Chinese Acrobats

A bill is working its way through the US Senate that would retaliate for Chinese currency manipulation by raising tariffs on certain Chinese manufactured products. The bill has raised the usual cries of alarm: "Awk! Free Trade!" opponents shout.

A bit of history is in order.

From the end of World War II until the 1970's, exchange rates for currency used in world trade were fixed. That is, they were firmly set. The Japanese Yen, for example, traded at an exchange rate of 360 yen to a dollar. That was the rate for years.

We would hear from time to time about a "balance of payments" problem or a "gold flow" problem. That might be caused by a country persistently buying more goods and services abroad than it sold abroad. That caused a balance of payments deficit. Another country might have a balance of payments surplus.

It was the intent of the Bretton Woods system established near the end of World War II that such a circumstance would be addressed by adjusting the relative value of currencies. The country with a persistent surplus would increase the value of its currency and the country with a persistent deficit would reduce the value of its currency. Trade would then more readily approach balance.

This almost never happened. In practice, only the country with a persistent deficit would adjust its currency by a devaluation. One day, for example, a British Pound might be worth 2,000 Italian Lira and the next day worth 2,200 Lira.

Fortunes could be made speculating in currency. Suppose you had one day converted two million Lira to pounds. If you timed it right, the next day the thousand Pounds you bought would be worth two million two hundred thousand Lira. More interestingly, the very fact that you had bought the thousand pounds (and other speculators did so as well), put pressure on the Lira, increasing the likelihood that the Italian central bank would devalue the Lira.

George N. Halm, my professor of international economics, was one of the leading economists who advocated doing away with fixed exchange rates, replacing them with flexible rates. Under the flexible rate system, it was thought, more gradual adjustments would allow the foreign exchange market to make continual adjustments. This would do away with the instant fortunes to be made by speculators.

But what if, instead of speculators, a large government with (practically) unlimited resources were to manipulate the market to give their industries a significant trade advantage?

It seems clear that is exactly what China is doing.

Here's a graph provided by economist Jared Bernstein, illustrating what China is doing.