Wednesday, December 03, 2008

Chinese Alchemy

Before we had Chemists we had Alchemists who most famously tried to turn lead into gold and, fortunately, I believe, failed. Had they succeeded gold would have, in a sense, lost its luster.

Currently it seems the Chinese are trying to perform an equally impossible feat- turning US$s into Gold.

Brad Setser notes: On Monday China apparently decided to allow the renminbi to depreciate against the dollar.

Given China's large external surplus and the US' large external deficit Mr. Setser, and I, find this policy choice most curious.

Why would China adopt this policy?

According to Mr. Setser: China — like the US – is feeling squeezed by the dollar’s recent appreciation. In real terms, the renminbi has appreciated by far more after it stopped moving up against the dollar that it ever did when it was moving against the dollar. Allowing the renminbi to depreciate against the dollar as the dollar rises would limit China’s real appreciation.

China, it seems, is reluctant to give up its policy of export driven growth, perhaps due to a combination of inertia- Chinese culture is very, due, in part to Confucius, conservative- and (not, in my view, misplaced) fear that a shift to consumerism would disrupt Communist Party control.

This view, however, as Martin Wolf notes below, is inconsistent with the tenets of our current financial architecture.

Countries with large external surpluses import demand from the rest of the world. In a deep recession, this is a “beggar-my-neighbour” policy. It makes impossible the necessary combination of global rebalancing with sustained aggregate demand. John Maynard Keynes argued just this when negotiating the post-second world war order.

In short, if the world economy is to get through this crisis in reasonable shape, creditworthy surplus countries must expand domestic demand relative to potential output. How they achieve this outcome is up to them. But only in this way can the deficit countries realistically hope to avoid spending themselves into bankruptcy.

Some argue that an attempt by countries with external deficits to promote export-led growth, via exchange-rate depreciation, is a beggar-my-neighbour policy. This is the reverse of the truth. It is a policy aimed at returning to balance. The beggar-my-neighbour policy is for countries with huge external surpluses to allow a collapse in domestic demand. They are then exporting unemployment

"OK," you might be thinking, "I see that, but where does the alchemy come in."

In order for an export driven growth policy to be successful over time you have to get something of value for your exports. No nation would trade manufacturing output for, say, grains of sand.

China gets, mainly, US$s in return for its exports. If the US$ sinks their massive retained earnings evaporate. Instead of letting their economy adjust the Chinese are trying to enforce a high value for the US$ through increased purchases of US debt. They are, in a sense, trying to turn US$s into Gold.

I suspect their efforts will prove about as successful as those of the alchemists of centuries gone.

Chinese alchemy is one of the primary causes of the current global deflation, which, according to Ken Rogoff leaves the world teetering on the precipice of disaster. ... Unless governments get ahead of the problem, we risk a severe worldwide downturn unlike anything we have seen since the 1930s.

Rogoff's prescription; Central Banks need to embrace inflation. I agree, although contra his view, I don't think we can, at this point, have just a little inflation any more than one can get a little bit pregnant.

The choice, as I have long argued, is between a crippling deflation or substantial inflation that eventually removes the US$ from its perch as major reserve currency. Inflation will also shift a good deal of purchasing power towards resource nations, like Russia and the oil exporters (which won't make the gang in Washington happy either) in whose company China can't really be counted.

Happily there is one way to turn US$s into Gold- even though the process will end up consuming increasing amounts of $s per ounce of Gold as time goes on- by buying it.