The yuan and the failure of diplomacy
By Peter Morici
When the Federal Reserve Open Market Committee meets on Wednesday, no one
expects it to raise the federal funds rate - the overnight bank rate that now
hovers below 0.25%. However, businesses, politicians and prognosticators are
eager, perhaps inappropriately so, to hear clues about when it will begin
raising short-term interest rates to a more normal level.
Simply, Fed policy is much less relevant to US growth and price stability than
in the days of Fed chairman Paul Volcker (1979-1987), because China's yuan
policy has substantially limited the importance of Fed interest rate decisions
by severing the historic link between short interest rates - like the federal
funds rate it targets - and long rates on mortgages, corporate bonds, and the
securities banks use to finance lending on cars and credit cards.
Through the boom years of the last decade, Beijing printed yuan
to purchase hundreds of billions of dollars in foreign exchange markets. That
made the yuan and Chinese products on US store shelves artificially cheap, and
imports from China, coupled with higher prices for imported oil, pushed the US
trade deficit to more than 5% of gross domestic product from 2004 to 2008.
When Americans spend that much more abroad than foreigners purchase in the
United States, American goods pile up in warehouses and a steep recession will
result, unless Americans spend much more than they earn or produce.
During the boom, China facilitated such folly by using its dollars to purchase
US Treasury securities, and that kept US long interest rates artificially low,
even in the face of Federal Reserve efforts to rein in spending.
From 2003 to 2006, easy terms prevailed on mortgages, homeowner lines of
credit, car loans, and credit cards even as the Fed raised the federal funds
rate. Americans borrowed against their homes, pushed real estate prices to
unreasonable levels, and spent on Chinese goods at Wal-Mart until the credit
bubble burst in late 2007 and 2008.
China continues to recklessly print yuan to buy dollars and US Treasuries, and
all those yuan are creating inflation and real estate speculation in China that
Beijing can't contain.
With the dollar still overvalued by some 40% or 50% against the yuan, the US
trade deficit with China, and other Asian countries practicing similar currency
mercantilism, is again growing. This deficit saps demand for US goods and
services, slows US recovery, suppresses US land values and fuels fears of
deflation in the United States, even though the US banking system is flush with
cheap credit from the Fed.
The fact is nothing the Fed does can appreciably accelerate US economic
recovery or stem deflation as long as China continues to print yuan, buy
dollars and US securities, and make its products woefully cheaper than its
comparative advantage warrants in the United States and Europe.
Coupled with its high tariffs and administrative barriers to imports on
anything the Chinese can make themselves, no matter how awkwardly or
inefficiently, Beijing is hogging growth and jobs, and spreading unemployment
and budget misery among workers and governments from Sacramento to Athens.
This past weekend, Beijing announced it will permit some more exchange rate
flexibility but we have heard those words before. China will likely permit the
yuan to rise slightly against the dollar - much less than 6% a year - while the
true value of the yuan rises much more, thanks to Chinese modernization and
China's announcement is a cynical ploy to assuage critics less than a week
before Group of 20 meetings, and without a substantial one-off revaluation of
the yuan Beijing's words are hypocritical and selfish.
China's yuan policy makes the Fed nearly irrelevant but for crisis management -
bailing out big banks and European governments that make fatal mistakes.
Worse, President Barack Obama's failure to take strong action against Chinese
currency manipulation - for example, a tax on dollar-yuan conversion to make
the price of Chinese products reflect their true underlying cost - crippled the
jobs creation effectiveness of his US$787 billion stimulus package and delivers
ineffective his broader efforts to resurrect the US economy.
Obama's exclusive reliance on diplomacy forfeits US monetary policy to Beijing,
renders impotent US fiscal policy, and visits enormous pain on American
Peter Morici is a professor at the Smith School of Business, University
of Maryland School, and the former chief economist at the US International