China Should Let the Yuan Rise

China has been criticized for its manipulation of the yuan. The belief of the economic establishment is that a weak currency is advantageous to an economy. Although this is a view held by many it is completely wrong, and as Americans are about to find out it is also very dangerous. 

It seems that most "economists" are impervious to economic principles. For this reason, they continue to encourage China to remove the currency peg that is propping up the US economy. When this happens the living standards of Americans will fall dramatically. If Australians want to protect themselves from following in America’s footsteps we must understand some basic concepts.

Purchasing Power

Imagine we live in an economy which operates with a sound money: gold. Growth of the supply of money would be limited by the quantity of gold extracted from mines. This means that the amount of gold in the economy would remain virtually the same whilst the production of goods in the economy would increase. If the same amount of gold has to buy a larger quantity of goods then each ounce of gold would have to cover more goods than it did before. Each unit of the currency would be stronger because it would now stretch further. Prices fall as a result. When a currency is able to buy more than it used to we say that it has increased its ‘purchasing power’. A currency is strong when the production of goods in the economy is large in relation to the production of money.

Now imagine we lived in an economy with an unsound money: paper. Growth of the money supply is limited by the ability of the economy to produce paper. But paper can be produced at virtually no cost and thus there is no limitation on the money supply. Instead, the money supply is subject to manipulation by the government, which grants itself monopoly powers over the production of money. This means that government can finance its love of spending through the printing press instead of the unpopular method of raising taxes.

The result is that the economy is flooded with a greater supply of money chasing the same quantity of goods. This means that each unit of money must cover a smaller array of goods to make room for the new units of money. The purchasing power of the new money is taken from the old money. Each unit of the currency is now weaker and can buy less than it used to. This forces prices up as more units of the weak currency are needed to buy the same old goods. The currency has lost its purchasing power. A currency is weak when production of goods in an economy is small in relation to production of money.

The Foreign Exchange Market

Currencies of the world are traded on the Forex market. We see the exchange rates of several currencies on the news each night. We can understand how these exchange rates are determined by way of example. Suppose you are about to travel to the USA. Before you leave you swap your Australian dollars for US dollars. What has happened is that you have increased the supply of Australian dollars on the Forex market. You have also decreased the supply of US dollars on the Forex market. The result is that the price of the Australian dollar falls in relation to US dollars. Where as one Australian dollar used to buy 94 US cents it may now only buy 90 US cents.

Most major currencies have their value determined by these market forces in the Forex market. However, some currencies are ‘pegged’ at a certain price against another currency. The most talked about currency peg at the moment is that of the Chinese yuan to the US dollar. We can also understand how a currency peg works by way of example.

Suppose the Chinese government decides that it wants to keep the yuan at around 15 US cents. China produces goods in great quantity. As such, the purchasing power of their currency tends to rise. However, in order to maintain the currency peg at the current level Chinese officials must work to weaken the yuan. As we saw in the previous section, the way to weaken a currency is to inflate the money supply.

As such, the Chinese government creates vast amounts of yuan and uses them to buy US dollars on the Forex market. The result is that the supply of yuan on the Forex market increases and as such the price of yuan falls. At the same time, the supply of US dollars decreases and the price US dollars rises. Chinese officials intervene in the Forex market continuously to maintain this currency peg.

Redirecting Purchasing Power

The currency peg has very important implications. The purchasing power of the yuan is not destroyed when the Chinese government inflates the money supply. Purchasing power can never be destroyed. But it can be redirected.

When the government uses inflation to finance its spending what happens is that the purchasing power of dollars in your wallet is transferred to the new dollars. However, the purchasing power of your money has not been destroyed. The power to buy the things that you can no longer afford is transferred to the government through the printing press. In effect, the government has raised its 'standard of living' by stealing your purchasing power.

Purchasing power is similarly redirected in the case of the Chinese currency peg to the US dollar. The yuan should be very strong to reflect the immense scale of production in the economy. But the yuan is worth just 15 US cents on the Forex market. So where has this purchasing power gone?

The purchasing power of the Chinese is transferred to Americans through the currency peg. The Chinese government transfers the purchasing power from existing yuan to new yuan when they create more money. This purchasing power is then handed over to the US dollar when the Chinese government intervenes in the Forex market to maintain the peg. The result is that Americans enjoy an artificially strong currency at the expense of an artificially weak Chinese currency. Remember, Americans produce almost nothing so there is no legitimate reason for their currency to be stronger than the yuan.

In reality, the exchange rate between the yuan and the US dollar should be reversed. The yuan should be much stronger than the US dollar. Instead, America uses Chinese purchasing power to buy goods produced by the Chinese. The Chinese constantly work to raise the living standards of Americans and get nothing in return. This used to be called slavery.

The False Allure of a Weak Currency

China manipulates their currency in order to boost exports. Conventional wisdom is that exports are good for the economy and as such a weak currency will help an economy. But this is totally and utterly incorrect.

The only reason Chinese products are more competitive internationally is because they receive a smaller amount of other currencies in exchange for their goods. Furthermore, the weak currency means that they have to pay more to import goods from other countries. The result is that China exports its goods to the world for as little as possible and can barely afford to import anything from the rest of the world in return. They are left with nothing but jobs.

But the goal of an economy is not to create jobs. It is to increase the abundance of consumer goods which raises the standard of living of the people. The Chinese do produce an abundance of consumer goods and raise the standard of living of millions of people. But not their own people. The fruits of Chinese labour are consumed by the Americans at no cost. The Chinese do work so the Americans don’t have to. And this is all made possible by the yuan-dollar currency peg.

And yet China is constantly coming under fire by the US because of the currency peg. Americans must be the most ungrateful society in the history of the world. They have a billion Chinese workers busting their guts everyday to provide a decent standard of living for them and they give nothing in return except criticism. It's a strange situation and is made possible by the inability of influential people to understand that a weak currency is not good for an economy.

One such person is US Treasury Secretary Timothy Geithner. Mr. Geithner has stated that he would take the necessary action to encourage China to let the yuan appreciate.

Geithner’s comments are representative of the conventional wisdom that the yuan-dollar peg is hurting US exports and hindering US growth. What Tim doesn’t understand is that the only reason US exports would become more competitive is because exporters would receive less foreign currency for their goods. Furthermore, the Chinese goods which Americans currently consume would become more expensive in terms of US dollars. In other words, the Americans will give more and receive less.

The Collapse of the US dollar

As has been explained, the artificial weakness of the yuan is the crutch that is maintaining the artificial strength of the US dollar. Once the peg is removed the US dollar will collapse. Interest rates that have been kept low in America due to Chinese savings will soar as China withdraws from US treasuries and any other US dollar-denominated debt. America will then be faced with the decision to default or to inflate the money supply to paper over its debt. The latter is more likely and is more destructive to the American economy.

Investors who usually abide in the US dollar as a ‘safe haven’ will instead flee the US dollar in an attempt to preserve their savings from the inflationary environment of the US economy. Instead they will recognise the safety of owning gold which will continue to soar in terms of American dollars.

Americans will see their standard of living decline as prices rise astronomically and Chinese purchasing power is transferred back to its rightful owners. This process will be accelerated once China begins to understand that a stronger yuan is in their best interest. Americans will be brought back to reality and will be forced to start manufacturing and exporting goods once again. The days of American hegemony are numbered.

The Chinese on the other hand will be released from their chains when the peg is finally abandoned. Prices will fall as the purchasing power of the yuan returns. Living standards will rise immediately as Chinese workers are finally able to enjoy the fruits of their labour instead of sending it overseas. The massive inflation that the Chinese government has created in order to maintain the peg will have to be addressed but the short term shock will be far outweighed by the gains.

China has under-consumed for decades. Under-consumption is a sacrifice and the reward for the sacrifice in the present is the increased abundance of consumer goods in the future. Because of the currency peg China has sacrificed in vain. Without the currency peg China will finally enjoy the benefits of a strong currency instead of letting those benefits accrue to Americans.

The tables will turn. America will become the country with a weak currency and a low standard of living while the Chinese continue to become richer. America will not be able to afford to import goods and will have to accept minimal amounts for their exports. The difference is that China has a choice. They can alleviate the suffering by simply allowing their currency to appreciate. Americans won't have that luxury.