US treasury secretary-designate Timothy Geithner’s charge that China “manipulates” its currency proves only one thing. Three decades after Deng Xiaoping’s capitalist rise, the US’ misunderstanding of China remains a key source of its own crisis and socialist tilt.
The new consensus is that the US failed to react to the building trade deficit with China and the global “savings glut” which fuelled the housing boom. A “passive” US allowed China to steal jobs from it while Americans binged with undervalued Chinese funny money. This diagnosis is backwards. The US did not underreact to the supposed Chinese threat. It overreacted.
We’ve heard the refrain: China was stealing wealth by “manipulating” its currency. But, in fact, China’s rise was based on sound money.
After 500 years of inward-looking stagnation, Deng opened 1979 with a bang. He freed 600 million peasants with history’s largest tax cut. He emulated Hong Kong and Taiwan by establishing four special economic zones on the sleepy southern coast. Before Beijing hardliners knew it, mayors across China were demanding similar low-tax, local-control freedoms. By 1993, 8,000 of these entrepreneurial free trade zones had swept the nation. Capital poured in from China and the world.
China needed an anchor for its complex transformation and, in 1994, linked its currency, the yuan, to the US dollar. The dollar-yuan link allowed a real price system to arise in China and created a single economic fabric stretching across the Pacific.
The opposite of currency “manipulation”, this dollar standard was a victory for free trade and global growth. But US economists missed its portent. The US Federal Reserve and treasury of the late 1990s did not supply sufficient dollars to match rapidly growing global demand. A scarce dollar shot higher, and hard assets fell. Oil plummeted to $10 a barrel (Rs489 now), gold fell to $250 from $400, credit shrivelled, and dollar debtors across Asia went bankrupt.
In 2003, Alan Greenspan and Ben Bernanke identified an exotic threat: deflation. The Fed was seven years late. Greenspan’s post-9/11 liquidity had already ended the 1997-2001 deflation. Yet, the Fed persisted with 1% interest rates through 2003-04 and easy money thereafter. Meanwhile, treasury secretary John Snow targeted China and its trade surplus as a big threat. He and his successor Henry Paulson agitated for a stronger yuan and, thus, a weaker dollar.
The US treasury’s trade deficit mania encouraged anti-China politicians. But the administration did not realize that the weak dollar policy was itself protectionism.
The US-China trade deficit grew. But the real threat was a devalued dollar. In mid-2005, Washington finally forced China to delink from the dollar and mildly appreciate the yuan. Nevertheless, the trade deficit accelerated. Economists urged a “more competitive dollar”.
The weak dollar had the opposite of its intended effect. Cheap dollar commodities exploded the trade gap. Conceived to make the US “more competitive”, the policy channelled money away from technology innovators and into home-building and home equity consumption. Inflation for a time does pump up demand, and so US consumers bought and Chinese growth shot even higher. Chinese foreign reserves grew further depressing the yields of US treasurys.
And yet, with sound-money advocate Paul Volcker in the Obama White House, the monetary mayhem of the last decade could give way to a worldwide, sound-money revival in 2009 and beyond.
THE WALL STREET JOURNAL
Edited excerpts. Bret Swanson is a senior fellow at the Washington-based Progress and Freedom Foundation. Comments are welcome at firstname.lastname@example.org