December 04, 2008

Currency Disaster

The Chinese currency slipped by a record yesterday on evidence that China is moving to weaken its currency to prop up exports.

A weakened yuan will be a disaster for the world. It is the worst possible move for China: a drop in the yuan threatens to multiply this little crash we are seeing into another Great Depression.

Bad Now and Worse Next Year

In the short run, a weakened yuan mops up the trillions of dollars of liquidity American taxpayers are injecting into the U.S. economy and sends that money to Chinese exporters. By making Chinese clothes, toys, and companies cheaper, a cheap yuan makes it impossible for the U.S. to invest dollars into U.S. production capacity. With an artificially cheap yuan, the rational way to spend an extra dollar of liquidity is to convert it to a pile of yuan.

In the long run, this will leave China with even less domestic demand and more production overcapacity, and it will leave the U.S. with less real investment and more unproductive debt. It will not do anything to strengthen confidence in balance of trade between U.S. and China: instead, ballooning current account numbers are more likely to precipitate a loss in confidence that global trade makes any sense at all.

I fear we will look back on the weakening yuan as the equivalent of the United States passing the Smoot-Hawley Tarriff Act in 1930: the triggering event that ended up shutting down global trade and sending the planet into a depression for a generation. One year after Smoot-Hawley, the British government defaulted on its gold obligations. Today, the mechanical result of increasing trade imbalances with China is that a huge trade deficit increases the risk of a Treasury default.

If we think the subprime collapse was bad, or if we think Lehman's bankruptcy was painful, we have to keep in mind that we haven't seen anything that compares to a U.S. government treasury collapse.

China should be wary of pushing Treasuries over the edge. Yes, the suffering of China's exporters is real. But Chinese authorities have an easy fix their for their domestic problems: they need to borrow, in yuan, to stimulate Chinese domestic demand. China needs to learn how to spend money on itself, instead of buying growth on the backs of U.S. credit.

Posted by David at December 4, 2008 06:46 AM

Your argument only applies to countries whose currency is historically strong in relation to China.

From the perspective of someone living in a country with a historically weak currency (UK), it's the right thing to do to keep the exchange rate within a band.

So actually, the problem isn't China weakening it's currency. The problem is the abnormally strong dollar caused by the perception that the dollar is a safe haven in troubled times. Anything the US can do to weaken the dollar (eg print lots of banknotes, rather than issue bonds) would help.

Posted by: RichB at December 4, 2008 08:45 AM
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