Friday, March 19, 2010

China's Currency Policy, The Financial Crisis and the Future of Financial Reform

China's currency policy is once again under attack. But this time, it finds support within the US from prominent economists close to the Bush Administration.

The current administration is on the verge of labeling China a currency manipulator. They believe China weakens it's own currency artificially to support exports; hurting American producers.

On the other side are 'Bush' economists who refuse to acknowledge this as a threat. As these economists were a part of the Bush Administration, their response is as close to the erstwhile regime's thought process as we can get. They believe consumers benefit from lower costs and if China wants to subsidize American consumers through a weak currency policy, there is no cause for alarm.

Not surprisingly, there is strong logic on both sides. After all, both have an almost equal share of the brightest minds working for them.

However, the Bush Administration's argument has a serious flaw. Consumer benefit is restricted to the price difference between goods made in US and China. Loss to the US economy is the total value addition in producing these goods which now belongs to China. Logic dictates that the latter is substantially larger than the former. In addition, more Chinese goods would result in imports rising without a corresponding rise in exports and trade deficits would increase substantially.

The Bush Administration chose to live with this outcome because they discovered the power of consumer lending. The disinflationary impact of Chinese imports allowed the Bush Administration to follow inflationary fiscal and monetary policies without resultant inflation. Interest rates were cut and money created at an unprecedented pace. Cheap and abundant money gave consumers the impression that they could borrow as much as they wanted, when they wanted, and that this had nothing to do with their income.

The resultant wellbeing and cheer made the Bush Administration confident that they had found the Holy Grail of monetary economics. Ben Bernanke (A Bush Appointee) even went to the extent of suggesting that if things went wrong, he could always carpet bomb whole cities with money from a helicopter.

What they did not foresee, or chose to ignore, was the impact of this policy on asset prices. Consumer prices were clearly under control because China could always produce goods cheaper. But neither China, nor any country in the world, could produce investment assets at the required pace. This inability was more pronounced when it came to real assets like Land where mass production stopped roughly around the beginning of time. With more money chasing existing assets, prices rose, causing asset price bubbles.

The resulting trade deficits would lead to a currency demand-supply mismatch for most countries. But not the US. The status of the US Dollar as the world's Reserve Currency makes them special. It gives the US the ability of borrow from foreigners in their own currency, the US Dollar, making them immune to foreign exchange risk.

The belief that they could create large quantities of money without the associated pitfalls lead to the belief that they will always have enough money to repay any borrowing, regardless of their income. This, in turn, allowed them to run fiscal deficts of an abnormal magnitude and finance them through borrowings.

So we got substantial trade deficits, fiscal deficits, asset bubbles and overleveraged consumers. All the required ingredients for a full blown financial crisis.

But is Chinese currency policy responsible for the financial crisis, or did it merely provide American policy makers the required environment to perpetuate one? The Obama Administration seems to believe that the answer is somewhere in between. And they want it to change.

But change will take more than twisting Chinese arms on currency management. It will need real financial sector reforms, which Chris Todd's proposed legislation is not. It is based on the belief that regulators were completely faultless and the financial crisis was caused by some rogue regulatees. It is designed to give more powers to the existing set of regulators and the odd new one in the hope that they will be able to identify financial risks earlier and contain them better than they have ever before.

At the moment. the solution to the worst financial crisis ever is based on some coercion and lots of hope. It's not nearly enough.

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