David Derosa: China Courts Economic Disaster

Chris Mayer examines David Derosa’s Book In Defense of Free Capital Markets on the hazards of fixed exchange rates and the fallacies of government intervention in currency markets.

 China Courts Economic Disaster

“The world is in permanent monetary crisis.”

— Murray Rothbard, economist

China’s currency is pegged to the dollar at the rate of about 8.3 renminbi (RMB) to the dollar. (“Renminbi” means “people’s currency” in Chinese.) It has been pegged to the dollar for about a decade. In other words, the government of China has committed to redeeming its currency at the rate of 8.3 RMB for every dollar. This is not a market rate, but one that is artificially maintained by China’s intervention in the currency market.

It is widely acknowledged that China is keeping its currency artificially cheap. By doing so, it is alleged that China is giving its exporters an unfair advantage against struggling U.S. manufacturers, who are having their lunch eaten by cheaper Chinese imports. Politicians have been crying that China’s not playing fair, etc., probably to the delight of their constituencies.

Most analysts cast this whole affair in terms of some kind of geopolitical standoff between the governments of China and the United States. It may be that, but I think the economics and history behind fixed exchange rates are far more interesting — and far more important.

The lesson that economics and history gives us is quite clear on the point of fixed exchange rates. They are, in the words of professor David DeRosa, “breeding grounds for great financial crises.”

DeRosa is the author of In Defense of Free Capital Markets, a clear exposition of the fallacies of government intervention in currency markets. As he shows in his book, the slew of recent financial crises — including the tequila crisis of 1994-95, the Asian crisis of 1997-98, the Russian and Brazilian meltdowns in 1998, and a host of others — all occurred in countries that were trying to maintain a fixed exchange rate.

It should be obvious that a fixed exchange rate is one that could not be maintained if the market were free. In a free market, the exchange rate is “found” through a discovery process of constant buying and selling among participants in the market. The true market rate is bound to be higher or lower than the wished-for rate by government finance ministries.

It may also be obvious that such meddling has consequences. Just as when a government tries to maintain prices of gas, corn, steel, and other goods by decree, it has a ripple effect in the market. Meddling creates tensions and unsustainable patterns that build up over time. Eventually, the dam breaks, and a crisis is born.

David Derosa: George Soros Teaches a Lesson
It’s a lesson the Bank of England had to learn the hard way, and George Soros taught it in a way it would never forget.

When Soros declared, in 1992, that he made a billion dollars in profit selling short the British pound, he helped maintain the mythology that speculators and “hot money” cause financial crises. But hot money no more causes a financial crisis than a sneeze causes a cold. Both are only symptoms, outward manifestations of underlying causes.

It’s like the recent civil unrest in Ecuador, where the government blames some radio station for fomenting instability. No, that’s not the reason. Normal, happy people don’t go into the streets in mass protest because they listened to a radio show. The protests reflect some deeper unease and unhappiness among the population. Banning the radio show, the government’s chosen path, is not the answer.

In the same way, shackling currency speculation is not going to cure the fundamental imbalances and distortions that accumulate as a result of repeated government interventions.

The British pound was doomed whether Soros made his bet or not. DeRosa makes a convincing case that the underlying fundamentals in the market did not support the exchange rates that the Bank of England was trying to maintain. It was the folly of British authorities to try to fight the market — a hopeless and futile effort that cost British taxpayers as much as 5 billion pounds in real money.

Yet the incident seemed only to fuel hostility toward currency speculators, a hostility that government officials everywhere eagerly cultivated. Soros, and others like him, provided the perfect scapegoat to mask the incompetence of government bureaucrats.

Even if China were to maintain this unnatural peg, it would cost China immensely. In fact, it has cost China a lot already, and the costs of maintaining the peg are rising all the time. Because the renminbi is undervalued, the Chinese government has had to redeem a lot of renminbi by buying the dollars that have come into the country.

David Derosa: One Dollar = Five Quarters?

It’s as if the U.S. government wanted to make a paper dollar worth five quarters and agreed to exchange dollars for quarters at that rate. As you might imagine, a lot of people are going to give the government the paper dollars in exchange for five quarters. The valuation gap for the renminbi is not that large, but I use the example to make the point that people in the market change their behavior to profit from such anomalies.

And forget all that talk about contagion. DeRosa skewers that myth too. “Financial crisis does not come right out of thin air to strike economically healthy nations and then spread like a communicable disease from one country to the next.” Commentators often talked about contagion when the Asian crisis seemed to spread from Thailand to Indonesia, Malaysia, and the Philippines. “Good economists…don’t hold contagion theory in high regard,” DeRosa writes. In truth, all of these countries pursued unsustainable pegged exchange rates (nonmarket rates) and wasted billions in reserves trying to defend them.

There are many more examples, enough to fill a book. But again, the lessons of history seem clear. Trying to battle the market is a costly endeavor and a losing bet.

Therefore, China should revalue its currency before the market forces its hand (in which case, the resulting crisis will be most unpleasant for the Chinese). It should move to a freely floating currency, the lesser evil compared to a pegged currency. (The best currency of all is one that is anchored by a metal, such as gold, entirely redeemable in species and whose creation is not controlled or managed by government officials — but that is too much to hope.)

Quite simply, China is courting economic disaster by maintaining its pegged currency. In a battle between government power and market forces, the market always wins in the long run. It’s only a matter of when…and how much China is willing to lose in the struggle.

In the meantime, the world remains, as Rothbard put it, in permanent monetary crisis. The world’s monetary systems remain a mishmash of floating and pegged currencies that lurch from crisis to crisis. “When will we realize,” Rothbard wondered, “that only a genuine gold standard can bring us the virtues of both systems and a great deal more: free markets, absence of inflation, and exchange rates that are fixed, not arbitrarily by government, but as units of weights of a precious market commodity, gold?”

That day of realization still seems a long way off.

Chris Mayer,
Core Contributor,
Whiskey & Gunpowder
May 11, 2005