The Chinese Aren't As Dumb As the Fed Thought

Here’s the first serious salvo across the bow of the USS Greenback. The head of China’s central bank said the dollar ought to be replaced by another reserve currency. Here’s the gist of the article in the Wall Street Journal:

China called for the creation of a new currency to eventually replace the dollar as the world’s standard, proposing a sweeping overhaul of global finance that reflects developing nations’ growing unhappiness with the U.S. role in the world economy…

Chinese officials are frustrated at their financial dependence on the U.S., with Premier Wen Jiabao this month publicly expressing “worries” over China’s significant holdings of U.S. government bonds. The size of those holdings means the value of the national rainy-day fund is mainly driven by factors China has little control over, such as fluctuations in the value of the dollar and changes in U.S. economic policies…

In recent weeks, senior Obama administration officials have sought to reassure Beijing that the current U.S. spending spree is a short-term effort to restart the stalled American economy, not evidence of long-term U.S. profligacy…

Mr. Zhou’s [governor of the People’s Bank of China] comments — coming on the heels of Mr. Wen’s musing about the safety of China’s dollar holdings — appear to be a warning to the U.S. that it can’t expect China to finance its spending indefinitely.

Zhou Xiaochuan

Mr. Wen had the temerity to suggest that replacing the dollar with a basket of currencies created by the IMF would be good for us because it would put a limit on our profligate ways. Those ways, he noted, led to the collapse of most world economies.

China has a problem because in large part its economy is tied to ours. They ship their goods to us because the price is right and we ship them back green pieces of paper called “dollars.” When the Chinese sellers of goods receive those dollars, they, in turn, are forced to exchange them for yuan at the official exchange rate. The Chinese government ends up with $1.95 trillion and needs to do something with them.

If they let the market determine the value of their yuan, it would go up in price and the dollar would go down. This would mean the dollars they hold would be worth less in relation to the yuan and it would also make foreign goods more expensive for them. They have tried to prevent this by tying the value of the yuan to the value of the dollar. If the dollar goes down, the yuan goes down, etc. So the relative value of the yuan-dollar exchange rate stays the same.

If the dollar goes down in value, however, their dollar currency reserves are worth less. They would much prefer it if the dollar would stay at the same value. But that’s not what’s happening. The Chinese have been quietly talking about this for years but haven’t done anything about it because, compared to all the other currencies in the world (those with worldwide acceptance), the dollar is seen as being more stable and, if reinvested here in US treasuries, safe.

The Chinese are very upset at us now. They blame us, rightfully, for the economic mess the world is in. Not that they and every other country in the world didn’t go on a real estate binge as well, so it’s somewhat hypocritical. But, it started here and we exported a Fed induced credit bubble which gave rise to junk mortgages, and, well, you know the rest if you’ve been following me.

I see this as a crack in the dike so to speak. When a power like China says these things, it’s serious. Things aren’t going to change overnight because of the complications of international trade and the role of currencies. But I see a trend. Last week’s announcement by the Treasury and the Fed that they were going to print a trillion dollars helped the discussion along. The whole world knows that eventually we’ll see inflation and the further devaluation of the dollar.

The consequences to us as a result of being replaced as the world’s reserve currency will be a further depreciated dollar. It will also make our taxes go up to pay the increased interest costs on our national debt as the Treasury finds it needs to make the rates on Treasuries more attractive to foreign investors.

What could replace the dollar? The Chinese and others suggest the IMF issue bonds backed by a basket of currencies—special drawing rights (SDRs). This would in essence, try to replace the dollar as a reserve currency and sort of create a supranational central bank. This is the worst thing that could happen to us. We’d have a group of Keynesian econometricians who are worse than our Keynesian econometricians controlling the world’s currencies and international trade. Trust me when I say we would get the short end of that stick.

What about gold? It worked pretty well for the last 6,000 years of human history. It is valued by everyone, it is seen as a monetary metal, it would create a stable medium of exchange, there is plenty to go around, and it takes away the power of the central banks to inflate. I believe, as do most free market economists, that it would serve us well. We’ve heard all the arguments against it and have some pretty good answers. This is not the time for me to expound on gold; I will do that at another time.

In the meanwhile, watch the fun at next week’s G20 meeting in London.