We have seen the cross of fixed exchange rates in fiat money. A few years back, Indian exporters were taking a hit as the Reserve Bank of India (RBI) didn’t allow Indian Rupee to freely fluctuate against other currencies. The Rupee, which was overvalued, appreciated considerably against the Dollar. This happened not just in India. As Henry Hazlitt noted in “Will Dollars Save the World?”, this was the policy followed by most European countries. Mostly Governments overvalued their currency, which led to a surplus of the overvalued currency and a shortage of the undervalued currency. This is an illustration of the often misunderstood “Gresham’s Law”. Gresham’s law states that “artificially overvalued money drives out of circulation artificially undervalued money”.(The definition that bad money drives out good is misleading, to say the least) The end result is commonly known as a “Dollar shortage”, accompanied with cries for dollar aid and rationing of imports. This policy has changed in course of time. Some countries follow the exact opposite policy-undervaluing their currency.
Paul Krugman, in his New York Times column, has pointed our attention towards China, which has pegged its currency at about 6.8 Yuan to the Dollar. China has a currency peg for a long time. This, Krugman says, is predatory leaving the Chinese manufacturers with a large cost advantage over its rivals, leading to huge trade surpluses. Krugman calls for protectionism to deal with the Chinese policy. The Yuan is undervalued, which makes price of exports low in terms of dollar. Foreigners find imports less expensive and exports more expensive. The Yuan, however, floats against other currencies.
It is important to see why it happens. Imagine that a good sells at 35 Yuan in China when the free market rate for Yuan is 3.5 Yuan. On a free market, that good would cost 10 Dollars. But, as a result of controls, one has to pay only 5 dollars. This makes exports from China cheaper for American consumers. The price is lowered by nearly 50%. So, it should be obvious that the Americans would want to import more from China in such a situation. In the same way, a good that costs $10 in the United States has a free market price of 35 Yuan. But, as a result of controls, the Chinese will have to pay 68 Dollars. That’s an increase of nearly 100%. As a result the Chinese would want to import less from the United States. It is almost as if in China, an import duty of around 100% is levied on American products. Who would want to buy American products at such a high price? This helps the exporting community in China at the expense of Chinese consumers and certain American producers.
Sounds economics tells us that if the Chinese government allows Yuan to appreciate, it would put a break on the inflationary boom. It would contain domestic inflation in China. It would also bring down the pressure on the US government to erect protectionist barriers. It is in the self interest of China, to change its policies for good. Contrary to what Krugman wrote, China’s policies don’t pose a threat to the world. China is not “stealing” other people’s jobs. This is not to say that China’s currency policy is good. It unfairly punishes Chinese consumers, to whom the prices of American products appear high. Probably, things will change in the near future. Some economists, including Surjit Bhalla, had predicted that China’s exchange rate will appreciate significantly starting 2010. Bhalla expects a first year appreciation to about 6 Yuan per dollar from the present 6.8 level.
Krugman is of the opinion that China doesn’t act like other major economies in its currency policy. This is a half truth. It is true that most major currencies float against each other. But, most countries peg their currency against some major currencies. Moreover, Yuan floats against many other currencies, which has caused both appreciation and depreciation in the recent past. It should also be said that Yuan is stronger against the dollar than when China put a rein on its appreciation. Is Krugman justified in his claim that Chinese policy causes unemployment in the United States? It is true that some people in the US will lose jobs as of a slackening in exports, but a reduction in overall employment will be brought about only by coercive labor policy. Some producers might make losses, but it will be largely offset by the gains of consumers, which they will save or spend.
Donald Boudreaux has written a wonderful piece on “Freeman”, attacking the protectionist position. Protectionists, he says, abhor the fact that Americans are importing more from China. The policies of foreign countries make them uncomfortable. He rightly points out that the low priced Yuan will make Chinese products cheaper to American consumers. This doesn’t help the Chinese and harm Americans. Quite the contrary, in fact! It harms the Chinese economy, and helps the United States and other countries which trade with China. Protectionism would only prevent goods from being produced in a cost-effective manner. The theory of comparative advantage tells us that free trade would lead to resources being used in the most efficient way. Boudreaux illustrates the principle with a simple example. His elementary school used to sell tickets in a fund raising fair. These tickets could be exchanged for various items students want to purchase. What if the school had undervalued the tickets? Would it help the school? Obviously not! It would have helped the students at the expense of the school. Students would be able to buy more items at a lower price. So, things should be obvious by now.
Krugman doesn’t see anything necessarily wrong with the policy other than that the Chinese Government has fixed an unreasonably rate. He is wrong there too. The issue has become too contentious that there are more than two sides to it. One side believes in Government’s supreme wisdom to set the exchange rate. The other sides, mostly monetarists call for a free market in exchange rates. “Why should the Government fix the price of gold?” they ask. While freely fluctuating currencies are better than fixed exchange rates in fiat money, to call for a free market as a final solution is absurd. Advocates of a gold standard rightly understand that gold lies in the vault of the central bank, and to denationalize it, the Government should set a value so that it is possible to exchange it, one for one, for the currency claims on gold.
Exchange rates are, ideally, not to be arbitrarily set by the government, or to be left to the market to decide. Each currency should be strictly defined in terms of gold, and fixed permanently that it is interchangeable and redeemable at that weight. When done so, each and every currency would be anchored to each other at a fixed exchange rate, that seasonal fluctuations wouldn’t wreak havoc on the export or import communities. The maintenance of fluctuating exchange rates and protectionism would only reduce the incentives to innovate and hence impede it.