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December 15, 2006
Bernanke in Beijing

Delivering a major address in Beijing, Fed Chairman Ben Bernanke today jumped headlong into the dollar-yuan debate. In many ways the speech is erudite and illuminating. But on the key policy question of the day, it falls short.

Bernanke says forcefully that the RMB (yuan) needs to appreciate, or strengthen, against the dollar. In the next breath, Bernanke says the foreign exchange value of the RMB should be set by the market. But if the vast and impersonal global market should set the rate, how does Bernanke know -- and advocate -- that the RMB should strengthen? Which is it, Mr. Chairman?

Nobel economist Robert Mundell believes that depending on the two nations' monetary policies and other macro factors, the RMB is just as likely to weaken versus the dollar if we precipitously broke the dollar-RMB link. Ronald McKinnon of Stanford agrees, arguing that forex values essentially follow a random walk and only react fundamentally to monetary policy. McKinnon believes our efforts to force a large Chinese yuan appreciation will get us less than nothing -- inflation, financial instability, and not even any "improvement" in the trade gap. The U.S. has been using supposed free-market rhetoric -- "shouldn't we let markets set the rates?" -- to disguise its real goal of a weak-dollar, strong-RMB policy.

Don Luskin insightfully weighs in:

Treasury Secretary Henry Paulson cuts a deal. The New York Times reports,
Mr. Paulson asserted that as a result of the talks, China would move to open its economy and enforce intellectual property rights, and would adopt "greater flexibility" in exchange rates. The United States, he said, would strive to increase its savings rate so that it borrows less from China to feed an addiction to imports.
Translation -- US to China: do everything we want, and as your reward we'll buy less stuff from you.

Bernanke also criticizes the Chinese for letting their currency weaken 10% over the last five years. But as Luskin also points out, we have let the U.S. dollar weaken by 24% over the last five years. And because the RMB was rigidly pegged to the dollar for most of that time, the Chinese weakening was entirely our doing. Who, then, are we to talk?

Clearly, the weakish dollar (and thus weakish yuan) has given both the U.S. and Chinese economies a short-term jolt, including some inflation (with more likely to come in future CPI and PCE readings). But one more question that no one can ever answer: If the Chinese currency is so dramatically weak, why don't they have run-away inflation, far beyond what we see?

Because of its mild appreciation over the last year after the Chinese opted for a more flexible dollar-RMB link, the RMB is actually stronger than the dollar. Who's the currency manipulator now?

-Bret Swanson

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