I’m slated to join the discussion at 7:20 on CNBC’s The Kudlow report on whether the US should try to force China to revalue the yuan. As Reuven Brenner and I wrote in December in First Things, the issue is NOT a minor adjustment in the relative price of US vs. Chinese goods, but the fact that the Chinese save more than half of their income. They should save less and spend more and buy American goods. Currency instability promotes precautionary savings.

The United States should establish a fixed parity for the dollar with the currencies of its largest trading partners, starting with China. By stabilizing the dollar against the yuan and, eventually, other currencies, the United States can create a shield behind which the capital markets of developing countries can flourish and capital can continue to flow to the United States. Developed nations can protect themselves against sudden shifts in the flow of capital, but poor nations with nascent capital markets cannot. Currency stability is the first precondition for the creation of capital markets in the developing world.

[snip]

Currency policy is the key to opening the world to American exports. What seem like minor errors in Western monetary policy have devastating effects on developing economies. The large industrial economies are like oceangoing vessels designed to withstand typhoons; ten-meter waves may roil them but will not sink them. Not so for the fragile craft in their wake. As former Federal Reserve chairman Paul Volcker once observed, the industrial nations’ deep financial markets allow participants to hedge against large shifts in currency parities. Not so for the shallow, inefficient financial markets of developing nations, in which the vast majority of firms do not qualify as derivative counterparties, and the yield curve is not liquid past the two-year mark.

A case in point is the Asian financial crisis of 1997. During the early 1990s, Thailand pegged its baht to the dollar. When the dollar rose sharply against the yen, Thai purchasing power rose sharply against that of Japan, then Thailand’s largest trading partner. The rising baht prompted short-term capital flows into Thailand and fueled a real-estate bubble not unlike the United States’ bubble of the past several years. The bubble collapsed in 1997, and the Thai currency collapsed along with the country’s real-estate market and banking system.

China, in particular, is the natural fulcrum for America’s proper economic policy. China’s requirements for infrastructure and capital equipment are enormous: Two-thirds of its 1.3 billion people still live in conditions of extreme backwardness. But rather than invest in its own interior, China has diverted its savings to securities in Western currencies as a rainy-day hedge against potential political and economic disruption. America should help China stabilize its currency by a solemn and formal agreement to link the renminbi to the dollar; China in turn should make its currency convertible and open its capital market to American institutions. Other countries may wish to participate in this arrangement; with the world’s two largest and most dynamic economies as an anchor, a Sino-American currency agreement would quickly become the point of orientation for the rest of Asia and eventually for other countries.

China’s demand for savings, to be sure, stems in part from the one-child policy, which requires Chinese to provide for their retirement with financial assets rather than offspring. But a good deal of Chinese savings is precautionary. With a nonconvertible currency and limited outlets for investment, Chinese are apt to exaggerate their rainy-day savings.

The chart below (from Merrill Lynch economic research) ought to make clear what the United States should aim for: a sharp fall in China’s savings rate and a big rise in domestic consumption. The way to get this is through fixed currency parities.

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