Is China dumping the dollar?

Reported in the Washington Post and picked up at Daily Kos with much alarm was the apparent intent of China to move some of its foreign exchange reserves away from the dollar. (All this by way of Pacific Views.)

Why? What does it mean? John Campanelli at DKos says, "In sum, we're screwed." (It was more descriptive yesterday, but has apparently been edited down.)

This was and is inevitable. "Trade" is trade of goods through the medium of exchange, the currency. It is not trade of the currency for the goods. It is supposed to be goods for goods. China can't eat all the dollars it has absorbed in its years of trade surplus with the US.

Standard economic theory predicts that in situations of trade imbalance, the currencies' exchange rates will adjust, making the goods of the surplus country relatively more costly and those of the deficit country more cheap. Standard economic theory, so far as I know, does not have an answer to why this has begun only after 30 years of immense US trade deficits -- if it is even happening now.

The dollar's value as de facto reserve currency may have made it valuable in itself. Remember, the last truly stable exchange mechanism went down with the collapse of the Breton Woods system under Nixon. Currencies have floated against each other since then, often to the detriment of the weaker nations. A notable exception is the aforementioned China, which pegs its ruan against the dollar and does not allow it to float.

Be that as it may, if as the Post report suggests, China is moving away from the dollar toward the euro, what is the catastrophe that will follow?

DKos put their finger right on it. The main problem is PANIC!

Markets operate on the principle of the herd. The currency market is a herd of rhinos. Too many people have too much money stuck in too many dollars. If they get spooked and the run starts, it could get ugly before it is over, as they try to get out before their investment loses value. This has been a worry of the Progressive Caucus of the US House for a decade. That group extrapolated a run on the dollar from the experience of the Asian currency crisis; they identified rogue speculators as the likely cause. There was some support at the time for the Tobin Tax, a tiny tax on currency transactions that would not hurt legitimate trade, but would multiply for speculators as they roam the world in search of small gains.

The cause of the dollar's demise will not be speculators, although George Soros and others stand to make a bundle from their short positions in the greenback. The dollar is the victim of decades of trade deficits, the renewed and now apparently unending federal budget deficits, and the myopia of the Federal Reserve.

A simple depreciation of the dollar which did not produce immediate panic might not be so bad. The goods of Boeing and other American manufacturers would be more competitive. It could ease our sea of red ink, since most of the debt is denominated in dollars. But it would be bad for prices. Imports would go up. American goods would be bid up by foreigners. A key commodity that we cannot avoid importing is energy, oil and natural gas. Some of the recent rise in oil prices is, in fact, not an increase in the price of oil but a decrease in the value of the dollar. Energy price increases would increase costs for manufacturers, and it would create a cost-push inflation.

Inflationary pressures will always cause an overreaction at the Fed. The Fed will panic. Anything over 5% will bring out the artillery. It doesn't matter that energy costs are reducing the purchasing power of American consumers, the Fed assumes that any inflation is to be snuffed out by higher interest rates. The distinction between cost-push and demand-pull inflation is invisible to Alan Greenspan, his successor and all the bankers who control monetary policy. Whenever they see inflation, they see an overheated economy and they apply the remedy, higher interest rates, tighter credit and higher unemployment. (Of course, you can't have people borrowing expensive dollars and paying them back with cheap ones, but you have to have some sense about it.)

I am not predicting the future, I am predicting the past. It has been the uniform, universal, continual and unchanging response of the Fed, when inflation rises, to pour water on the fire, even if inflation comes in the form of rain. It is not inconceivable that higher interest could lead to higher costs and thus to the dreaded "spiraling inflation." More panic.

The appropriate response to a significant depreciation of the dollar and consequent inflationary pressure is to take our medicine, which is the sea change in the price level. This will not be happy news to those whose non-indexed pensions lose their value, or to those workers whose wages do not follow the general rise in prices, or to those sectors who are left behind, or to those investors .... to a lot of people. But it is a return to reality and the inevitable result of a significant decline in the dollar.

But don't worry. That won't happen. The Fed most certainly will not allow a sea change in the price level without a fight. They will misidentify the cause and apply the nuclear remedy. Millions of unemployed will be the unwilling soldiers drafted into the battle. This will not lead to any other destination, but will make the road there a lot more volatile and dangerous.

A significant depreciation of the dollar would have one more result. Economists would have to pay attention to trade deficits again. During the Reagan years, trade imbalances were the big econom news. Economists explained them by pointing to the Reagan budget deficits, saying the higher interest rates needed to attract capital into bonds produced a higher dollar. The higher dollar disadvantaged domestic manufacturers. The period is often called the de-industrialization of America.

Unfortunately for economists, the budget deficit went away during the Clinton years, but it did not take the trade deficit with it. In fact, the trade deficit increased. Economists simply ignored their mistake and switched to the "they like us" model. Trade deficits were good because the capital inflows (the dollars returning to the land of dollars) meant the rest of the world thought America was a good place to invest.

Now we simply ignore it and pretend things are okay. After all, it's been like this for a long time.

Until now.