East of Eden

"Gentleman, you had a helluva first day."
--Viper (Top Gun)

One of the first official statements out of the new treasury secretary's mouth was that the Obama administration believes that China manipulates its currency. In fairness to Secretary Geithner, officials linked to previous administrations have voiced concerns about the yuan's value as well, although their words were less edgy. Chalk it up to a rookie mistake of the tongue.

But singling out China is amusing because all countries manipulate currencies through both words and deeds. For instance, U.S. officials have chronically jawboned a strong dollar policy (while in the background enacting policies destined to weaken the USD). Some countries 'peg' their currencies to others in an attempt to mitigate market forces. Overt manipulation comes in the form of currency market intervention, which by definition changes the monetary supply/demand dynamic to something other that established by market forces.

In a global economy of fiat currencies, the preferred choice of policymakers over time is to weaken your currency versus others, thereby increasing the attractiveness of your products in the eyes of foreign buyers. Such a policy encourages exports.

As China's export industries have grown, more outsiders have accused them of artificially weakening their currency to support mercantilist export policy. Of course, determining just what constitutes 'artificial' is in the eyes of the beholder. After all, how do you objectively value pieces of government-issued paper, particularly when all nations are engaged in similar programs aimed at devaluing their currency--the so called 'race to debase?'

In China's case, American bureaucrats should be careful for what they wish. The day China decides to let the yuan substantially appreciate, there's a real chance of capital flight away from, and perhaps out of, the U.S. towards Asia. Many smart cookies are getting long the yuan because they think such a trend is likely regardless of whether the Chinese government intentionally moves to strengthen it. Moreover, fewer cheap Chinese goods coming into the U.S. would put upward pressure on domestic prices, which could fan inflationary flames currently simmering under $ trillions of government sponsored economic stimulus programs.

The correct policy, of course, is to get our own house in order. The fact that we continually look outside our house for causes and remedies speaks volumes about our internal capacity for effective problem solving.

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