OP-ED: The Chinese Disconnect, By PAUL KRUGMAN, New York Times, October 22, 2009
Solid piece by Krugman.
I quote at length:
Some background: The value of China's currency, unlike, say, the value of the British pound, isn't determined by supply and demand. Instead, Chinese authorities enforced that target by buying or selling their currency in the foreign exchange market -- a policy made possible by restrictions on the ability of private investors to move their money either into or out of the country.
There's nothing necessarily wrong with such a policy, especially in a still poor country whose financial system might all too easily be destabilized by volatile flows of hot money. In fact, the system served China well during the Asian financial crisis of the late 1990s. The crucial question, however, is whether the target value of the yuan is reasonable.
Until around 2001, you could argue that it was: China's overall trade position wasn't too far out of balance. From then onward, however, the policy of keeping the yuan-dollar rate fixed came to look increasingly bizarre. First of all, the dollar slid in value, especially against the euro, so that by keeping the yuan/dollar rate fixed, Chinese officials were, in effect, devaluing their currency against everyone else's. Meanwhile, productivity in China's export industries soared; combined with the de facto devaluation, this made Chinese goods extremely cheap on world markets.
The result was a huge Chinese trade surplus. If supply and demand had been allowed to prevail, the value of China's currency would have risen sharply. But Chinese authorities didn't let it rise. They kept it down by selling vast quantities of the currency, acquiring in return an enormous hoard of foreign assets, mostly in dollars, currently worth about $2.1 trillion.
Many economists, myself included, believe that China's asset-buying spree helped inflate the housing bubble, setting the stage for the global financial crisis. But China's insistence on keeping the yuan/dollar rate fixed, even when the dollar declines, may be doing even more harm now.
Although there has been a lot of doomsaying about the falling dollar, that decline is actually both natural and desirable.
Because China insists on remaining pegged to the dollar, which is inevitably and naturally weakening (meaning it's worth less abroad but our stuff is cheaper to export), they're hitching a ride on our devaluation--in effect, screwing the entire world.
Worse, says Krugman, China's policy endangers the recovery--especially among the world's poorest nations:
By pursuing a weak-currency policy, China is siphoning some of that inadequate demand away from other nations, which is hurting growth almost everywhere. The biggest victims, by the way, are probably workers in other poor countries. In normal times, I'd be among the first to reject claims that China is stealing other peoples' jobs, but right now it's the simple truth.
Most counter-intuitively:
The thing is, right now this caution makes little sense. Suppose the Chinese were to do what Wall Street and Washington seem to fear and start selling some of their dollar hoard. Under current conditions, this would actually help the U.S. economy by making our exports more competitive.
In fact, some countries, most notably Switzerland, have been trying to support their economies by selling their own currencies on the foreign exchange market. The United States, mainly for diplomatic reasons, can't do this; but if the Chinese decide to do it on our behalf, we should send them a thank-you note.
Very informative piece and well written.