There’s a clamor in Congress to try to force China to revalue its currency. Advocates say that would make a more-even playing field for U.S. produced goods. But they should be careful what they wish for. Consider these examples:
Some 33 years ago, as a young farmer, I went to the auction of a neighborhood farm. This was the height of the 1970s boom and the winning bid was for an unheard-of amount. I knew the purchaser and congratulated him. “Yes,” he replied, “We have the extra land we needed. Now if only the government would get inflation under control and do something about the value of the dollar.”
At that point, I had not taken a single economics course, but I gasped. Even to a history major dropout it seemed clear that the only way the purchaser could hope to pay off his new mortgage would be if inflation continued for years.
Five years later, President Jimmy Carter appointed Paul Volcker to head the Federal Reserve. Volcker squeezed inflation out of the system, interest rates rose sharply, the U.S. dollar rose in value and the once-happy farm buyer, like hundreds of thousands of others who had bought expensive land, lost the farm, had to liquidate his entire farming operation and went through bankruptcy.
In the 1890s, the Canadian Pacific Railroad got government funding for a new rail line that passed through Crowsnest Pass in the Canadian Rockies. The deal involved perpetually low freight rates for Canadian prairie farm products destined for export. Over time, it extended to all railroad lines in Western Canada.
By the 1970s, U.S. farmers railed against “the Crow rate” as an unfair export subsidy for Canadian wheat. They campaigned hard for its abolition, thinking it would make Canadian grain more expensive in competitive export markets, thus helping move U.S. grain.
Canada did abolish the rate in 1995 for domestic political reasons. Canadian farmers reacted rationally. If the price of wheat drops because it now costs more to ship to an export port, grow barley instead. Feed the barley to hogs and ship them down Interstate 29 to slaughter in Sioux Falls, S.D. Then U.S. farmers really howled.
Congress now has a bipartisan wolf pack baying about how China’s unfairly low-valued currency keeps Chinese exports to the U.S. cheap. Congressional critics are correct that currency manipulation creates a trade advantage, and many see this as unfair.
Individuals in both parties advocate laying down the law to China. Immediately revalue the yuan by 30 percent or we will impose a tariff of that magnitude on imports from China, they threaten.
Their idea is that more-expensive Chinese products will reduce competition for domestic U.S. producers, allowing them to increase production and hire more workers.
It would do that, to some extent, but the return to profitability would derive from consumers paying higher prices. With imported alternatives more expensive after a Chinese revaluation, U.S. producers would be able to raise prices, and they would.
A Chinese revaluation of the yuan has the same effect as a devaluation of the U.S. dollar. Latin American countries, many of which long sought to keep their currencies as strong as possible, know the painful effect of a sharp devaluation. So do those of us who remember the devaluation of the dollar when the Nixon administration unilaterally ended the Bretton Woods payments system in 1971-1973. For countries that import a great deal, devaluations cause spikes in inflation rates.
If China were to revalue the yuan by 30 percent next week, U.S. consumers would experience a sudden epidemic of sticker shocks.
The only way to keep suddenly-more-costly imports from fueling U.S. inflation would be for the Federal Reserve to sharply crimp the money supply. In other words, they would have to raise interest rates.
It gets more complicated. China keeps its currency weak by printing lots of yuan that it then sells to buy dollars. These dollars are invested in U.S. bonds.
If they stop printing yuan and stop buying U.S. bonds, they will have done what the U.S. Congress asked. But that will suck hundreds of billions of dollars out of U.S. capital markets. Interest rates on Treasury bonds will go up. So will interest rates on home mortgages, car loans and business and farm operating loans. The Fed won’t be able to replace diminished Chinese investment because doing so would require money supply increases that would fuel inflation.
Current Chinese monetary and export policies do cause some harm to the United States. Ending these policies, particularly if done abruptly, would cause other harm. Higher interest rates and worsening inflation would not be helpful right now.
Gradual adjustments usually are less traumatic than sudden shocks. China is letting its currency value float upward slowly. We can encourage it to do so more rapidly. But a sudden Chinese revaluation might cause pain that China-bashers in Congress never even thought about.
© 2007 Edward Lotterman
Chanarambie Consulting, Inc.