Donald Trump Should Apologize to China, and Turn His Wrath On the Fed
On Tuesday, August 11, China began devaluing its currency unit, the yuan, against the U.S. dollar. Later that day, Republican presidential candidate Donald Trump denounced China, saying:
“I think you have to do something to rein in China. They devalued their currency today. They’re making it absolutely impossible for the United States to compete, and nobody does anything.”
For a candidate whose pitch is based upon being smarter than everyone else, Trump has taken a spectacularly stupid position with respect to China—not just economically, but politically. After all, it was less than three years ago that Mitt Romney threw away his chance to win the 2012 election by running TV ads in Ohio accusing China of “currency manipulation”. The electorate did not buy monetary mercantilism then, and they would not buy it today.
Here is what there is to understand about China’s currency move. Last week, China began manipulating the yuan in the same way that The Donald would manipulate his Mercedes on a winding mountain road in order to avoid following the car in front of him off a cliff. The People’s Bank of China (PBC) simply did its basic job: it moved to keep the real value of the yuan (approximately) stable.
During the last four days of last week, the value of the dollar rose by 2.26% against the CRB Index*, while the yuan fell by 2.84% against the dollar. The net result was that the real value of the yuan fell by 0.64%. This amounts to a rounding error, not a currency war.
The Donald’s assertion that the dollar/yuan exchange rate is a source of America’s economic woes is absurd. In the late 1990s, the U.S. economy was growing strongly. We reached full employment in April 2000. Obviously, China and the yuan were not problems for us then.
From 1Q1999 to 2Q2015, the yuan appreciated by 33.53% vs. the dollar. Last week’s devaluation still left the yuan up by 29.62% from 1Q1999. If this is a currency war, then a 29.62% revaluation of the yuan represents unconditional surrender on the part of the Chinese. America has serious economic problems, but China’s currency policy is not one of them.
It is clear that either: a) Mr. Trump has not taken the time to acquaint himself with the facts; or, b) he buys into the same “a weak dollar is good for the economy because it boosts exports” delusion that caused George W. Bush to cheer on Alan Greenspan and Ben Bernanke while they trashed the dollar during the mid-2000s.
Actually, it is possible that both a) and b) are true in the case of Mr. Trump. If so, he would not be the only presidential candidate that does not have a clue about monetary policy. Mr. Trump would also not be the only presidential candidate that attributes the economic damage done by an unstable U.S. dollar to unfair competition from America’s trading partners.
The fact is that the exchange rate between two fiat currencies is a meaningless number. And, with $2.5 trillion of excess reserves stuffed into the U.S. banking system, our Fed Funds interest rate is also a meaningless number. To see what is really going on, you have to look at the value of the dollar (and other currencies) against something real.
The CRB Index represents something real: a basket of 19 widely traded commodities. And, against the CRB Index, what is going on right now with the U.S. dollar is monetary deflation.
During 2005, which was the last decent year for U.S. real GDP (RGDP) growth (which came in at 3.34%), the monthly CRB Index averaged 312.06. Over the past 10 years, the monthly CRB Index has averaged 302.01. In June 2014, the CRB Index stood at 308.22.
On August 14, the CRB Index closed at 197.97. This represents a 35.77% decline from June 2014. This fall in commodity prices is equivalent to a 55.69% increase in the real value of the dollar. This is monetary deflation—pure, simple, and dangerous.
Despite what Keynesians (like Paul Krugman, and, apparently, Janet Yellen) believe, monetary inflation is bad for economic growth. Inflation distorts price relationships, and induces malinvestment (e.g., America’s housing bubble). It also creates risk, and thereby raises the real cost of capital. However, deflation is even worse, because of the asymmetry inherent in debt.
Inflation produces an unfair transfer of real value from creditors to debtors. However, its impact on existing debt is incremental, and its effect on the real economy (and employment) is limited, at least in the short term. In terms of the CRB Index, the dollar lost 29.33% of its real value between December 2002 and December 2005, but RGDP growth actually rose (from 2.81% to 3.79%) from 2003 to 2004, and then slowed only slightly from 2004 to 2005 (3.34% vs. 3.79%).
In contrast, deflation has the potential to set off a cascade of debt defaults. This, in turn, can disrupt the alchemy by which the banking system transmutes long-term assets into “liquidity” (see the chapter entitled “The Scandal of Money” in George Gilder’s important book, Knowledge and Power, for more on this).
Once a liquidity crisis starts, it can easily turn into a self-reinforcing deflationary spiral, with a rising real value of the dollar forcing more debt defaults, and the additional debt defaults causing a further rise in the real value of the dollar.
Obviously, none of this can happen if the real value of the dollar remains stable. The Federal Reserve was created in 1913 specifically to prevent liquidity crises from starting, and to stop a deflationary crunch if one did get going. In 2008 – 2009, the Fed failed spectacularly at its most important job, and the result was economic havoc.
From 2Q2008 to 1Q2009, the Fed allowed the value of the dollar against the CRB Index to rise by almost 110%. This produced the worst economic crash since the 1930s, with annualized RGDP falling by 3.93% and the loss of 6.4 million FTE** jobs. Memo to The Donald: the Chinese had nothing to do with this.
China relies on debt financing even more than the U.S. does. Accordingly, it is vital to China that they avoid monetary deflation. If the yuan is pegged to the dollar and the real value of the dollar rises, the real value of the yuan will rise with it. Given this, it is perfectly understandable that the PBC last week decided to unhook its yuan boxcar from the Fed’s dollar train.
If the PBC had pegged the yuan to the CRB Index at the end of June 2014, instead of leaving it pegged to the dollar, Friday’s exchange rate would have been 9.66 yuan to the dollar, rather than the 6.39 rate that Donald Trump finds so objectionable. (If China had pegged to gold, Friday’s exchange rate would have been 7.39.)
If Mr. Trump truly wants to make a difference, he should apologize to the Chinese for his uninformed criticism, and then turn his wrath against the FOMC***. It is the Federal Reserve and its rules-free, 100% discretionary monetary policy, not China, that is America’s biggest economic problem right now.
*The CRB Index is a commodity price index comprising: Aluminum, Cocoa, Coffee, Copper, Corn, Cotton, Crude Oil, Gold, Heating Oil, Lean Hogs, Live Cattle, Natural Gas, Nickel, Orange Juice, Silver, Soybeans, Sugar, Unleaded Gasoline, and Wheat.
**FTE (full-time-equivalent) jobs = full-time jobs + 0.5 part-time jobs
***Federal Open Market Committee, which is the body that determines the Federal Reserve’s monetary policy