Then along came China.
The Chinese government liked the outcome of the Hong Kong dollar experience, and proceeded to tie its own currency, the yuan, to the dollar. In so doing the Chinese government envisioned stability in trade relations at a time when mainland China’s growth was accelerating. So far, so good. However, in time, the perceived advantages of this linkage have become serious problems.
Chinese export prices should be rising today, but they are staying low because of the dollar fix and thus offering domestic producers in the U.S. unnecessarily stiff competition. Meanwhile, by continuing to implement a fix to the dollar in an environment of a weaker dollar, the Chinese are becoming too competitive in world markets, something the Chinese would prefer to avoid given the risks of trade wars with current and prospective trading partners. The weak dollar also contributes to Chinese inflation (currently running above 4 percent), with imported non-dollar denominated goods and services rising in price as the yuan falls in unison with the dollar.
In short, the yuan-dollar fix is doing more damage than good. The Chinese government therefore should reconsider its adherence to traditional exchange-rate theory and reconsider a free-floating yuan. A floating yuan would rise in value, not fall; the problem of inflation will abate as the rising yuan lowers the cost of imports; China’s domestic economy will slow, a desirable result for a nation that needs to catch its breath; the resulting fall in export growth will reduce trade tensions; and lower prices for imported goods will raise the Chinese standard of living.
U.S. congressmen have threatened trade laws that would punish the Chinese unless the yuan floats, such as a 27 percent tariff on Chinese imports. Such intervention would be counter-productive. What’s needed is for China’s government to embrace a floating-yuan policy as the best scenario for both China and its key trading partner, the United States.
Exploding world trade and the accumulation of capital by oil-exporting nations is wreaking havoc among major currencies. However, the combination of a free-market global economy and free-floating exchange rates — in particular between the dollar and the yuan — would minimize the damage of these currency-price fluctuations. For U.S. investors who have placed a large bet on Chinese stocks, a floating yuan wouldn’t be a bad thing either.