The Currency Battle Continues: China vs U.S.A.

With Chinese president Hu Jintao set to meet with President Obama today, readers can expect numerous media mentions of China’s (NYSE:FXI) allegedly “undervalued” currency, along with calls by various members of the political class in Washington meant to convince them to revalue it upward against the dollar. Now’s the time for the Chinese to call Washington’s bluff.

About this, it can’t be stressed enough that in pegging their currency to the dollar, the Chinese have been and continue to do the right thing. Money is not wealth, rather money is a representation of wealth that enables the easy exchange of goods between consenting individuals.

In that sense currencies should be pegged to each other as a way of reducing the friction and uncertainty wrought by floating exchange rates that retards wealth-enhancing trade. Simply put, the 1944 Bretton Woods agreement which pegged foreign currencies to the dollar authored a huge boost in global trade, while the chaos wrought by Bretton Woods’ collapse in 1971 has since then fostered a great deal of trade disharmony.

When currencies float against each other, the purpose of production is compromised. Rather than individuals exchanging products for products with currencies serving as the stable referee of value, trade in floating periods becomes quite a bit more contentious as “winners” and “losers” emerge depending on the direction of money values.

So while China’s peg to the dollar isn’t as ideal as it would be in a system of fixed exchange rates measured in gold, it’s the next best alternative for producers being able to denominate the values of goods to be exchanged in currencies that move in tandem with each other. In short, when the dollar weakens so does the renminbi, and when the dollar strengthens, so does the renminbi.

Importantly, this tight currency relationship has proven beneficial to both countries as evidenced by the surge in trade between the two. The sole purpose of money is once again facilitation of the exchange of goods, and from 1999 to 2008 U.S. exports to China rose 446% versus a 312% increase in Chinese exports to the States.

But China should still call Washington’s bluff, and it should base its decision on Japanese economic history beginning in 1971. It was then that President Nixon severed the dollar’s link to gold, and with the dollar lacking any definition, it went into freefall.

Japan (NYSE:EWJ) smartly did not follow our 1970s lead, and the happy result for a country still recovering from the death and destruction of World War II was that it did not suffer the inflation that fostered a “lost decade” for the U.S. economy in the ‘70s. Japan’s economy boomed thanks to it issuing a relatively strong yen, while the U.S. faltered as a weak dollar drove investment into hard, commoditized, unproductive assets of the past least conducive to economic growth.

While a dollar (NYSE:UUP) bought 360 yen in 1971, by 1980 the weakened greenback only purchased 240, and by 1994 the yen had appreciated 250% against the dollar. But far from an economic negative, or something that harmed the ability of its producers to export, Japan’s avoidance of our inflation corresponded with it becoming a first world economic power.

Indeed, as Ronald McKinnon and Kenichi Ohno recounted in their 1997 book Dollar and Yen, though Japanese exports accounted for roughly a quarter of U.S. exports in 1964, by 1995 Japan’s exports grew to well over three-fourths. Considering GDP, McKinnon and Ohno pointed to a Japanese economy in 1955 that was 6% of the U.S.’s, but by 1994 that number had skyrocketed to 68%.

As for Japanese trade, contrary to the false notion that a strong currency is an export killer, Japan rode a strong yen all the way to nominally cheap imported inputs that reduced the cost of production for its exporters. The mercantilists in our midst regularly talk up cheap money as the way to spur sales, but they never consider the longer-term truth that devalued money drives up the cost of production, labor and the transport of goods overseas.

If Japan made a mistake, it had to do with giving in to continued U.S. pressure to strengthen the yen against the dollar once policy for the latter improved in the ‘80s and ‘90s. Indeed, while a strong yen greatly benefited Japan’s economy in the ‘70s and part of the ‘80s when the dollar was weak, a persistently strong yen forced by the protectionist 1985 Plaza Accord eventually threw Japan’s economy into a deflationary spiral as the yen tripled in value against gold beginning in 1985.

Importantly, China needn’t fear Japan’s post-1985 difficulties. With gold having risen over 400% against the dollar since 2001, the U.S. has suffered an inflationary outbreak that has revealed itself through a 1970s style rush into hard, commoditized assets that has killed investment in the productive economy. Basically U.S. monetary history has repeated itself with Bush/Obama Treasury officials mimicking the monetary errors of their Treasury predecessors in the Nixon, Ford and Carter administrations.

So for China to revalue now as Washington is naively demanding, the benefits would undeniably accrue to its economy for the revaluation of the renminbi upward allowing the country’s economy to escape our inflation. And just as Japan’s exports boomed amid the yen’s crushing of the dollar beginning in the ‘70s, much the same would occur today for the same reasons.

If mercantilists in Washington are needlessly intimidated by China’s economic rise now, one can only wonder what they’ll think once a stronger renminbi lures even more investment there on the way to an all-too-real economic boom authored by China’s departure from our devaluationist policies. In short, now’s the time to call Washington’s obtuse currency bluff.

John Tamny is a senior economic advisor to Toreador Research & Trading, a senior economist with H.C. Wainwright Economics, and editor of RealClearMarkets and Forbes.

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