Currency basket case

Larry Kudlow
Posted: Jul 23, 2005 12:00 AM

Of all the news stories regarding China's so-called currency reform, "Saying Goodbye to Mr. Greenspan," written by Keith Bradsher of the New York Times, hits the nail closest to the head. Bradsher reports that an unknown central banker, Zhou Xiaochuan, the governor of the People's Bank of China, will be replacing Alan Greenspan as China's currency and monetary guru now that China has decided to partially delink its yuan from the dollar.

 Bradsher also writes that China's tight peg of the yuan to the dollar, which has been the case for more than a decade, generated "impressive stability [that] helped prompt business executives and entrepreneurs from around the world to invest $60 billion a year in new factories and other operations in China. These investors were confident that they knew what those businesses and their exports would be worth in dollars."

 Bradsher is exactly right.

 Economist Arthur Laffer has referred to this situation as the outsourcing of Alan Greenspan to China. I would add that while the peg wasn't perfect, it still gave China a highly credible currency as a medium of exchange and a store of investment value.

 One cannot help but wonder whether China's move toward a somewhat more discretionary policy is linked to the retirement of Greenspan in January 2006. While most of the media have focused on the China-bashing trade-protectionist threat within the U.S. -- with senators Smoot Schumer and Hawley Graham driving this sentiment -- Greenspan's retirement could also be a significant factor in the new Chinese thinking.

 In fact, Greenspan's upcoming retirement adds as much uncertainty to U.S. monetary policy as it does to China's. For better or worse, the "Greenspan Standard" has brought down inflation and interest rates pretty steadily for nearly 20 years (following Paul Volcker's brave fight to do the same while chairing the Fed).

 We have almost no idea who will replace the Maestro, or what that person's monetary views will be. Though Greenspan's tenure has been marked by his highly personalized, often-changing view of how the world works in economic and monetary terms, he has been an effective administrator of policy.

 On the whole, Greenspan has governed as a supply-sider. He has favored lower tax rates to spur economic growth and price stability to sustain growth. While the U.S. greenback over the past 10 years has sometimes behaved like a Coney Island roller coaster, non-inflationary growth has been the rule in the U.S. as well as China. What happens next is anybody's guess.

 As for the new, more discretionary China, it may well peg the value of the yuan to a dollar-dominated basket of currencies. There may be a bit more influence from the yen and the euro, but the best possible spin is that the peg will be dollar-based. This suggests currency stability and more non-inflationary growth for the Big Tiger. It also rules out a creeping appreciation of the yuan, which could cause deflation in China and inflation in the U.S. The currency-basket rule would also eliminate an Argentina-like crackup of the yuan, which would lead to a total loss of confidence by international investors.

 In this sense, the currency-basket rule would still reflect significant dollarization of the China and Pac Rim economies, a good idea for growth, trade and even diplomacy. This model would maximize connectivity between the regions and might also throw off positive benefits for political democratization and wartime cooperation. Free trade and dollarized currency connectivity could in theory lead to a more peaceful and prosperous world.

 I am still, however, bewildered at the Treasury Department's great faith in the merits of floating exchange rates. Does anyone, for example, truly believe that the dollar-euro relationship has been a healthy one? In dollar terms, the euro was first offered at about $1.17. It then dropped as low as 80 cents, shot up as high as almost $1.40, and is now around $1.21. Talk about roller coasters.

 The failure of the G-7 economic powers to generate greater currency stability is a glaring omission. Currency stability is a key building block of economic growth, while radical fluctuations of major currencies have been a detriment to growth. Just look at the stagnant economies of Japan and Western Europe. This subject is swept under the rug time and again at major economic summits, favoring economic failure rather than success.

 Free markets function best when the basic monetary unit of account is steady and predictable. While others cry "currency manipulation," I counter that China's stability relative to the dollar is a success story. More, the interactions of the dollar, euro and yen have been manipulated on a grand scale. Yet we only bash China.

 Global currency reform to promote monetary stability and maximize economic growth has been completely ignored by Europe, Japan and the U.S. Instead of blaming China, the major powers should take a hard look at their own failures.