China’s uncomfortable choice

Change for a dollar

One of the major flashpoints in the ‘currency wars’ which have attracted comment recently has been between the USA and China. Given that you have a dispute between the world’s only superpower and its only challenger some see storm clouds on the major geo political weather front of the 21st century.

The US, on the one hand, is angry with China for pegging its currency to the dollar meaning that, as the Federal Reserve forces the dollar down to stimulate exports, China has been cancelling this effect out by forcing the yuan down. President Obama has called this an “irritant”. The Chinese, on the other hand, are angry with the US for devaluing the dollar, partly because it is meant to undercut Chinese exports and partly because China is holding $2.6 trillion in reserves. A Chinese central bank official recently warned the Federal Reserve’s loose monetary policy could make “the occurrence of another crisis is inevitable”.

A question to be asked, however, is just how strong is China’s footing in this dispute? Recent inflation figures suggest that China’s dollar peg is already under pressure. In October inflation rose to 4.4%, up from 3.6% in September, the fastest rise for two years. The Financial Times reported “Li Wei and Stephen Green at Standard Chartered in Shanghai said that on a seasonally adjusted basis, consumer price inflation increased at an annualised rate of 12.1 per cent in October, up from 5.2 per cent the month before”.

The Chinese are adopting some well worn old methods to deal with this. Blaming hoarders for forcing prices up the Chinese cabinet warned it would take “forceful measures” against them and mooted capping prices. It’s unlikely that these band aids will work any better than they have in any other place at any other time, leading instead to market distortions, shortages and a thriving black market. This is because, as Milton Freidman observed nearly 50 years ago, inflation is a monetary phenomenon. If the supply of money increases relative to the amount of goods and services in an economy (subject to the massive caveat that demand for money doesn’t change) then you will have inflation.

By pegging its currency to the dollar China is importing American monetary policy. With low interest rates and fresh bouts of quantitative easing the Federal Reserve is pumping out an enormous amount of dollars pushing down their value. To maintain parity the Chinese must also lower the yuan by pumping more of them out. Reliable figures are hard to get hold of in this secretive state but one estimate is that 4.3 trillion yuan have been injected into the Chinese economy. Given the current policy of the Federal Reserve China can either keep its dollar peg and accept inflation or raise interest rates and see the yuan rise against the dollar. Their only win win situation is if the Fed can be convinced to tighten, a cause in which the Politburo has some unlikely allies in Congressional Republicans.

As China pushes for this outcome expect ‘currency war’ barbs to keep zipping across the Pacific. Both sides will continue to hurl charges of currency manipulation at the other. Theses charges are empty. In the age of fiat currencies everyone is a currency manipulator.

This article originally appeared at Global Politics

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