This Is the Real Reason China's Currency Devaluation Is Bad News
In the late 20th century and the first decade of the 21st, Alan Greenspan led a Fed that—in retrospect—kept monetary policy loose for an exceedingly long period of time. Inflation was tame, and wage pressures were nonexistent due to the acceleration of global competition for jobs, and the relocation of American manufacturing jobs to China. Seeing none of the typical indicators of an overheated economy, low interest rates seemed a reasonable means to spur job creation and spark some wage inflation.
The end result was a housing bubble. And housing created the type of low or noncontestable jobs that were impossible to find in other sectors of the economy. Housing construction jobs were easy transitions from the manufacturing floor, and they could not be taken offshore easily—they were China proof. But the housing bubble burst in spectacular fashion. The inflation—excepting home prices—never materialized, and Greenspan is given credit (blame) for building the housing bubble.
Today, China is creating complications for the Fed again. Its surprise move to devalue the Yuan will have a profound effect on the global economy. Deflationary pressures will be exported to countries who import Chinese goods, which in turn will affect monetary policy decisions in those countries. The U.S. economy and the Fed are not immune to these forces, and deflationary pressures could give the Fed pause as it moves toward lifting interest rates off zero. It all feels a little too familiar, and, without care, the Fed could fall into the Greenspan Trap—again.
There are reasons to be skeptical of the People’s Bank of China (PBoC)’s timing. The “one-off” reset of the Yuan was certainly an unexpected move. But the critical aspect of the move was the shift in the mechanism for setting the fix (the target value of the Yuan against the Dollar). Instead of being set unilaterally by the PBoC and allowed to move very little, the Yuan will now be, in part, set by market forces—a move the International Monetary Fund has been calling for ahead of China’s possible inclusion as a reserve currency. The resetting of the Yuan’s value has only just begun.
If the Yuan drifts lower over an extended period of time, advanced economies will feel steady deflationary pressure through commodity and import channels. China will become incrementally more competitive with other emerging nations, and will cause those countries’ central banks to rethink their near-term monetary policies—not to mention the developed world. For the United States, it means deflationary pressures from the Middle Kingdom will last for a long-time—not dissimilar from the long, slow off-shoring of manufacturing that kept wages and inflation in check in the Greenspan Era.
This time the U.S. economy has steadily created jobs, but inflation and wage growth have disappointed. Greenspan’s low rates were a result of the terrorist attacks of 9/11. His Fed faced a trickle of jobs and a competitive threat to the vestige of American manufacturing. The Fed has already kept rates low for a long time, drawing criticism and even threats of congressional oversight. Now, China, instead of taking jobs, is moving toward a market mechanism to determine exchange rates (and probably wanted to get ahead of a Fed rate hike).
Despite the differences in circumstances, the similarities bear watching. China is tempting the Fed to delay lifting-off for as long as it likes. Deflationary pressures from China will persist as long as the Yuan is under pressure and the Dollar is rising—regardless of what the Fed chooses to do, there will be deflation.
Even before the Yuan began its revaluation, the Fed was up against significant policy headwinds from other large trading partners—Europe and Japan are both undergoing large-scale easing. China is only playing catch-up with its currency moves. It was only natural for China to join the fray, and the Yuan has depreciated far less than the Euro or Yen did last year. Regardless of the high visibility of the devaluation of the Yuan, it should be thought of in a much broader context of a global race to the bottom.
The current Fed should heed the lesson of history or risk repeating it—the risks appeared benign and nonexistent until they are malignant and obvious. While low inflation can be used as an excuse to push out a lift-off, it should not be. China has exported disinflation to trading partners before. The mechanism is different this time, but the deflationary pressures are the same. Yes, the Greenspan Trap is tempting but should be resisted. Otherwise, history repeats and the United States will eventually find another subprime somewhere.