Mises Daily

A Closer Look at China’s Currency Manipulation

There is much disagreement on how the United States should deal with China’s persistent devaluation of the yuan. Worse, there is still substantial confusion on the actual effects of an undervalued yuan on capital markets, “trade deficits”, and the economy in general. The most widely accepted and common theory goes something like this: currency devaluation helps China by boosting its exports, and hurts the United States by widening the “trade deficit.” Indeed, President Barack Obama recently suggested that the United States needed “to make sure our goods are not artificially inflated in price and their goods are not artificially deflated in price; that puts us at a huge competitive disadvantage.”

Given the near consensus — at least among mainstream academia — on the hurtful consequences of an undervalued yuan, most disagreement lies in deciding in what form the United States should respond or retaliate. Nobel laureate and Princeton professor Paul Krugman suggests imposing tariffs on Chinese goods as a way of undermining the efforts of the Chinese to make their goods cheaper in dollars. Greg Mankiw argues otherwise, fairly citing that protectionism is not a way of stimulating trade.

While the thought of engaging in trade wars — in the midst of a global depression — with the Chinese is unnerving, the worst part of it all is that the relevant economists have failed to see their mistaken premise. Mainstream academics have fallen for an old mercantilist fallacy: the theory that inflation helps the economy by driving exports. As Paul Krugman claims,

As I’ve written many times in various contexts since the crisis began, being in a liquidity trap reverses many of the usual rules of economic policy…. Mercantilism works: countries that subsidize exports and restrict imports actually do gain at their trading partners’ expense. (emphasis mine)

Krugman’s premise is incorrect. For the individual Chinese entrepreneur, the undervalued yuan has brought disaster. China’s central bank is not subsidizing the Chinese exporter but the American importer. Furthermore, ongoing inflation will only hurt both the Chinese consumer and the Chinese saver, as prices go up and savings are confiscated by depreciating their value. This is an economic fact whether the economy is growing or crashing. The liquidity-trap caveat is Krugman’s form of attacking savings. Not only are savings necessary for recovery and growth, but, ironically, it is only due to the so-called “trade deficit” that the Chinese have been able to finance much of the American government’s spending — the Keynesian panacea for recessions.

While it’s worrisome that some of the most respected economists of the mainstream have failed to assess the yuan’s situation correctly, it is outright frightening that this mistake has led to the application of more bad economics. Currently, world governments are looking to enact tariffs and quotas on each other in an effort to win an “upper hand” in the global marketplace. But, as the saying goes, “the road to hell is paved with good intentions.” These Keynesian — nay, mercantilist — economic policies will lead only to global disaster, and most of the damage will not be done on foreign markets, but on the markets the politicians claim to protect.

China and the Undervalued Yuan

Oftentimes, when looking at international trade from a macroeconomic bird’s eye view, one loses perspective on how trade actually works. The truth is that trade between China and the United States works no differently than trade between a tailor and a neighboring baker. It is far easier to objectively assess the current trade situation between China and the United States by looking from the perspective of the individuals who make up the exchanges. In other words, trade between two countries is nothing more than exchanges between individuals from Country A and individuals from Country B. Taking money into consideration makes the concept only slightly more complex.

“The Chinese government is not only sponsoring theft from China’s producers but also from her consumers and savers.”

Chinese goods are usually valued in yuan. The Chinese producer is interested in selling his goods only to make an income so that he may purchase either consumer or capital goods. Given that the producer lives in China, the only currency that is generally valuable to him is the yuan. An American, on the other hand, usually only holds dollars, because that is the most widely accepted unit of currency in the particular area he usually trades in. It thus becomes necessary for the American to buy yuan from someone interested in holding dollars, so that the American can turn around and use the yuan to buy the goods from the original Chinese producer. The price of the yuan in dollars, or vice versa, is known as an exchange rate. The dollar–yuan exchange rate is decided roughly by the supply and demand of either unit.

The People’s Bank of China increases the supply of yuan as a way of devaluing it, allowing an American to buy more yuan for the same dollar. This makes Chinese goods cheaper, thereby attracting foreign buyers. Now, this is where many economists, including Paul Krugman, get confused. Krugman writes,

The more depreciated China’s exchange rate — the higher the price of the dollar in yuan — the more dollars China earns from exports, and the fewer dollars it spends on imports.

Well, not exactly. By making Chinese goods cheaper through inflation, the People’s Bank of China is effectively subsidizing the American importer. Think of it this way. The Chinese producer fabricates Widget X, which before inflation is on the market for eight yuan. Let us assume that at this point the natural, market dollar–yuan exchange rate is one to four, which means that Widget X effectively costs two dollars (one dollar buys four yuan, and the widget costs eight yuan).

However, China’s central bank steps in and inflates the yuan, causing the exchange rate to change to one to eight (one dollar to eight yuan). Now Widget X will cost the American consumer only one dollar. The winner is clearly the American, who purchased the good for half of the original price. The loser is the Chinese producer, despite now having eight yuan; each yuan is really worth half as much as before inflation. In effect, inflation cheated the Chinese producer out of half of the value of the good being sold. Although this example does not represent real-world changes in the exchange rate, the point stands. Over the long run, it becomes clear just how injurious currency devaluation is to the Chinese economy.

Krugman’s mistake in his quote above is a product of sloppy analysis. By looking at the macroeconomic picture, or the total volume of exports garnered through inflation, Krugman fails to realize that the Chinese are selling their goods at a loss. They are making less dollars for the same amount of goods being sold, and that certainly is not good for business.

Tragically, not only the Chinese entrepreneur is harmed, but so is the Chinese consumer. While inflation does not occur simultaneously and throughout an entire market, over a period of time there occurs a rise in the price of consumer goods. Indeed, as the new money trickles into the hands of the average Chinese citizen, through wages, the price of goods in demand are bid up. It follows that the Chinese consumer becomes poorer. Worse, savings are confiscated as the value of the accumulated savings depreciates in the face of rising prices. The Chinese government is not only sponsoring theft from China’s producers but also from her consumers and savers.

That Darned Liquidity Trap!

According to a Keynesian — well, at least to Paul Krugman — basic economics is turned on its head during recessions. Krugman writes,

By creating an artificial capital account deficit, China is, as a matter of arithmetic necessity, creating an artificial current account surplus. And by doing that, it is exporting savings to the rest of the world.

There is nothing wrong with the first sentence, but the second should be clarified. What Krugman means by “current account surplus” is that China is holding a “surplus” of dollars. It does not necessarily follow that the average Chinese individual will then save them. The dollar, as previously established, is not particularly useful to the Chinese individual. In China, goods are sold and purchased in yuan. So, a dollar is only useful for buying American goods or buying corporate bonds and other types of private securities. In all cases, the dollar is returning to the United States.

In a Keynesian world, however, there is another reason why the Chinese would like to buy dollars. As Krugman writes,

In normal times, you could argue that this policy provides benefits to the rest of the world, by reducing borrowing costs (although given what we did with those capital inflows, maybe not). But these aren’t normal times. We’re currently living in a world in which both central banks and governments are unable or unwilling to pursue sufficiently expansionary policies to eliminate mass unemployment; so it’s a paradox of thrift world, in which anyone who tries to save more reduces demand, reduces employment, and — because investment responds to excess capacity — ends up actually reducing investment.

The shaky credibility of the Keynesian “paradox of thrift” aside, Krugman is arguing that lower borrowing costs are not justified when American investors aren’t borrowing. Instead, Krugman believes that the Chinese should be consuming more.

“We are in a frightening state of affairs, where the government feels the need to commit acts of aggression, through the use of tariffs and quotas, as means of ‘economic defense’.”

But dollars being sold to the Chinese for their goods aren’t just sitting in a tall pile in the center of Beijing, or stashed under Chinese mattresses. The Chinese aren’t purchasing American goods, because American public debt has shown itself to be a much more lucrative buy. Dollars not spent on American goods are being used to purchase Washington’s growing debt: $889 billion worth. The dollars “accumulated” by the Chinese through their trade surplus are being spent by the US government! If there is anything deserving of blame for wasting dollars, it is the American government.

Mercantilist Economics

Central planning is a necessary tool of the state. Whether the state’s role is to protect property rights or to oversee the economy, a state must coordinate the flow of resources in order to fulfill its role. History has shown that when the state has grown to a degree where it can intervene at will, it begins to assume that it has the responsibility to do so. Bureaucrats feel required to intervene in behalf of “the people” as a method of guaranteeing the well-being of the citizenry. Thus is born the economics of mercantilism, otherwise known as Keynesian economics.

But such economics are not built from the perspective of the individual, but of the state — policy makers fail to realize how their decisions affect the average American (or worse yet, policy makers cater to specific interest groups at the expense of the general welfare). How else could one think that a tariff, making foreign goods more expensive, benefits the average person?

Indeed, the mercantilist arguments for currency devaluation seem to all revolve around the concept of reducing or increasing the national trade deficit, or increasing the national gross domestic product. But, looking at economics from this angle leads to severe theoretical flaws. It is, as Frederic Bastiat would have put it, looking at the seen, but not the unseen.

The market is not ruled by overarching laws. Markets are composed of interacting individuals, each of which have their own laws, trends, and subjective valuations. Therefore, government intervention can only distort the way individuals interact with each other. Under all circumstances, interventionism does more harm than good. Necessarily, in each act of intervention a government must benefit one group at the expense of another, because only through voluntary exchange can all parties feel satisfied.

This remains true in the case of Chinese mercantilism. China’s inflation has been benefiting Americans at the expense of her own people. Just as well, retaliatory mercantilism by the United States will do the same. Only an individual can truly judge, through rational thought, whether or not to engage in an exchange. When the state intervenes on behalf of the individual, the leviathan has a tendency to forget about said individual and instead focus on the well-being of the bureaucracy. This leads not only directly to impoverishment, but also to war.


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We are in a frightening state of affairs, where the government feels the need to commit acts of aggression, through the use of tariffs and quotas, as means of “economic defense.” As even our current experience with China shows, trade wars have a tendency to escalate. It is even more unfortunate that a large proportion of a nation’s academia — supposedly of great erudition — agree with economic policies that will only lead to the destruction of wealth and to political disaster. It suffices to say that if the present rate of intervention continues to accelerate, the future looks dim indeed.

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