Driving Miss Dollar

It's not at all clear how well the title above works with Caroline Baum's latest commentary at Bloomberg, but, my guess is well enough. There's something about Morgan Freeman driving Jessica Tandy around that somehow oddly fits the current U.S.-China relationship, particularly in light of the current Newsweek cover story.

President Barack Obama got an earful from China’s leaders on his inaugural trip to Asia earlier this month.

They wanted to know about the weak U.S. dollar, rock-bottom interest rates, big budget deficit, trade protectionism in the form of tire tariffs and “massive speculation” inflating asset bubbles around the world. China’s top banking regulator, Liu Mingkang, said U.S. policies were creating “new, real and insurmountable risks” to the global recovery, especially in emerging economies.

Obama took it all in. Too bad his ubiquitous teleprompter didn’t provide him with an appropriate response: The dollar is our currency, but your problem.

That’s what President Richard M. Nixon’s Treasury Secretary, John Connally, told a delegation of Europeans worried about exchange rate fluctuations in 1971. The comment is equally relevant today.

In hitching its currency, the yuan, to the dollar, China cedes sovereignty over its monetary policy. That’s China’s choice.

While admittedly still catching up on Thanksgiving weekend reading, that's the first time that those Nixon-era comments about the U.S. currency have crossed my computer screen applied to the situation today.

It really is their problem and they've been fine with the arrangement up until just a year or two ago, all of which makes you think that there's a major restructuring of the global monetary system in our not-too-distant future.

Some comments by former St. Louis Fed President William Poole help to explain why any "restructuring" is not likely to come voluntarily from the U.S.

-- It is not the responsibility of the U.S. to conduct its policies for the benefit of other countries;

-- Neither the Fed nor any part of the U.S. government has an obligation to maintain the purchasing power of dollar- denominated assets in a currency other than the dollar;

-- The U.S. is obligated to maintain price stability at home, which is good for the world economy.

U.S. interest rates may be too low, the dollar may be too weak and speculation may be rampant in emerging markets. But these are considerations for U.S. policy makers as they relate to U.S. price stability and economic growth. It is not the Fed’s mandate, nor its business, to deliver price stability to China, Taiwan and Singapore.
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When a country decides to maintain a fixed-exchange rate, it has to buy or sell its own currency to maintain the peg. China is an extreme example, accumulating $2.3 trillion of foreign exchange reserves, most of it in U.S. dollars, from its trade surplus.

China’s exporters get paid in dollars and convert those dollars to yuan, courtesy of the People’s Bank of China. Where does the PBOC get the constant stream of yuan it needs to buy dollars? It creates them, which has the effect of increasing bank reserves. The banks, in turn, lend those yuan out, which increases the money supply.

China’s M2 money supply is growing at a 29 percent year- over-year rate, which, in economist parlance, is “unsustainable.”

That word keeps popping up everywhere these days - "unsustainable".

Caroline suggests that letting the yuan float would be a step in the right direction, but, surely the Chinese learned something from Japan's experience with the 1985 Plaza Accord where a stronger yen contributed to asset bubbles that made even Alan Greenspan blush.

It seems there are no easy solutions for any of today's currency problems.