Sadly, but perhaps predictably, Secretary of Treasury John Snow recently declared, “Addressing imbalance in the global economy is a shared responsibility among the major economic regions of the world.” This, along with other less oblique statements, is intended to force, or at least encourage, the Chinese to de-link their currency to the U.S. dollar.
Be careful Mr. Snow. The outcomes from a sudden or quick decoupling could produce some very unexpected and potentially harsh outcomes for the U.S. economy. While the de-linking would almost certainly push the dollar lower against the Chinese Yuan increasing the price of Chinese goods in the U.S. and lowering the price of U.S. goods in China, it would have several deleterious impacts on the U.S economy.
First, by increasing the price of Chinese goods in the U.S., the move would contribute to higher U.S. inflation. This would, of course, force the Federal Reserve to more aggressively raise short-term interest rates. The current funds rate of 3.0 percent is the highest since the summer of 2001 and is still accommodative by historical standards. This simply means that the Fed, even without Chinese action, would be raising short term rates. Allowing the Chinese currency to float would mean even higher rates in the months ahead. Cheap Chinese goods have been an important factor restraining U.S. inflation.
Second, the trade deficit with China has meant that the Chinese central bank has accumulated a mountain of U.S. dollars over the past decade. They have used these dollars to buy U.S. Treasurys, particularly long term instruments. This action raises the price of U.S. Treasurys and lowers the yield (or effective interest rate) on them. This is an important factor that has produced what Alan Greenspan terms a “conundrum.” (Why are long term interest rates so low?) They are so low because our Asian neighbors, including China, have sent their accumulated dollars to the U.S. Treasury. They have been especially generous lenders to a gluttonous U.S. government and big-spending U.S. consumer.
While it is certainly correct that allowing the Chinese Yuan to float would lower the U.S. trade deficit with this very large trading partner, the Bush Administration must be prepared to deal with some of the negative consequences. Don’t let CNN’s Lou Dobbs bully you into unwise policy. I do support a market determined Chinese currency. However, the movement must be at a measured pace free from the demagogic blather of protectionists such as Senator Charles Schumer of New York.