Of course this is theory, not practice. I defer to bsetser’s description of the actual politics. “Brutal” is probably right.

the scenario that worries me is one where US imports from China rise substantialy (China is moving upstream, into autos, into chips, into machinery …. i.e. sectors where there is still industrial production in the US) during a slowdown. The politics there would be brutal. And China might not be willing to take policy steps to slow its exports if a US slowdown combines with an investment slump inside China. Investment is a huge share of Chinese GDP, and it can be volatile. China may want to try to export its way out of an investment slump. That strikes me as politically impossible given the size of China’s pre-existing surplus.

In a sense, outsourcing means that the US might finally be able to export something to China- a slowdown.

But it is perhaps easy to overstate the difference between using new money to peg an exchange rate and using new money to fund your new Ministry of Sport. The one seems very 21st-century and the other is very ’70s, but in both the apparent profitability of an enterprise is dependent on the subsidy.

You could calculate the subsidy that the RMB peg has provided to Chinese exporters if you could calculate the free-market exchange rate between RMB and the dollar. Of course this is not calculable, which is the whole point of intervention. But if China refrained from intervention and instead printed new RMB, courtesy of a big fiscal deficit, and used it to fund something like an export tax credit, the effect (within China and excluding PBOC dollar holdings) would be the same.

If you think of the Ministry of Sport as a (presumably quite unprofitable) business, you can approach the same analogy from the opposite direction. Ministry of Sport, Ministry of Export - same deal.

The key difference is just that, when you spread diluted money around a large, growing economy and condition it on actually producing something of value, you get a much healthier and more helicopter-like distribution of the new funds, than if it all goes to the former revolutionary comrades now manfully manning their new desks at the Ministry of Sport.

From the perspective of “inflation” in the sense of a consumer price index - a political indicator rather than an economic one, but no less important for that - this improved distribution, which is both more Hayekian and more egalitarian, may actually be more problematic than if the money just goes to the aforementioned fat cats. Nobody riots when the price of Bordeaux goes up.

But in both cases you’re doing strange and awful things to the market for savings. A monetary system is stable when there is no other asset whose forward price curve exceeds the cost of forward money. Keeping X under your mattress should not yield a predictable profit relative to keeping money under your mattress. Otherwise, holding money is an irrational act. When you have 20% more money every year and your long-term rates are 5%, you have a lot of goods whose dilution-adjusted price has to drop very steeply for a very long time to avoid looking like obvious candidates for X.

Money is the bubble that doesn’t need to pop. As long as there is demand for indirect exchange, at least one asset will be stockpiled by hoarders, hence experience demand that is not a consequence of any direct utility, hence be overvalued. As long as the storage cost for this asset is zero and the supply in existence is fixed, you have a perfect Nash equilibrium - using any other asset as a medium of indirect exchange provides no advantage, and runs the risk of buying into a bubble which will subsequently pop as punters revert back to the stable standard. If the forward price of an asset which is not the current monetary standard, but which is theoretically capable of replacing it, rises to exceed the forward price of money, arbitrageurs will buy it now and store it, increasing the present price and closing the gap between the yield curves.

Even bimetallic (eg, gold and silver) monetary systems are unstable in this simple model - even without any attempt to fix the bimetallic ratio. It is a pencil balancing on its point. If demand shifts for some random reason toward one of the metals, it creates a feedback loop which will eventually demonetize the other, leaving it priced by normal commodity criteria.

Of course this is a simplistic free-market approach and does not even begin to describe the complexity of the various official forces acting on monetary systems. It just provides some indication of the pressures lurking under the surface.

Besides of course the “export subsidy,” I suspect that some of the industrial overcapacity in China (not to mention residential overcapacity in the US!) is a result of this blind search for a replacement currency, a savable good whose price will not underperform the dilution rate. Factories, especially, make a very bad monetary system, because they are not inelastically supplied (unless you have a very large supply of environmentalists). But the supply of shares on a stock market may not respond instantaneously to an influx of demand, temporarily mimicking an inelastically supplied commodity, and tricking the unwary.

The EM crises of the past were the result of governments diluting their currencies to the point at which they became uncompetitive with the dollar as a medium of indirect exchange. This historical pattern is responsible for the usual mental association between expansionary monetary policies in emerging markets, local boomlets in the classic inflationary pattern, and eventual busts with capital flight back to the dollar.

I suspect that anyone who is waiting to see this pattern reemerge (except perhaps in Iceland!) will have to wait quite a while.

The old crisis pattern occurred because EM fiscal and monetary policy was relatively loose compared to its US equivalent. Today, EM fiscal and monetary policy is absolutely loose - in terms of dilution rates (liquidity growth) - but, compared to the US and Europe, it is relatively tight. Money supply growth in China certainly still exceeds the US dilution rate, but the growing prosperity of China (= increasing demand for money) seems to more than make up for this.

In other words, for most of the second half of the 20th century, the fiscally sound monetary systems of the First World - mainly the US - provided the financial equivalent of a fire sprinkler for the emerging world. When local monetary policy got out of control and entered an ascending inflationary spiral, the currency-competition fuse melted down, capital flight ensued and the country got a cold, wet lesson in the dismal science.

Now that political sclerosis and generational imbalances have placed the First World currencies on an apparently unstoppable path to indefinite monetary expansion ($50 trillion in unfunded US entitlement liabilities, etc), the sprinkler system is greatly weakened. The roof tank is not entirely dry - dollars can still be traded for many delightful goods and services - but it is, arguably, no longer the primary constraint on the expansion of money and short-term credit in emerging markets.

If this is true, it is interesting to speculate on what that primary constraint might be. Is it “inflation” in the modern sense of the word - that is, political opposition due to visible price increases in various consumer goods? Or could it be competition from an entirely different class of currency - for example, a natural one?

Certainly, the argument that the direct demand-reducing effect of a recession in the US will be sufficient to cool China strikes me as very unsound. Suppose US demand for Chinese goods falls by 5%? Suppose the PBOC decides not to let the RMB appreciate by that same 5%. Or even depreciates it! The point being: because they are not under the gun of currency competition, they have all the flexibility they need.

Basically, the PBOC is in the business of creating RMB to buy the products of Chinese industries. As far as it affects anyone in China, the fact that these goods are shipped to Long Beach and exchanged for US dollars, then for dollar bonds, is irrelevant. They might as well be dumped into the ocean. Or the dollars, or the bonds, could be burned. The comparison to a wartime boom, in which the goods produced are never used in the producing economy, is precise.

Now, if the severity of a US recession was such that dollar liquidity actually fell - an effect that, since there are far more dollar claims in the world than actual dollars, could be easily and quite dramatically produced by “throwing away the printer” - the force of currency competition would return. A credible promise of zero future dollar creation would send everyone in the world, China included, rushing head over heels for the Benjamins.

But it would also make Manhattan look like Sadr City, which is why it’s probably not going to happen. In fact, given political realities, a recession in the US seems more likely to lead to looser US policy and a relative weakening of the dollar. If China deflates, it will be for Chinese reasons.

dollar v makin. dollar is i think arguing that $1 trillion means there is little risk of an external run a la Asia 97. he is right. makin is arguing that the expansion of domestic credit, domestic stock bubble and overinvestment in the external sector will create a different kind of crisis. he too might be right. i recommend — surprise, surprise — my own paper on the topic which was published be CESIfo (title “the Chinese conundrum: External strength, domestic weakness”)

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