April 17, 2013

Finest Hour 153, Winter 2011-12

Page 30

Churchill for Today / China’s Challenge / Overvalued Yuan? Or  “Sterilization”?

By Ryan Brown

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The rapid rise of China as a global economy and major trading partner is stirring controversy in the United States Congress. Accusations of Chinese currency manipulation have lawmakers considering a bill that would encourage protectionist tariffs to punish China for augmenting its trade surplus and stealing American jobs.

As a centrally planned economy, China is intentionally trying to expand its exports at the expense of its trading partners. But targeting the value of the Chinese Yuan through protectionism will not correct these festering imbalances. In this quandary, there is much we could learn from the Churchill experience.

Today’s international economic system is dominated by “Chimerica,” a moniker for the complex financial and commercial relationship between the two largest world economies. For decades, the Yuan has been pegged to the U.S. dollar at a specified rate of conversion. This type of fixed exchange rate establishes a single currency zone between the two countries, but leaves their national monetary policies autonomous.

Since there is no fixed quantity of money (as there would be under the Gold Standard) the fluctuating amounts of paper money in circulation change the value of these respective currencies. This puts tremendous pressure on the fixed exchange rate to adjust according to those changing values. Currently, the Yuan is too cheap compared to the dollar. This keeps Chinese prices lower than other nations’ products.

The undervalued Yuan has allowed China to run a chronic trade surplus at the expense of other nations. This process, however, would quickly collapse under the weight of market pressure were it not enabled by government intervention on both sides of the Pacific. The exchange rate is only the surface of this problem; the root of these trade distortions is something few talk about: currency sterilization.

When the U.S. uses paper money to purchase foreign goods, recipients of those dollars generally use them to finance the purchase of American goods or sell them to their government in exchange for domestic currency. Both these actions stabilize the balance of trade—by increasing imports or adjusting the domestic price level upwards.

But when American money reaches China, the central bank prevents these dollars from financing imports of international goods by purchasing them with newly issued Yuan. The People’s Central Bank then raises reserve requirements on banks and sells “sterilization bonds” to pull these additional Yuan off the market and keep the price level static.

The Chinese government takes this reserve of sterilized dollars, which functions as their “national savings,” and purchases debt securities from the United States government to finance American deficit spending. The U.S. government remonetizes these dollars by spending them, reinitiating the distorted balance of payments cycle.

On one side of “Chimerica,” the People’s Central Bank is hoarding vast sums of capital. On the other side, the Federal Reserve is fueling American overconsumption through excessive borrowing.

Addressing these unsustainable trends is imperative, but the recently introduced Currency Exchange and Oversight Reform Act fails to diagnose the problem or propose a realistic solution. As the American economy continues to flounder, Chinese manufacturing, supported in part by America’s burgeoning trade deficit, flourishes. The proposed bill would enable the government to establish protective duties on nations declared to have “fundamentally misaligned currencies.” Lawmakers seeking to punish China for currency manipulation forget that American fiscal policy depends on similar monetary interventionism, such as “quantitative easing” (the Federal Reserve purchases bonds with newly printed currency to inject money into the market, thereby devaluing the dollar).

It is true that the undervalued Yuan causes distortions in the global economy and should be revalued. But forcing Americans to pay more money for imports (through higher tariffs) will not reduce the trade deficit or stop China’s practice of monetary sterilization.

Well-meaning bills often have unforeseen consequences: an appreciation of the Yuan, for example, will enhance the competitiveness of Chinese businesses by increasing their profits. The trade deficit has already widened over the past six years as the Yuan rose against the dollar in two different periods. A trade imbalance will persist until Chinese capital controls are removed or broken by market pressure. Had the United States complied with the laws of supply and demand, these Chinese antics would have backfired long ago; instead, American policymakers have facilitated Chinese trade manipulation.

If American lawmakers really desire to restore a stable balance of trade, they must first stop stimulating overconsumption and bring the federal budget much nearer to balance. The fiscal interventionism of the United States government is the great enabler of Chinese currency sterilization. Rather than risk a trade war with China or potentially violate World Trade Organization commitments, Congress should encourage job creation by liberating American producers from restrictive regulations and high corporate taxes.

These antiquated policies, not the success of China, are a leading cause of American unemployment. Restoring American financial order will help to break this vicious trade cycle. Nevertheless, the international problem still demands a multilateral solution. The World Trade Organization must be consulted in this process, and the Chinese, for their own sake, must stop sterilizing capital inflows. If the present cycle continues, market forces will continue to build pressure on both the Chinese and American economies until a crisis returns the world financial order to equilibrium.

Although many of the specific policies employed by Winston Churchill are no longer available to us, the principles that guided him endure. During his tenure as Chancellor of the Exchequer, Churchill opted for the Gold Standard because it would provide the strict fiscal discipline that Britain desperately needed and purge the British economy of rampant imbalances.

As he dealt with Britain’s floundering export industries in the wake of World War I, Churchill fought to restore fair competition by removing barriers preventing economic realignment. Though Britain’s finances were hampered by war debts, he still sought economy in government to give room for private enterprise to grow. Most of all, Churchill had the foresight to see through popular protectionist fallacies. As he explained, “To think you can make a man richer by putting on a tax is like a man thinking he can stand in a bucket and lift himself up by the handle.” Churchill understood that tariffs were occasionally a necessary tool to defend the freedom and independence of a nation. But they are not the means to create wealth.

As Britain’s Chancellor in the 1920s, Churchill endeavored to lay the foundations of a stable world system on economic reality. He did not try to ignore these fundamentals with monetary policy, or by capitalizing on trade anomalies for short-term advantage.

Though currency sterilization was rampant in Churchill’s era, his fiscal policies did not allow Britain to engage in this practice, or to accommodate this form of trade manipulation directly.

Rather than searching for quick fixes, or proposing symbolic distractions from real problems, Churchill bravely chose the most difficult path open to him, because he was convinced it would restore genuine prosperity to Britain and balance to international trade. As Churchill navigated the turbulent interwar years, he recognized the need for temporary sacrifices to obtain lasting prosperity. We face the same great challenge of abiding by the timeless principles—despite their temporary costs.

Works Cited

Niall Ferguson, “What ‘Chimerica’ Hath Wrought.” The American Interest, January-February 2009. http://bit.ly/tYDEYb.

John Greenwood, “The Costs and Implications of PBC Sterilization,” The Cato Journal, vol. 28, no. 2 (2008): 208. http://bit.ly/uDrKeU.

Daniel Ikenson, “Create Jobs? China Bill 300 Percent More Likely to Destroy Jobs” Cato Institute, http://bit.ly/tKcMhh.

Lewis Lehrman, “China: American Financial Colony or Mercantilist Predator.” The American Spectator, 13 September 2011, http://bit.ly/rN5xwW.

United States Senate, 111th Congress, S. 3134, Currency Exchange Rate Oversight Reform Act of 2010. GovTrack.us (database of federal legisla- tion), 2010, http://bit.ly/u4hz3f.

Winston S. Churchill, “The Free Trade League,” Speech at Free Trade Hall, Manchester, 19 February 1904, Churchill Centre, http://bit.ly/tXB21w.