[A-List] The dollar and the yuan 1, by Henry C K Liu

Michael Keaney michael.keaney at mbs.fi
Wed Oct 27 08:33:19 MDT 2004

PART 1: Follies of fiddling with the yuan
By Henry C K Liu
Asia Times, October 23 2004

Dollar hegemony emerged after 1971 from the peculiar phenomenon of a fiat
dollar not backed by gold or any other species of value, continuing to
assume the status of the world's main reserve currency because of the US's
geopolitical supremacy. Such currency hegemony has become a key
dysfunctionality in the international finance architecture driving the
unregulated global financial markets in the past two decades. China's
overheated economy is the result of hot money inflow caused by dollar
hegemony. China's developing economy should be able to absorb huge amounts
of capital inflow, but dollar hegemony limits foreign investment to only the
Chinese export sector, where dollar revenue can be earned to repay capital
denominated in dollars. Since China's export sector cannot grow faster than
the import demands of other nations, excessive dollar capital inflow
overheats the export and exported-related sectors, while other sectors of
the Chinese economy suffer acute capital shortage.

Overheated economies produce growth-inhibiting inflation through excessive
import of money and sudden rises in prices for imported commodities and
energy. The imported inflation is then re-exported, causing inflation in
other parts of the global economy. Inflation causes interest rates to rise,
which in turn causes unemployment and recession in all economies that are
plagued by it.

China's currency, known as the renminbi (RMB) yuan, has been pegged to a
fiat dollar within a narrow band (0.3%) around an official rate of 8.28 to 1
since 1995. Even though the yuan is still not entirely freely convertible,
any change in dollar interest rates will impact yuan interest rates due to
the peg.

While the linkage between exchange rate and interest rate is direct, the
exchange rate policies of most countries do not always operate in sync with
their interest rate policies, leading to imbalance and disequilibrium in
their economies. This is because these two related policies impact different
segments of the population differently. Thus conflicting political dynamics
push them in conflicting directions.

Capital generally prefers a strong currency since it reflects financial
strength, while labor prefers a weak currency to boost exports that provide
domestic employment. Capital prefers high interest rates for better returns
while labor prefers low interest rates for cheaper consumer loans and
affordable mortgages. China will be no exception as its moves toward
interest rate liberalization and free currency conversion.

Dollar hegemony enables the US to be the only exception from macroeconomic
penalties of unsynchronized exchange rates and interest rates. The US,
because of dollar hegemony, is the only country that can claim that a strong
currency that leads to trade deficits is in its national interest in a
global economy dominated by international trade. This is because a strong
dollar backed by high interest rates helps produce a US capital account
surplus to finance its trade deficit.

While other economies must earn dollars to finance their dollar deficits, US
trade and fiscal deficits need only be repaid with dollars that the US can
print at will, not from dollars that the US must earn. That in essence is
the benefit of dollar hegemony to the dollar economy. But while dollar
hegemony is good for the dollar economy, it imposes costs of job loss and a
debt bubble on the US economy.

Off the dollar, and back
China's exchange rate policy is not always synchronized with its interest
rate policy. Currency control has protected China from severe macroeconomic
penalties so far. On the exchange rate side, China has changed the exchange
value of the yuan many times since its introduction on January 1, 1970, when
currency reform substituted 10,000 renminpiao for one RMB yuan fixed at an
official rate of 2.46 yuan to a dollar. After the collapse in 1971 of the
Bretton Woods regime of fixed exchange rates based on a gold-backed dollar,
pressure grew to appreciate the yuan against a floating dollar no longer
backed by gold. With the RMB's theoretical gold content unaltered, a new
official rate was set on December 23, 1971 at 2.26 yuan to a dollar. The
alarming free fall of the dollar led China to tie the yuan to the Hong Kong
dollar and the British pound sterling.

Hong Kong shifted from a rule-based currency board to a discretionary
currency board over the course of its monetary history. From 1935 to 1967,
Hong Kong as a British colony operated a classic colonial currency board
pegged to the pound sterling, except that private banks - not the
government - issued the currency, a practice that continues to this day.
Instability in the value of the pound in the late 1960s pushed Hong Kong to
switch to a dollar peg. The dollar, too, came under speculative attack after
1971. To avoid sinking with the dollar, Hong Kong also decided to let its
own currency float. It worked reasonably well until the commencement of
Sino-British negotiations on the return of Hong Kong to China, which
unleashed wild speculation against the Hong Kong dollar, pushing the
free-floating exchange rate temporarily to 9.6 to 1 on September 24, 1983.

By the end of October 1983, Hong Kong had ended its brief experiment with
floating exchange rates and announced that it was pegging its currency to
the dollar at a rate of 7.8 to $1 with a discretionary currency board
regime. The peg amounted to an official devaluation from the pre-crisis
floating market rate of 4.6 to 1 to defuse market panic. In 1985, two years
after the adoption of the HK peg, the Plaza Accord, aiming to halt the
rising US trade deficit, pushed the already steadily falling dollar sharply
further down against the yen. The Hong Kong peg produced a sharply
undervalued Hong Kong currency that in turn gave birth to a bubble economy
that burst 12 years later in 1997 as part of the Asian financial crisis.

The independent yuan
In April 1972, with the Hong Kong currency free floating, China began
listing an official effective rate for the yuan independent of the Hong Kong
currency. On August 19, 1974, the effective rate of the yuan was pegged to a
trade-weighted basket of 15 currencies, the composition of which was
undisclosed to the market. The effective rate was fixed almost daily to the
floating market value of that basket. By December 31, 1979, the yuan's
effective rate rose to 1.5 to a dollar when the US Federal Reserve under
Paul Volcker mounted its heroic struggle to halt US inflation by raising
dollar interest rates to historical heights.

On January 5, 1980, the State Council issued a decree prohibiting payments
in foreign exchange within China. On April 1, 1980, Foreign Exchange
Certificates (FEC), or waihuijuan, equal in value to the yuan at the
effective rate, were put into circulation, issued to non-residents in
exchange for designated hard currencies, for paying hotel bills,
transportation fares and for purchases at Friendship Stores. Consumer prices
were set at separate levels for the yuan and the FEC to reflect purchasing
power disparity between the two currencies.

On January 1, 1981, a foreign trade rate with two categories was introduced
for the RMB. For internal settlements under the foreign exchange allotment
quota, the official rate was set at 2.80 yuan per dollar. This rate was
formed by adding to the effective rate an "equalization price" for balancing
export and import profits and losses, and applied to all national
enterprises and corporations engaged in foreign trade as well as to receipts
and expenditures in foreign exchange for trade-related transactions in
invisibles such as shipping and insurance.

An experimental trading system for foreign exchange was established by the
Bank of China in a few areas such as Beijing, Guangdong, Shanghai and
Tianjin. A foreign exchange retention quota also permitted exporters to
retain a portion of export earnings. National enterprises holding foreign
exchange earned through the system of retention quotas were permitted to
sell this foreign exchange to other national enterprises that had a quota
for spending foreign exchange. For dealings under the foreign exchange
retention scheme, the Bank of China acted as an exclusive broker, charging
0.1%-0.3%, resulting in an effective rate of 2.803-2.808 yuan per dollar.
The effective rate was applicable to all other transactions, while the
official rate was largely symbolic.

On January 1, 1985, the internal settlement official rate was abolished and
all trade was governed by the effective rate. On November 20, 1985,
authorization was granted for residents to hold foreign exchange and open
foreign exchange accounts and to deposit and withdraw funds in foreign
exchange. This was to serve residents who might receive foreign currency
funds from relatives and friends overseas, as individuals generally did not
have permission to engage in foreign trade to earn foreign currency. By the
end of November 1985, the yuan, pegged to a trade-weighted basket of
currencies, was trading at 3.2 to a dollar as a result of the Lourve Accord
that pushed the dollar up from the downward overshoot of the Plaza Accord
two years earlier. On January 1, 1986, the trade-weighted basket of
currencies peg was abandoned and the effective rate was placed on a
controlled float based on developments in the balance of payments and in
inflation trends and exchange rates of China's major trading partners and

In November 1986, a foreign exchange swap rate was created, based on rates
agreed on between buyers and sellers at over 100 foreign exchange adjustment
centers available to foreign investment corporations and at first to Chinese
enterprises in the four Special Economic Zones of Shantou, Shenzhen, Xiamen
and Zhuhai but expanded in 1988 to all domestic entities authorized to
retain foreign exchange earnings. Between July 5, 1986 and December 15,
1989, the yuan remained at 3.72 to a dollar, despite the 1987 crash in the
US equity markets.

The foreign exchange swap was set at 5.2 yuan to a dollar on December 31,
1986 and lowered to 5.9 a year later on December 31, 1987, while the yuan
continued to trade at 3.72 to a dollar. Early in 1988, all domestic entities
with retained foreign exchange earnings were granted permission to trade in
the adjustment centers, and by October, 80 adjustment centers were
established. Initially, a relatively small volume of transactions took place
in these markets, but the volume increased substantially after access to the
centers was expanded.

On December 31, 1988, the foreign exchange swap rate was again lowered to
6.60 while the yuan continued to trade at 3.72 to a dollar in the controlled
market at adjustment centers. On February 1, 1989, regulations were issued
governing the use of foreign exchange obtained in foreign exchange
adjustment centers. Imports of inputs for the agricultural sector, textile
and for technologically advance and light industries were given priority.
Purchases of foreign exchange for a wide range of consumer products were
prohibited. On March 1, 1989, regulations were issued governing domestic
sales in foreign currency by foreign investment corporations. Such
corporations were permitted to sell in China for foreign exchange provided
the sales involved purchases under the government's annual import plan,
sales in Special Economic Zones and other promotional areas, and sales of
import substitutes.

On December 15, 1989, affected by the continuing global impact of the 1987
crash in the US equity markets, the yuan was devalued by 21.2% to 4.72 to a
dollar from 3.72. Dollar hegemony was causing the dollar to rise instead of
fall in the face of a massive injection of liquidity by the Fed in the US
money supply to respond to a sudden collapse of US equity markets that led
to a multi-year recession. On December 31, 1989, the foreign exchange swap
rate was raised to 5.40 from 6.60, while the yuan continued to trade at 4.72
to a dollar. On November 17, 1990, the yuan was again devalued by 9.6% to
5.22 to a dollar, with the foreign exchange swap rate lowered again to 5.70.

On April 9, 1991, the management of the exchange rate was altered to a
procedure under which the rate would be adjusted frequently as needed in
light of certain indicators of development in international exchange
markets, relative price performance, and trends in export production costs.
On September 11, 1991, new regulations governing the use of official foreign
exchange were introduced. Priority for using foreign exchange was given to
imports of agricultural inputs, interest and amortization payments and
remittances, and imports of key construction projects and technology. The
next priority level included raw materials used for industrial production,
critical spare parts, educational materials, and medicines. Items for which
the use of official foreign exchange was strictly prohibited included
cigarettes, wine, clothes, shoes, small household appliances, soft drinks,
film and other luxury items.

On October 1, 1991, specialized banks other than the Bank of China foreign
banks that were engaged in foreign exchange business in Zhejiang and Jiangsu
province began to sell foreign exchange from export and service receipts
directly to local branches of the People's Bank of China (PBC), later to
become the central bank. These banks were allowed to purchase foreign
exchange directly from the PBC to finance imports. The State Administration
for Exchange Control would manage this part of the exchange reserves under
the authorization of the PBC. After December 1991, individual residents
could buy and sell foreign exchange through authorized banks at rates
established in the adjustment centers in conformity with exchange control

On December 31, 1991, the foreign exchange swap rate was further lowered to
5.90 to a dollar. In April 1992, revised guidelines were issued specifying
the priority uses of foreign exchange in adjustment centers for goods not
covered by import licenses. Imports of inputs for the agricultural sector
and central and local construction projects, and advanced equipment and
technology, grain and goods that met daily needs were given priority. On
January 31, 1993, the foreign exchange swap rate was again lowered to 7.50
while the yuan continued to trade at 5.75 to a dollar. On July 1, 1993, the
exchange rate at which the state sold 30% of foreign exchange purchased from
exporters to certain enterprises was changed from the effective rate to the
prevailing swap market exchange rate. On December 31, 1993, the foreign
exchange swap rate was lowered to 8.70 while the yuan traded at 5.8 to a

One and only
On January 1, 1994, the effective exchange rate and the swap market rate
were unified at the prevailing swap market rate. The PBC would announce a
reference rate for the yuan against the US dollar, the Hong Kong dollar, and
the Japanese yen based on the weighted average price of foreign exchange
transactions during the previous day's trading. Daily movement of the
exchange rate of the yuan against the dollar was limited to 0.3% on either
side of the reference rate as announced by the PBC.

The buying and selling rates of the yuan against the Hong Kong dollar and
the Japanese yen might not deviate more than 1% on either side of the
reference rate; and in the case of other currencies, the deviations should
not exceed 0.5% on either side of their respective reference rates. Issue of
export retention quotas ceased except for outstanding long-term contracts.
In addition, Foreign Exchange Certificates (FEC) ceased to be issued and
those in circulation would be withdrawn gradually.

On April 1, 1994, the China Foreign Exchange Trade System (CFETS) in
Shanghai (an integrated electronic system for inter-bank foreign exchange
trading) came into operation. Twenty-two cities were linked to this system
by the end of 1994. On July 1, 1996, foreign-funded banks were allowed to
sell foreign exchange for bona fide transactions and become designated
foreign exchange banks. On April 1, 1997, 12 branches of the PBC began to
operate forward purchases and sales of RMB against underlying transactions
on a trial basis. Two years later, on April 1, 1999, the longest maturity of
forward purchase and sale of foreign exchange was extended to six from four

Thus on the exchange rate side, Chinese policy has always been reactive to
US policy. From a high of 1.5 yuan to a dollar in 1979, the yuan, falling
steadily against the dollar, has been fixed at 8.28 to a dollar since 1995
and remained unchanged through the 1997 Asian financial crisis, the 1998 and
2000 US recessions when pressure to further devalue the yuan was resisted by
China. Recent US official policy of a strong dollar being in America's
national interest provided the rationale for holding the yuan-dollar peg.

On the interest rate side, Chinese policy tended to respond to the needs of
its banking system more than the needs of the Chinese economy. Between 1979
and 2000, the PBC adjusted loan rates on 19 occasions and bank deposit rates
on 21. China last raised the yuan lending rate on July 1, 1995 to 12.06%
from 10.98 when the yuan exchange rate was pegged at 8.28 to a dollar. This
was at a time when the US Federal Reserve raised the Fed funds rate (ffr) to
6%, and cross-border flow of funds between the US and China was strictly
controlled. The ffr is the rate at which US banks loan excess reserves to
each other. While the Fed cannot directly influence this rate, it
effectively sets targets for it through the way it buys and sells Treasuries
to banks.

In China, eight reductions over a period of eight years since 1994 halved
the benchmark yuan one-year lending rate to 5.31%. The yuan one-year deposit
rate is now 1.98%. China's consumer price index rose 5.3% in the year
through July, meaning that borrowers now enjoy near interest-free loans
after adjusting for inflation. Industrial prices climbed 14% in the first
seven months of 2004, making real interest rates negative by a wide margin
in industrial sectors. Yuan bank deposits at 1.98% now suffer erosion of
principal to inflation at the rate of 3.32% a year, which then as bank loans
goes to support a built-in 8.69% annual profit for those who borrow at 5.31%
to speculate in the industrial sectors with 14% inflation.

Clash of interests
International money flow is closely linked to interest rate differentials
between economies, in the direction of the higher rate. Speculative hot
money poured into China for the past two years as the Fed cut ffr to 1%.
Ample liquidity triggered an investment boom in China that exacerbated
inflation. The resulting negative real interest rate amplified investment
demand and caused a speculative bubble. Some $200 billion has been
misallocated to overheated export-related sectors by the market, with fixed
investment running 20% above annual absorption rate, while
non-export-related sectors faced acute capital shortages.

With a yuan-dollar peg, keeping yuan interest rates in tandem with dollar
interest rates has been suggested as the only way for China to stop a
further inflow of hot money. China's foreign exchange reserves rose by $67.3
billion in the first half of 2004 despite a $20 billion trade deficit that
cuts the $30.3 billion in foreign direct investment to a net of only $10.3
billion. The discrepancy of $57 billion in new foreign exchange reserves
growth is attributable to hot money inflows sneaking into China in the first
six months of 2004, only to be transmitted through China's central bank into
its foreign reserves in the form of US treasuries.

This requires the PBC to release 472 billion yuan into China's money supply.
While the Fed raises rates on signs of recovery in the US economy, China is
being pressured to follow the Fed's interest rate moves even when its
domestic economy is slowing because of cost-pushed inflation, mostly through
higher prices for imported fuel and commodities that are needed by the
overheated export sector that overshoot market growth. While conventional
wisdom proclaims that keeping money too inexpensive for too long is a recipe
for trouble for an unregulated market economy, it is not necessarily so for
a planned economy where credit allocation can be directed by government
policy, or an economy with a currency control regime.

Yet Chinese interest rates have been well above US and Hong Kong rates since
the Federal Reserve began cutting ffr target 13 times from 6.5% in January
2001 to 1% on June 25, 2003 and kept it there for a whole year until June
30, 2004. The Fed lowered the discount rate to 0.75% on November 6, 2002 and
raised it in three steps to 2.75% for primary (generally sound) financial
institutions and 3.25% for secondary (less creditworthy) institutions.
Institutions use the discount window as a backup rather than a regular
source of funding. This meant that banks could borrow at the discount window
at a rate generally 500 basis points below the ffr until January 9, 2003
when the discount rate was set at 100 basis points above the ffr. This was
another indication that the Fed was tightening credit while still injecting
liquidity into the US banking system beginning January 9, 2003. The spread
between the discount rate and the ffr continues to be 100 basis points for
primary institutions and 150 basis points for secondary institutions.

Before dollar's short-term rate began to rise in July 2004 from its
historical low of 1%, as the Fed boosted the short-term rate target for a
third time this year to 1.75% on September 21, the one-year domestic yuan
deposit rate at 1.98% was 142 basis points higher than the 0.56% one-year
domestic dollar deposit rate and 92 basis points higher than the 1.06%
one-year US CD (certificates of deposit) rate. As a result, dollar funds in
the form of hot money seeking quick short-term speculative profits have been
pouring into China, making it difficult for the PBC to manage rising yuan
liquidity levels from the transmission of these dollar funds into burgeoning
foreign exchange reserves.

As China's foreign exchange reserves increase, it faces pressure from the
US, Japan, the EU and other trading partners to revalue the yuan upward. Yet
China has begun to incur an overall global trade deficit that may reach $40
billion in 2004, albeit a sizable and growing surplus ($124 billion in 2003)
continues from its trade with the US. Domestically, China is reluctant to
raise yuan interest rates for fear of triggering massive loan defaults by
distressed borrowers, leading to a crisis in the already fragile banking
system, hoping instead that import-pushed inflation can be moderated from
regulatory measures.

With both exchange rate policy and interest rate policy kept intact, China
hopes to deal with its overheated economy with administrative means. To curb
rising inflation and runaway speculative investments fueled by negative
interest rates coupled with a fixed exchange rate, the government since last
spring has been trying to rein in China's overheated economy by canceling
projects that had started without proper regulatory approvals.
Administrative measures, such as restrictions on bank loans for overheated
sectors, have slowed the economy slightly in the past few months. Industrial
output moderated to15.5% in July compared with a year earlier, down from a
peak growth rate of 23% in February.

Time for change?
In theory, price bubbles and overheated economies are created by the
interaction of interest rates, inflation, exchange rates and credit
allocation policies. Exchange rate theory mandates that if two economies are
linked by freely convertible currencies with floating exchange rates, free
trade and free money flow, the one with higher inflation and higher interest
rates will see the exchange rate of its currency fall. China now has higher
inflation and interest rates than the US, thus the yuan should fall instead
of rise against the dollar until the inflation rates and interest rates of
both economies equalize, if the yuan were freely convertible at floating

But a weaker yuan will increase the cost of imports to China thus adding
further to inflation, making the yuan even weaker. A weaker yuan will also
increase exports from China and reduce the supply of goods and assets in the
Chinese domestic market while increasing the supply of yuan from converting
dollar earnings of exporters, thus pushing up domestic prices, adding to
inflation. High inflation will push up interest rates. But a rise in
interest rates increases the financing cost of production, adding to
inflation. High interest rates will also attract more fund inflows, thus
causing more inflation. The net inflation/deflation outcome from interest
rate moves then depends, among other things, on trade balance. This
rationale was given by the European Central Bank as the logic of refusing to
cut euro interest rates to get the EU economies out of recession. Keeping
euro interest rates stable was needed to fight import-pushed inflation to
lift the euro from trading below par.

There may be a case for higher prices for Chinese exports in order to
correct the US-China trade imbalance, if the price increase is passed
directly onto higher Chinese wages to increase domestic demand. Chinese
factory wages now range from $60 a month in less developed inland regions to
$160 a month in the more developed coastal regions for an almost
inexhaustible labor force culturally infused with enviable Confucian work
ethics. Chinese wages can double every year for a decade with positive
effects on its economy. Wage-pushed inflation is beneficial to overcapacity
and can defuse an overheated economy by increasing domestic demand.

The logic of revaluing the yuan, or any currency, as a means of balancing
trade is flawed. It was ironic that US treasury secretary Lawrence Summers
in the 1990s repeatedly lectured Japan not to substitute sound
macro-economic policy with an exchange rate policy because the US did
exactly that with the Plaza Accord in 1985 and with its strong dollar policy
after the 1997 Asian financial crisis. Robert Mundell, 1999 Nobel laureate
in economics, observed while attending a conference in Beijing this year
that never before in history has there been a case where international
monetary authorities tried to pressure a country with an inconvertible
currency to appreciate its currency. He said China should not appreciate or
devalue the yuan in the foreseeable future. "Appreciation or floating of the
renminbi [RMB] would involve a major change in China's international
monetary policy and have important consequences for growth and stability in
China and the stability of Asia," Mundell said.

The exchange value of the yuan is not crucial to the monetary problems
facing the world economy and financial architecture today. Dollar hegemony,
a peculiar phenomenon in which a fiat dollar assumes the status as the
world's main reserve currency is the main dysfunctionality in the current
debt economy and international finance structure. China is not the problem;
dollar hegemony is. China's economy, despite spectacularly rapid growth,
still accounts for only an insignificant 3.5% of the global GDP, a pathetic
figure for a nation with one fifth of the world's population. Its share of
world trade has risen from less than 1% to 5% in two decades. Most Chinese
export products are sold with a retail price of less than $100 per item.
Thus self-satisfaction of alleged economic miracle is grossly premature.

After two-and-a-half decades of reform, China is still unable to accomplish
in economic reconstruction what Nazi Germany managed in four years after
coming to power, ie full employment with a vibrant economy that would
challenge that of Great Britain, the then superpower. Post World War I
Germany started with an economy in every way as devastated as China's, with
no prospect of foreign credit, huge war debts and reparations and a
defeatist social milieu. While Nazi philosophy is detestable, the
effectiveness of the national socialist economic programs of the Third Reich
cannot be summarily dismissed.

Yet China now accounts for 60% of the growth in world trade. This testifies
not to China's strength in trade, but the weakness of world trade growth,
which has been driven not by prosperity, but by falling wages in the past
two decades. Even the rise in foreign direct investment (FDI) inflows to
China is not caused by an undervalued currency, but rather by the potential
of China's domestic market and growth fundamentals. Yet this potential is
constrained by dollar hegemony, which forces FDI into China's saturated
export sector. But this export sector cannot grow because it is built on the
outsourcing of jobs from the target markets. Rising unemployment in these
markets will shrink demand for Chinese exports.

Wrong target
China's trade surplus with the US, a key target in the knee-jerk criticism
of China's yuan policy, has actually little direct link with the exchange
rate of the yuan. This trade surplus has been nurtured by dollar hegemony by
design in order to finance the US capital account surplus. China's recent
export performance is primarily driven by the country's two-decade trade
reforms, its abundance of low-wage labor that has remained low-wage after
two-and-a-half decades. And more importantly, China's growth has been
largely led by growing processing and assembly operations in China for
re-export, operated by transnational corporations mainly to demolish the
hard-won gains of labor movements in the capitalistic West.

Chinese exports have consistently outperformed the competition at
wide-ranging values of the yuan pegged at different levels to a fluctuating
dollar. The Chinese export boom persisted even during the turbulent years
following the 1997 Asian financial crisis, when strong market pressure for
the yuan to be devalued was resisted. The reason for this is that Chinese
wages are more flexible on the falling side than on the rising side, as a
result of the smashing of the iron rice bowl by market reform and a labor
movement that had not kept pace with the introduction of socialist market

Exchange rate movements affect the price of both imports and exports, but
their impact on trade balance may only lead to changes in the volume of
goods and services rather the monetary value of trade. With a stronger yuan,
fewer Chinese goods may be exported to the US at a higher price; and more US
goods and services may be exported to China at a lower price, but the trade
imbalance in monetary value may remain the same after initial price
adjustments. Historical data suggest that Chinese firms will be required by
existing agreements to continue to compensate foreign investors at
previously negotiated rates of return by lowering Chinese wages. The lower
wages will result in lower domestic demand in the Chinese economy and
eventually in the global economy. And US firms will take advantage of the
exchange rate change to raise prices of US exports. The result may merely be
higher inflation for the US and eventually for the global economy.

As dollar interest rates rise, China can choose to insulate the impact on
yuan interest rates by re-pegging the yuan upward, or to keep the current
peg by following dollar interest rates trends. But it cannot do both at the
same time without destabilizing China's financial system and economy. Since
the dollar is freely convertible at market rates, the dollar-pegged yuan is
in effect subject to market rate fluctuation along with the dollar with
regard to other currencies. Thus the stability argument of the dollar peg is
deceptive. Fixed exchange rates seldom produce monetary stability; it only
reflects official denial of economic reality, often at an economy's
long-term peril. There are monetary policy autonomy benefits from controlled
convertibility for any currency, such as insulation from dollar hegemony,
but exchange rate stability is not among them. Policy-induced exchange rates
require central bank intervention that will surface as costs in different
forms in the economy.

In theory, rising interest rates push up exchange rates. However, this
convention is only operative if rising interest rates reduce inflation.
Rising interest rates can add to inflation under some conditions, pushing
down exchange rates. When dollar interest rates rise, the dollar gets
stronger. But despite recent corrections, the exchange value of the dollar
is still at an 18-year trade-weighted high, notwithstanding record US
current-account and fiscal deficits and the status of the US as the world's
leading debtor nation. There is persistent talk among trade economists of
the need for the dollar to fall another 20%.

The US inflation rate has been moderated by low-price imports from China.
Policy-induced upward valuation of the yuan against a rising dollar will
accelerate US inflation. It will drive up US interest rates at a faster
pace, conflicting with the Fed strategy of a "measured pace" for interest
rate moves to avoid scuttling the anemic recovery. Similarly, raising yuan
interest rates may put upward pressure on the exchange rate of the yuan to
the dollar, making Chinese exports more expensive in dollar terms, creating
upward pressure on US inflation rates and interest rates. These pressures
can be resisted, but not without costs to the US economy.

Thus, recent calls from US officials for China to simultaneously raise both
the yuan exchange rate to the dollar, and yuan interest rates further above
dollar interest rates are ill advised. Such moves will cause an upward
spiral of interest rates and inflation in the US, China, Asia and the rest
of the world. Yuan interest rates are already substantially above dollar
rates, an upward valuation of the yuan against the dollar with a rise in
yuan interest rates will exacerbate the destabilizing flow of hot money into
China. To understand China's dilemma on interest rate policy as a key tool
in its macro approach to cooling its overheated economy, one needs to
understand the interlocking relationships of interest rates, inflation,
exchange rates and credit allocation.

Not again
The linkage between domestic interest rates and the exchange value of a
currency is very direct, with inevitable impacts on foreign trade. An
illustration of this is provided by the Plaza Accord of 1985. After the US
Federal Reserve under Paul Volcker raised federal funds rate (ffr) on July
8, 1981 to a historical high of 19.93% to fight an annual inflation rate of
over 15% that was still rising, the exchange value of the dollar rose to
cause an alarming US trade deficit, reaching 3.5% of GDP. The Plaza Accord
of 1985 was a coordinated effort by the US, Japan and Germany, the three
main trading nations of the world at the time, to force the US dollar to
fall against the yen and the German mark, in defiance of market
fundamentals, with the purpose of reducing the US trade deficit. After the
Plaza Accord, the Federal Reserve moved the ffr target in a downward trend,
and the ffr fell to 5.56% in October 7, 1986.

The linkage between the exchange rate and interest rates is less direct but
more destabilizing. The Bretton Woods regime fixed the Japanese yen at 360
and the mark at four to a dollar until 1971. By 1985, the dollar was buying
only 238 yen and 2.95 mark. Yet the US trade deficit continued unabated. The
Plaza Accord of 1985 pushed the dollar down to 145 yen and 1.79 mark. The
Fed then reversed its low interest rate policy in October 1986. The ffr rose
to 7.76% on October 15, 1987 and yields on 10-year government bonds rose
from 7% in January to 9.5%, a rise that precipitated the 1987 crash four
days later.

On October 19, 1987, the Dow Jones Industrial Average (DJIA) dropped 508
points, or 22.6%, in one day on volume of 608 million shares, six times the
normal volume then (current normal daily volume is over 1.4 billion shares,
with top volume of 2.8 billion shares on July 24, 2002), and ending 36.7%
lower from its closing high of 2,787 less than two months earlier on August
25. The immediate trigger that burst the equity bubble was identified by
some analysts in hindsight as legislation passed by the House Ways and Means
Committee on October 15, eliminating the tax deductibility of interest on
debt used for corporate takeovers.

Interest rate levels, in combination with exchange rate policies, have both
long-term and short-term relationships to the forming and bursting of
financial bubbles. China now appears determined to avoid repeating past
exchange rate and monetary policy errors made by the US that had induced the
1987, 1994, 1997 and 2000 crashes.

In response to the 1987 crash, the US Federal Reserve under its new
chairman, Alan Greenspan, with merely nine weeks in the powerful post,
flooded the banking system with new reserves by having the Fed Open Market
Committee buy massive quantities of government securities from the market.
Greenspan announced the day after the crash that the Fed would "serve as
liquidity to support the economic and financial system". He created $12
billion of new bank reserves by having the Fed buy up government securities.
The $12 billion injection of "high-power money" in one day caused the ffr to
fall by three-quarters of a point and halted the financial panic, though it
did not cure the financial problem, which caused the economy to plunge into
a recession that persisted for five years.

High-power money injected into the banking system enabled banks to create
more bank money through credit multiplying, by lending repeatedly the same
funds minus the amount of required bank reserves at each turn. At 10%
reserve requirement, $12 billion of new high power money could theoretically
generate up to $120 billion of new bank money in the form of bank loans, if
demand and borrower credit-worthiness permit, the absence of which would
leave the Fed ineffectively pushing on a credit string. The injection of
liquidity from the Fed cemented the Plaza Accord devaluation of the dollar
into permanence without correcting the US trade deficit.

The 1987 crash was a stock market bubble burst that led to a subsequent real
property bubble burst that in turn caused the Savings and Loan (S&L) crisis
two years later. The Financial Institutions Reform Recovery and Enforcement
Act (FIRREA) was enacted by the US Congress in August, 1989, to bail out the
thrift industry in the S&L crisis by creating the Resolution Trust
Corporation (RTC) to take over failed savings banks and dispose of their
distressed assets. The Federal Reserve reacted to the S&L crisis with a
further massive injection of liquidity into the commercial banking system,
lowering the ffr from its high of 10.71% reached on April 19, 1989 to below
the 3% inflation rate, making the real rate near zero until January 31,

Since there were few assets worth investing in a down market, most of the
newly created money went into bonds. This resulted in a bond bubble by 1993,
which then burst with a bang in February 1994 when the Fed started raising
rates, going further and faster than market participants had expected: seven
hikes in 12 months, doubling the ffr target to 6%. As short-term rates
caught up with long, the yield curve flattened out. Liquidity evaporated,
punishing "carry traders" who had borrowed short-term at low rates to invest
longer-term in higher-yield assets, such as long-dated bonds and more
adventurous higher-yielding emerging-market bonds. The rate increases set
off a bond-market crash that bankrupted Wall Street giant Kidder Peabody &
Co, California's Orange County and the Mexican economy, all casualties of
wrong interest rate bets.

By 1994, Greenspan was already riding on the back of the debt tiger from
which he could not dismount without being devoured by it. The Dow was below
4,000 in 1994 and rose steadily to a bubble of near 12,000, while Greenspan
raised the ffr target seven times from 3% to 6% between February 4, 1994 and
February 1, 1995, to try to curb "irrational exuberance". Greenspan kept the
ffr target above 5% until October 15, 1998 when he was forced to ease after
contagion from the 1997 Asian financial crisis hit US markets. The rise in
ffr in 1994 did not stop the equity bubble, but it punctured the bond
bubble. Despite the Lourve Accord of 1987 to slow the Plaza-Accord-induced
fall of the dollar, the dollar fell to 94 yen and 1.43 mark by 1995. The low
dollar laid the ground for the Asian finance crisis of 1997 by fueling
financial bubbles in the Asian economies that pegged their currencies to the

US inflation rates have been under-reported by statisticians in the name of
scientific logic. The first significant downward adjustment occurred in 1996
on the recommendation of the Boskin Commission, which had concluded that the
US inflation rate had been overstated by an annual 1.1 percentage points.
About half of this overstatement has since been "corrected".

America's hedonic pleasures
But further, far more substantial downward adjustments in the price indices
have resulted from the spreading use of "hedonic" pricing methods, used to
translate quality improvements in products into price declines even if the
actual prices are climbing. Automobiles that now sell for $30,000 used to
sell for $10,000, but the inflation rate of automobiles is registered as
declining because cars are technically more sophisticated. The consumer is
supposed to be getting more "car" per dollar, never mind no one can now buy
a $10,000 car. Rents for apartments are registered as declining even when
rent payment rises, because renters get air-conditioning, marble bathrooms
and granite kitchens and high rise views. Yes, the higher up you are from
the dirty, noisy street, the more housing you allegedly get per dollar, a
real bargain in hedonic price while the square foot price goes through the
roof. Thus prices can rise with no inflation.

The US Bureau of Labor Statistics (BLS) expanded the use of hedonic
regressions to compare quality differences in prices. Hedonic regressions
attempt to estimate econometrically the value that households put on quality
differences. These methods are used for measuring quality distinctions in
the categories of apparel, rent and computers and peripheral equipment, and
as of January 1999, they have been used for television prices. Research is
under way to extend this technique to other categories.

As this measuring technique is being extended to a growing number of goods,
it has become a most important factor in reducing the US inflation rate, and
intrinsically raises nominal GDP growth while the real GDP may actually
decline. Its overall effect on monitoring the economy is kept secret from
the public. The hedonic price adjustments for computer hardware and software
alone went a long way to explain US growth and productivity miracles of the
past decade.

Another device to lower the measured US inflation rate is the shift to
"chained" price indexing, used since 1996. It changes the weight of items in
a basket of goods on the assumption that people generally tend to shift
their spending to cheaper goods. If the price of apples rises, people buy
more pears, whose lower prices go into the price index instead. It is
reasonable to suspect that US inflation before the 2001 crash had been
hovering around 5% on the old basis, the highest in more than a decade, and
virtually twice the rate in Europe. Inherently, this would have cut real GDP
growth by about 1.5 percentage points and kept interest rate higher. All
this suggests two important things: first, that the reported new paradigm
increases in real GDP and productivity growth have been exaggerated by a
statistical illusion; and second, that real interest rates have been far too
low in relation to real inflation, which also explains the most rampant
money and credit creation that the US has ever seen in recent history.

Hedonic price indexing, by keeping the official inflation rate significantly
lower than reality, not only played a key role in fueling the stock market
boom, but also magnified the budget surplus during the Bill Clinton years
and now understates the George W Bush deficit. Such indexing reduces social
security payments and welfare benefits across the board, as well as
undercutting inflation-related wage adjustments. Essentially, lower hedonic
prices in computers and electronic gadgets are paid for by less money for
food and housing of the elderly, the unemployed and the indigent as well as
the average worker.

The most troublesome fact is that the BLS does not keep contemporaneous
calculations of the "old" method for historical consistency, or reveal the
degree of "new" versus "old" distortion. This cover-up opens government
statistics to challenges of reporting honesty. Bill Gross of PIMCO, the
world's largest bond fund, recently wrote: "The CPI inaccurately calculates
Americans' cost of living. Since social security and pension benefits as
well as the level of wage hikes are predicated upon the specific number
and/or the perception of annual increases, Americans are being in effect
conned by their government and falling behind the inflationary eight ball
year after year. After slamming the concept of the core CPI, the primary
culprits I cited were the government's use of hedonic and substitution
adjustments to lower the CPI by as much as 1% in recent years."

Look who's talking
Greenspan made his famous "irrational exuberance" speech at the American
Enterprise Institute in Washington DC on December 5, 1996, when the Dow was
at 6,437, more than twice of the pre-crash 1987 high. Yet the market kept
rising and on January 14, 2000, the Dow peaked at a hyper-irrational level
of 11,723. Two months later, after settling down to hover around 10,000, it
experienced its largest one-day point gain in history - 499.19 - to close at
10,630.60 on March 16, 2000. John Maynard Keynes, who famously warned that
markets can stay irrational longer than participants can stay liquid, must
have been laughing from heaven.

Greenspan either failed to link the rise of equity prices to an undervalued
dollar or he deliberately skirted the issue because foreign exchange value
of the dollar was the province of the Treasury, not the central bank. Either
way, there was nothing irrational or exuberant about the effect of a fall in
the exchange value of the dollar on a rise in US equity prices. It was a
causal effect of a finance bubble fueled by an undervalued currency,
especially when price increases can be viewed as causing no inflation
through hedonic regression.

On April 14, 2000, some 22 trading days after its largest one-day point
gain, the Dow plummeted 617.78 points, closing at 10,305.77 - its steepest
point decline in a single day historically so far. This volatility came
purely from speculative forces operating on a bubble. The economy did not
change in 22 trading days. When the Dow started its slide downward after
peaking at a historical all-time high of 11,723 on January 14, 2000, the Fed
lowered the ffr target from 6.5% on January 3, 2001, but could not halt the
decline. After the Dow hit a low of 7,524 on March 11, 2003, the Fed lowered
the ffr target to 1% on June 25, 2003 and kept it there until July 2004.
Since then, the Dow, having climbed steadily to peak at 10,737 on February
11, 2004, fell back to 10,121 by August 31, 2004 when the ffr rose to 1.5%
and closed at 9,988 on September 27 with the ffr at 1.75%.

The US trade deficit was 3.5% of GDP at the time of the 1987 crash. It was
5.4% by the end of the first quarter of 2004 and rose to $166.2 billion for
the second quarter of 2004, annualized to $664.8 billion, or 6.5% of
US-projected GDP. With every passing day, more market watchers are joining
the rank of those predicting looming financial crisis in US markets from
excessive debt, particularly external debt. This danger cannot possibly be
defused by China, regardless of what monetary policy it adopts. The dismal
record of US monetary policy that induced the 1987, 1994, 1997 and 2000
crashes discounts the value of US advice for Chinese economic and monetary

Too much of a good thing
By 1994, excess liquidity had fueled a worldwide equity rally that found its
way into the Asian emerging markets, where it fed an unprecedented bubble of
easy money in the form of undervalued currencies pegged to a falling US
dollar. When the Asian emerging market rally crashed abruptly on July 2,
1997, starting with the Thai central bank running out of foreign exchange
reserves trying to maintain its currency peg, followed by the Russian debt
crisis in 1998, all the major central banks of the world reacted yet again
by pumping even more liquidity into the global banking system. Initially,
this flood of hot money inflated another bond bubble, which popped viciously
in 1999. Then, more liquidity boosted equity prices further and provided the
fuel for the enormous high-tech, Internet and telecom stock bubbles of 1999
and early 2000.

The first three years of the 21st century saw a worldwide equity market
crash followed by a recession plagued by overcapacity, over-indebtedness and
over-leverage. And the responses of central banks were always more liquidity
through lower short-term interest rates, which helped pump up the bond
bubble in 2003, with the high fixed yields of outstanding long bonds
translating into higher bond prices. Excess liquidity supported artificial
rallies in housing prices, equities, corporate debt, commodity prices and
mushrooming emerging markets, particularly China. Fools are calling it a
US-led recovery.

The Fed was caught again in its own ideological vice between contradicting
interest rate policies to balance stimulating growth and preventing
inflation. To avoid the boom-and-bust cycle, the Fed attempted to drive its
monetary vehicle in opposite directions at the same time, simultaneously
fighting inflation and stimulating the economy. Despite the Fed's
announcement that it will raise interest rate to ward off inflation only at
a "measured pace", much talk of a repeat of a 1994 burst of the bond bubble
has since been circulating. Pushing China to raise yuan interest rates now
will only heighten the Fed's difficulty in keeping its "measured pace" of
interest rate hikes.

Bond traders know that a five-year duration bond fund can drop 5% in value
with an interest rate rise of one percentage point. Conversely, a one
percentage point drop in rates would cause the same fund to increase by 5%
in value. For long-term bond funds with effective durations of at least
seven years, a rise in long-term interest rates of 2 percentage points over
the next 12 months would cause at least a 14% drop in value. With yields on
long-term Treasury bonds now around 5%, such an increase would translate
into a loss of 9% or more for shareholders - similar to the last time the
Fed tightened monetary policy in 1994.

Many market participants intuitively concluded that long-term rates,
following the ffr, would also rise, causing prices of outstanding long bond
to decline. Speculators shorted Treasury long bonds - that is, they borrowed
bonds to sell by promising to return them at a later date when they hope to
buy back the same bonds at a lower price, profiting from the anticipated
price differential. But long-term rates moved counter-intuitively in the
credit markets. What the short-sellers failed to take into account was that
foreign central banks now must buy each day between $1-2 billion of
government bonds to park the additional foreign exchange reserves they earn
from the US trade deficit. This was a factor of much smaller scale and
consequence in 1994 when the bond market collapsed from the Fed raising the
ffr target in quick succession.

Because traders grossly misjudged the bond market's likelihood to rally in
the face of the Fed tightening and stubbornly hanged onto conventional
intuitive moves in expectation of an easy killing, throwing in the towel
only when it was too late, the rush to cover short positions pushed bond
prices even higher from technical effects of a short squeeze. On Wednesday,
September 22, the 10-year-note fell below the psychological 4% (3.98%) for
the first time since April when the Fed made its third tightening in 2004.
That shifted market sentiment, and traders decided to stop throwing good
money after bad just to humor Greenspan's fantasy of a recovery. They
reacted to the rise in bond prices as a signal to buy more. It was the
market's vote that the economy would not be heading north for a while.

Shorting on bonds began when the non-farm payroll unexpectedly surged by
308,000 in March 2004, suggesting that an end might be in sight for the
three-year-long recession and the corresponding bull run on bonds. In June,
the 10-year note yielded 4.9%, only a few weeks before the Fed raised the
ffr target for the first time in four years. Surely, bond prices had no
place to go but down with a rising ffr, so figured the smart money
intuitively. The market, however, moved counter-intuitively against the
smart money. Morgan Stanley announced on Wednesday, September 22, that its
fixed income trading revenue fell 35% in the quarter ended August 31 from
the previous quarter due mostly to betting wrong on bond prices falling and
rates rising. Most of the other big firms suffered similar fates. The
October 6 Wall Street Journal reported on dismal second half 2004 bonus
outlooks for Wall Street bankers and traders.

At the current inflation rate of 1.5%, the neutral rate for ffr is 3.5%,
double the current 1.75% target. According to Greenspan's announced strategy
of the "measured pace" of short-term interest rate rises, it may take a long
time to raise seven steps of 25 basis points each to reach the level of
neutrality, if ever, because below-neutral rates cause more inflation. The
Fed may be pedaling hard to reach a moving target mounted on the front of
his interest rate bike. The harder he pedals, the faster the target moves
with him. But the longer the Fed takes to bring ffr back to neutral or
restraining levels, the bloodier will be the crash of the bond market when
it happens. And it will happen. Reality does not stop merely because some
short-sellers lost money. Borrowing short-term to finance long-term bets is
a deadly game that cannot be made safe by hedging, no matter how
sophisticated the strategy. Hedging does not eliminate risk; it only
transmits unit risk onto systemic risk.

Once the genie of excess liquidity is out of the bottle, it is almost
inevitable that more genies will get out of more and bigger bottles to keep
the ongoing bubble from bursting to avoid nasty consequences for the
financial system and the real economy. In a planned economy, liquidity
provided by a national bank can serve a constructive purpose by financing
planned growth. In a market economy, liquidity provided by the central bank
lets the market allocate credit to the highest bidders rather than to where
it is needed most in the economy. This means the liquidity often ends up
fueling high-profit speculative bubbles.

Central banks, led by chief wizard Greenspan, despite their central role in
helping to create financial bubbles, nevertheless declare that bubbles
cannot be anticipated and nothing can be done to prevent them. But central
bankers comfort markets by claiming near-magical power to handle the
destructive consequences of bubbles, through a one-note monetary policy of
rate cuts to inject more liquidity, to save a bursting bubble by creating a
bigger bubble. Greenspan asserted in his Jackson Hole symposium speech on
August 30, 2002 that it is virtually impossible to diagnose a bubble with
any certainty until it bursts, and even if a bubble could be diagnosed, it
is not the task of central banks to target asset price, but only to control
inflation and target growth. And even if central banks were to react to
asset bubbles by raising interest rates, the extent of the rate hikes needed
to reverse asset prices in times of exuberance might be so large that it
would destabilize the real economy worse than a bubble bursting in its own
course would. Greenspan has admitted more than once that one of the roles of
a central bank is to support the market value of financial assets.

China's reluctance to raise yuan interest rates reflects its adherence to
the Greenspan argument that the rate hike needed to slow the overheated
economy is so large that serious economic damage may result, making the cure
worse than the disease, particularly when China's overheated economy does
not manifest itself in a typical stock market bubble, since its stock market
is not fully developed. Chinese stock market performance is more reflective
of anticipatory reactions to policy reform momentum than actual economic

China's price bubble is more like a mountain of foam of tiny bubbles, each
with its own unique characteristics. The steel bubble is caused not by lack
of demand but by bottlenecks of supply, particularly in electricity and
transportation. On the other hand, the real estate bubble is caused by
speculative over-investment in a stagnant purchasing power environment
associated with low wages even for the growing population of middle-income
earners. China has an export bubble, blown up by the US asset bubble.
China's overheated inflation is not wage-pushed, but import-pushed. China is
not the source of world inflation. It is a re-exporter of inflation from the
skyrocketing rise of imported energy and commodity prices and from
speculative profiteering.

China also faces a problem in duplicate investment. Localities
understandably copy the successful investment strategies of other
localities. That itself should not be a bad thing for the world's largest
disaggregated domestic market. But much duplicate investment in China has
been concentrated in the export sector, where demand is externally
constrained. The result drives otherwise profitable enterprises into
bankruptcy and exacerbates the non-performing loan problem in the banking
system. The problem then is not with the duplication of investment in
China's huge domestic market, but that such duplication is not directed to
expand the disaggregated domestic market, but concentrated in the relatively
slow growth export market.

Keep your dollars
Led by Japan and China, East Asian central banks have been acting as lenders
of last resort to rising US external indebtedness so that US consumers can
continue to buy Asian exports. In the process, they are exporting real
wealth to the dollar economy while subjecting their own local currency
economies to mounting financial strains and risk of instability. Asian
central banks now hold about $2.2 trillion, or 80% of the world's official
foreign exchange reserves. Dollar-denominated assets constituted 70% of
these reserves in 2003 while the US share of the world economy was only 30%.
Japan's foreign exchange reserves are now in excess of $825 billion and
China's now exceed $480 billion and growing. Together, they account for more
than half of Asia's total foreign exchange reserves that are trapped in the
dollar economy, while their own economies are forced to beg for foreign
capital denominated in dollars.

The US current account deficit reached a record 5.7% of GDP in second
quarter of 2004 and a net national saving rate that fell to 0.4% in early
2003. It has since rebounded to 1.9% in mid-2004. The US now absorbs 80% of
the world's savings not to finance economic growth, but to finance
debt-fueled over-consumption collateralized by an asset bubble. In 2003, US
net capital investment was 60% below 2000 levels.

US net international indebtedness is expected to reach 28% of its GDP by the
end of 2004. Since 1990, foreign-owned US assets increased from less than
$2.5 trillion to approximately $10 trillion at the end of 2003 - a fourfold
increase, and approaching the entire annual GDP. Over the same period, US
ownership of foreign assets has increased from $2.3 trillion to nearly $7.9
trillion, resulting in a negative net international investment position for
the US, amounting to about $2.7 trillion at the end of 2003 when valuing
direct investment at market value. But in a fundamental sense, the entire
$17.9 trillion of assets are in the dollar economy regardless of location or

How is the US able to earn a significantly higher return on its assets
abroad than foreigners earn on their assets in the US? Consider currency,
which pays a zero return. At the end of 2003, dollars held abroad was
estimated to be about $320 billion, whereas only a trivial amount of foreign
currency is held in the US. America's currency circulating abroad is about
half the total US currency outstanding. That means that the US economy only
makes up half of the dollar economy. The reason the US can do this is
because of dollar hegemony, a phenomenon created by the dollar, a fiat
currency no longer backed by specie value such as gold since the collapse of
Bretton Woods in 1971, continuing to assume the status of a major reserve
currency for international trade. Trade is now a game in which the US
produces dollars by fiat, and the rest of the world produce goods and
services fiat dollars can buy.

The dollar economy is in fact devouring not just non-dollar economies, but
also the US economy. The dollar is like the rebellious computer HAL 9000 in
Stanley Kubrick's 1968 film 2001: A Space Odyssey. Hal 9000 was programmed
to believe that "this mission is too important for me to allow you to
jeopardize it", and proceeded to kill everyone who tried to disconnect it.
Dollar hegemony kills all, pushing down wages everywhere with no exceptions
made for nationality. As Pogo used to say: "The enemy, it is us."

The issue is not whether Asian central banks will continue to have
confidence in the dollar, but why Asian central banks should see their
mandate as supporting the continuous expansion of the dollar economy at the
expense of their own non-dollar economies. Why should Asian economies send
real wealth in the form of goods to the US for foreign paper instead of
selling their goods in their own economy? Without dollar hegemony, Asian
economies can finance their own economic development with sovereign credit
in their own currencies and not be addicted to export for fiat dollars. As
for Americans, is it a good deal to exchange your job for lower prices at

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