Many countries, including the United States, have criticized China's fixed exchange rate, which critics say was keeping the country's exports too cheap and hurting manufacturers and traders worldwide. A group of U.S. senators had even threatened to slap tariffs of as much as 25 percent on all Chinese goods coming into the United States if China did not allow the yuan to appreciate against the dollar.
Though you wouldn't know it from the media coverage, the argument for floating exchange rates to balance trade flows is Keynesian -- embraced on the left by Paul Krugman and Larry Summers and on the right by Martin Feldstein and Larry Lindsey -- and descends from mercantilism.
Supply-side economics, descended from classical economics, has opposed the mercantilist proposition for four decades, for numerous reasons.
1) Unstable currency values make trade significantly more hazardous, thereby reducing it at the margin. The central reason financial derivatives have become such big business is exchange rate instability over the last 12 years. The great eras of international trade and commerce have coincided with more stable currency regimes.
2) While rising or falling currency may influence trade in the short term, it is impossible to alter the fundamental terms of trade through currency manipulation. If country A devalues its currency against country B's, all things being equal, as A's currency declines, commodity prices and later all prices will rise to reflect its lower value. (This is what happened in the U.S. in the 1970s.) Whatever immediate trade advantage the cheaper currency provides is cancelled out by rising prices. This is most obvious in the case of oil, the largest single component in America's trade deficit. As the dollar has fallen this decade, oil's price in dollars has risen proportionally, increasing the trade deficit.
Conversely, if nation B raises its currency's value, as China is being urged to, it will face downward pressure on prices, eventually undercutting A's trade advantage.
3) The mercantilist framework assumes a closed economic model, where greater purchases of goods and services by one country must be eliminated by currency fluctuation. But the more accurate model in our times is the open economy model, which assumes national economies are interwoven and all trade ultimately balances. In practice, this means current account deficits balance through capital account surpluses, i.e. foreign nations return the dollars they earn through trade by investing in U.S. debt and equities.
4) Demographics and economic fundamentals are the main influence on trade flows, not mispriced currency. Wealthy nations such as the U.S. can buy far more from the world than comparatively poor nations such as China (per capita GDP, $3000) can buy from America's menu of more expensive products such as pharmaceuticals, high technology and financial services.
Moreover, as Reuven Brenner and David Goldman argue, Europe, Japan and China are aging faster than the relatively young U.S. To fund retirees, they need reliable, entrepreneurial economies in which to invest, which generally means the U.S., which means they need dollars, which they get from trade.
5) Currency gyrations have real impact on economic well-being. According to Nobel Laureate and supply-side innovator Robert Mundell, the current U.S. economic recession was caused primarily by the dollar's fall against foreign exchange and gold from 2001-08, which led the housing boom to overshoot into the sub-prime bubble. The dollar's abrupt 30 percent rise in 2008 then caused the fragile financial system to implode, leading to crisis, bailouts and recession. Today, Mundell sees the dollar's rise against the euro as threatening the U.S. economy yet again.
The dollar's rise in the late 1990s pushed the tech boom into a bubble, which inevitably burst causing the 2001 recession. As a result of the strong dollar, a currency flu spread across Asia, several Latin American economies were hurt, and commodity-based economies struggled.
In 1994, as Mexico boomed after NAFTA's passage, economists from the IMF and Clinton Administration advised it that its trade deficit was too large and it needed to devalue. The resulting run on the peso unleashed inflation and wrecked its economy, pushing workers north in search of jobs.
At the urging of American exporters, in the late 1980s Congress pushed Japan to raise the yen against the dollar. The result of the yen's rise was its deflationary Lost Decade.
Regarding China today, Prof. Mundell believes a major yuan rise will cause its stock and real estate markets to crash and create deflationary pressure in China's interior, its poorest region.
6) The U.S. has run trade deficits for most of its history, rising to the world's economic superpower. In general, trade deficits are a sign of prosperity and global confidence in America.
Any how, the next G-20 summit is coming up and this move by China may be a P.R. exercise meant to reduce U.S. pressure in time for the conference. It would be a great shame -- and potentially dangerous to world peace -- if China's progress toward market liberalism were short-circuited by bad currency policy.