THE CHINESE CURRENCY: A BIG SHOE THAT COULD DROP!

For over a year the U.S. economy has been just chugging along without any apparent stresses. I mean, nothing has happened within our economy to cause panic or increase the level of fear people are feeling. Certainly, the economy is far from healthy. It is not growing to speak of. Unemployment is very high and few jobs are being created. Some communities appear to be in depression, while others are only marginally affected.

In the political area, the focus related to the economy is all of the promises made and no results. The current administration isn’t being blamed for making things worse, just not making them better. The government has declared that the “big drop” is over, the recession has ended, but the signs that growth is occurring or may happen in the future are muted at best.

My own mood is that of waiting for the other shoe to drop. Well, there are many shoes that could drop. And any of them could be more disastrous than the big dip of 2007. Which one will it be? Or perhaps the question to ask is which one will be first? Only time will tell. Let’s think about one potential shoe, the push to have the Chinese revalue their currency.

One issue that the politicians are focusing upon is the international value of the Chinese currency. It is contended that if the Chinese currency is valued more in line with real relative national purchasing power, the U.S. dollar would be stronger and the U.S. would benefit from a greater demand for its products. There are several things that are difficult about this. It is true that China’s approach is the old, thoroughly discredited view (among those who are aware of the history of economic ideas) that a nation’s wealth is achieved by hoarding valuables. At the beginning of the exploration of the New World, for example, countries would scour for gold and silver in the Americas, bring it home, and put it in a vault and declare that they were wealthy. So, several Asian countries, including Japan and China, insist on controlling the exchange rates (although Japan is trying counter balance that now) and hoarding the dollar and the Euro (China has a large surplus with the Euro Zone as well).

Of course, hoarding anything is not wealth. A dollar, or any currency is only as valuable as what it will buy. A currency, especially a fiat currency, in international trade is a claim on that country’s production.

On the other hand, a country does need reserves (speaking within today’s structure), i.e., a stash of cash available when and if needed to settle international debt or payments. What cash is available? Well, they aren’t going to begin using gold, if for no other reason than that the process of beginning to use gold would cause the value of the dollar to die. The same problem holds for any other currency that could be chosen other than the dollar. If the process of changing to another currency was done slowly, perhaps the dollar wouldn’t collapse. Unfortunately, such a process should have started a couple decades ago.

As it is, the international system is stuck with dollars into the foreseeable future. Okay, but there is no need for countries like China and Japan to continue accumulating dollars. They have more than they need, and they are worried about the constant flow of dollars and what that means for the future. What they could do is to turn around and begin buying stuff from us with the dollars that they would have hoarded, the current cash flow. Sounds good, right?

We will even ignore the probable, immediate consequence that the dollar would lose significant value just because it wasn’t being hoarded as before. Forget that. Forget that immediately, foreign goods would be significantly more expensive. Let’s just concentrate on our own goods.

The mainstream economists think that to create growth, what is needed is consumption, more spending. That is why they set things up to expand the money supply. More money, more spending, more wealth, they think. Great, huh! So, these same economists would be happy for foreigner to be spending more in the U.S. It means more demand. They felt the same way years ago when the economy seemed to be humming right along, with very high employment, and very low unemployment. We had what some called “full employment”. I always wondered what they thought was going to happen. The unions, progressives, Keynesian economists all thought that more money running after our goods was going to be good, when there was no one to produce them.

Today things are a little different. We have a large number of people unemployed and lots of capacity that is sitting idle. It is not the most efficient capacity, but it is there. What we don’t have is a significant amount of raw material sitting around. Nevertheless, as foreigners began to send those dollars that they don’t hoard back to the U.S., we will now see more dollars running around. At first, the new demand will cause some shortages, and prices will begin to rise, since the actual stock of good will be unaffected, at least for a while. Then, over time, more capacity will be used, more people rehired, more produced. But, then the real bottleneck appears. Or rather two bottlenecks. One will be the need for raw materials for the higher level of production. Costs will have to rise to compensate for the higher costs of materials as users bid for the material available. The other bottleneck is that some new investment will be needed, but the government has soaked up all available savings for its deficit. To get loans or attract investors, businesses wanting to expand will have to bid against the government for savings. That will also tend to raise costs, and the cost of government borrowing will also increase.

What this really means is that the return of all of the money we send out in a year for foreign trade will result in higher prices, both for domestic goods and much more so for foreign goods. It is unlikely that we would see the “gentle” 1-3% inflation we have seen with few exceptions over the last couple of decades. It will be higher.

Now why would we see higher inflation just because foreigners spend the money that we sent for goods? It certainly wasn’t the case throughout our history, right? Wouldn’t it make sense for there to be a balance? Well, yes. But our situation over the last decades is very different. It is hard to understand, apparently. Some supposedly free market bloggers don’t accept my thinking here.

For decades we have had not only a trade deficit, but a cash-flow deficit, called a current account deficit. While the trade category covers trade, obviously, it doesn’t include investment flows between nations and government transfers. Normally, if a country has a trade imbalance, the difference is made up by the return of the deficit in investment, or the purchase of government bonds, for example. Even then, if the current account is not in balance one year, it swings back the other way the next, or at least over time a country’s current account will balance out. This has not been the case for the U.S. for a long time. The current account deficit will be less than the trade deficit.

One way to understand what is happening would be to imagine that you are a country and buying from other people – countries – often. Your purchases are all made by check. You send out many checks and everybody honors them and sends you the merchandise you want. But, you find out, by analyzing your checkbook that some of your trading partners are not cashing your checks. They are just keeping them (for some strange reasons – your crazy cousin has all kinds of weird theories as to why, saying that they want your checks as reserves, that your partners use them as cash with other people, etc.). So, you have both the things you bought and the money you with which you thought you bought them. Sounds like a good deal. It is sort of. But, if your honest, and know that there is a future, you might be somewhat worried about what happens when all of those checks come wondering back, especially if they all come back at once!

Let’s take 2009. The U.S. bought more stuff than it sold by $374 B. The current account difference was $378 B (usually, the current account deficit is smaller than the trade deficit). You can look at the history of the U.S. current account here. So, there have been billions upon billions of dollars that have left the country and not come back, not even as loans to our government. My discussion in this post is limited just about this year’s money not returning. (Think how bad things would be if the money from past years returned as well!)

Under a gold system, if money left every year and didn’t return, the money supply would continue to shrink and there would be a corresponding drop in prices. There would be ramification of a continued outflow of dollars. There are ramifications under the present circumstance, just not the ones that would occur in a rational economy. In the present circumstance, the U.S. price level actually continues to creep up. That is because the money supply continues to creep up. The money supply creeps up in spite of billions of dollars being lost every year to foreigners. Where is the money that is being lost coming from? I am sure that you know the answer. It is the Fed., the official U.S. money maker upper!

One key fact to remember about international trade is that it functions completely on credit. When an importer buys, he sends a letter of credit, which does not pay the exporter until the goods are received and accepted by the importer. The letter of credit is a bank document, and is what it says it is, a credit, a loan. Purchases by U.S. importers are financed by bank credit pushed by the Fed. We see that even though banks in the U.S. are not making loans to businesses for new production, they are making loans for importing, i.e., we still have a big trade deficit. The money we have been exporting for years is all made up, Fed. produced money. So the Fed increased the money supply, we sent it overseas to buy stuff, and those people kept the money, just like the example with your checks. (Why? See my discussion of Schiff’s book, Crashproof. The “Why?” is even more a big question after they have kept so many dollars after so many years.)

The situation is not good for the Chinese and other countries that have built up big surpluses of foreign money (which is mostly in digital form). Recently, there was a push to move away from dollars toward a “basket” of currencies, including Euros. The wisdom of that idea was demonstrated this summer as many of the Euro Zone countries have been shown to be in financial difficulties. Maybe people will begin to realize that fiat currencies of any stripe will not stand up to normal, mixed economy political processes. The dollar became strong, i.e., higher priced against the Euro, for a while because the dollar again looked like the strongest, safest currency. That view will fade. So the Chinese, to use them as the example because they have the biggest hoard, are sitting on vast sums of dollars, some of which are “invested” in U.S. government debt, a little of which is invested in other countries, both real assets and government debt, and some of which is sitting as reserves, as gold would sit. If and when the dollar falls, the value of these massive holdings will fall, which would not be good for the Chinese economy. Thus, the Chinese are walking a tight rope, trying to keep the dollar from a death dive, which also means their currency at a lower price, and make small moves to reduce their dependency on the dollar. Everyone is watching them. They have to be careful.

Which also means that they are confused by the U.S. political leaders constant demands that they increase the value of their currency. The Chinese realize to some extent the consequences of that action. They can only be astounded by the U.S. politicians. Those fine people, the Congressional leaders don’t seem to have much understanding of international economics (not surprisingly, since they don’t have much understanding of domestic economics, either). They do understand that the jobs issue plays very well in this country. They see that demanding that the Chinese buy more U.S. stuff there might be more U.S. jobs, and play it for all they can. Real consequences are far out weighted by political appearance. They can always blame someone else for the unexpected consequence.

But if the Chinese, and the other Asian countries begin spending those dollars on U.S. goods, we begin to see those made up dollars running after the few goods we have purchased and prices begin to rise, interest rates begin to rise, and the quiet calm that we have had, a quiet calm in which we have been able to have good fight for our lives, will end and who knows what could happen then.