Hyperinflation led to Hitler and Mao. What will China's currency manipulation lead to?

China's currency manipulation aggravates US politicians, but it could also upend its own economic gains. By keeping the yuan artificially low, China increases inflation to dire levels. Instead of whining about the policy, the US must emphasize this dangerous tradeoff to China.

The US Treasury Department’s recent report downgraded the Chinese yuan from simply “undervalued” to “substantially undervalued.” This was predictably met by renewed claims from Senators Charles Schumer (D) of New York and Max Baucus (D) of Montana that China is manipulating its currency, and there is surely much more of that kind of rhetoric on the way from them and others. It’s always politically useful to have a boogeyman ahead of elections, and with the 2012 electoral campaigns apparently underway, China is the undeniable boogeyman du jour.

But this is no time for indignation, righteous or otherwise. Far more effective would be to emphasize to China that its currency policy presents a challenge that, if unchecked, could well upend its own tremendous economic gains. In other words, China could be shooting itself in the foot.

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If imitation is indeed a sincere form of flattery, then China has flattered us mightily with its currency policy. Pegging its currency to the US dollar has worked wonders for its export machine and affirmed early on the importance of the US market. This much has been of mutual benefit. But as we all know, there can be too much of a good thing.

How China keeps the yuan low

As China exports, the sine qua non is that the purchaser of the wares must also purchase Chinese currency. This exchange is usually invisible to the purchasers themselves, but somewhere along the supply chain, someone on the purchaser’s behalf must buy Chinese currency with which to pay the exporter. Done repeatedly, this “demand” for Chinese currency would normally drive the “price” of the Chinese currency upward.

But as we know well from the political rhetoric accompanying President Hu Jintao’s recent visit, China keeps intervening to prevent its currency’s rise in order to maintain its meal ticket at the US lunch counter.

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China keeps the value of its currency low by constantly increasing the overall supply of yuan, thereby cheapening the value of each yuan. This is done in precise measure to offset the upward pressure exerted on the yuan by the country’s export success. With its currency now artificially low relative to the dollar, China can continue to export more “cheap” goods to the US market. That’s the meal ticket.

The flipside of China's policy

However, the flip side of keeping its currency weak for so long is that when Chinese exporters exchange back their earned dollars, the People’s Bank of China is actually overpaying yuan or long-changing (the opposite of short-changing) for those dollars. The net effect of this on the yuan after many years is exactly what happens when a company brings too much of any product to market. The value of each yuan is diminished, and therefore many more of them are required to buy anything. The net effect is not unlike what the United States will eventually face after years of monetary loosening, although Federal Reserve Chairman Bernanke can at least claim that desperate times required unprecedentedly desperate measures. Not so in China.

It should therefore not be surprising to hear recent reports about food price increases in China, which never seem to portend anything good for anywhere in the world. Not to torture a recently coined and already overused metaphor, but the tiger mom example can be instructive.

If a central bank were tiger mom, the economy would be its cub, money supply would be its food, and inflation would be the cub’s babyfat. If tiger mom provides an inadequate amount of food (money supply), the cub won’t grow. On the other hand, if tiger mom gives more food than the cub needs, the cub will first get chubby, then really fat, then hideously obese (high inflation). We can assume what the law of the jungle will do to an obese cub. But that’s precisely what China risks becoming – a chubby little cubby all stuffed with fluff. I’m all for warm and fuzzy, but that might not be the ideal goal of economic policy.

Historical dangers of inflation

Most people are aware that hyperinflation in post-World War I Germany led to disaffection among the population and the eventual rise of Adolf Hitler. Less well known is that hyperinflation in post-World War II China contributed to turning the population against the ruling Nationalists and into the arms of Mao Zedong’s guerillas, the forerunners of China’s modern leadership. The historical irony of an economic policy that stokes the fires of inflation again is as palpable as it is frightening.

For a variety of reasons, the China of the 1940s could legitimately claim to be the victim of cruel circumstance. In contrast, modern China faces a demon of its own design. Like its regional neighbors, China seems quite intent on maintaining the export-heavy model of economic development. Therefore, the self-inflicted inflation of its currency policy will very likely intensify.

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In continuing to keep the yuan weak from this point forward, China will confront multiplying patches of inflationary pressure that it will somehow need to pound down like an arcade whack-a-mole. Or China can simply stop stemming its currency’s natural rise. Articulating and elaborating upon this tradeoff might well be more effectual for US policy and lawmakers than simply decrying China’s current policy – which has gotten us nowhere.

Born in Hong Kong, Michael Justin Lee served as Financial Markets Expert-in-Residence in the US Department of Labor from 2003 to 2005. He teaches in the department of finance at the University of Maryland’s Robert H. Smith School of Business.

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