As I mentioned last week, economic systems appear to be very robust.  Economic policy, not geopolitical concerns, drove economic conditions by the end of the year. 

One of the reasons why economic systems are robust is because markets tend to move toward balance.  Normally, quantities demanded rise as prices fall.  At the same time, profits earned, and therefore the desire to provide goods and services, decline as prices fall and increase as prices rise.  This leads to an intersection of demand and supply that leads to stability in normal markets.

There are exceptions, but they are not normally pervasive.  Thus, even if one market gets out of balance (perhaps because expectations of further price increases raise current demand even as prices are rising), the exhaustion of purchasing power in exploiting that expectation will reduce activity in other markets. 

Nevertheless, there are instances where market instability creates greater distortions rather than resolution of economic imbalance.  One example is when economic institutions are damaged by market instability (e.g. banks become insolvent because of changes in asset values caused by market distortions).  Another is when prices are not permitted to change as economic imbalances develop.  

This latter problem is exactly what is happening in currency markets.  China is holding the value of its currency to a fixed price relative to the dollar.  As the dollar falls in value against other currencies, so is the Chinese yuan.  This increases the competitiveness of Chinese production. 

Although increased Chinese employment leads to greater imports, the falling yuan causes exports to rise even more rapidly.  The result is a large trade surplus. 

If currency values fluctuated, that surplus would begin to increase the value of the Chinese currency, leading to a restoration of trade balance between China and the remainder of the world. 

However, a portion of that growing trade surplus is at the expense of the U.S.  As our trade deficit grows, our dollar falls in value, which leads to a further fall in the value of the yuan against world currencies.  Thus, our lost competitiveness with China is not restored, but China's competitiveness with the remainder of the world is increased. 

When China's economy was small, the amount of purchasing power flowing to China had minimal impact upon the world.  Now, however, the flow of purchasing power accumulated by China is approaching $200 billion a year. 

Some of that purchasing power is used to increase production capacity in China.  However, the enormous gains in technology in the past few years allow some new Chinese plants to be built with cutting edge technology.  This leads to falling production costs in China, and even greater growth in their competitiveness. 

Eventually, rising production in China will create a boom in asset values in China.  Indeed, the rise in Chinese asset values now is second only to Thailand in the past twelve months, while housing values around the major Chinese cities are beginning to explode.  Eventually, domestic prices and labor costs will rise faster than new technology will cause production costs to fall. 

By that time, the accumulation of unused purchasing power by the Chinese at the expense of other countries could be pushing much of the world into recession.  At the very least, the economic distortions caused by these unbalanced flows of capital could unleash another currency crisis similar to the one that began in Thailand in 1997.  (The good Thai performance this year partially reflects a continued rebound from that Asian disaster). 

Of course, the ideal response to this growing problem is to sever the fixed exchange rate between the U.S. and Chinese currencies. 

Weakness in the capital allocation system in China, especially in its major banks, has raised Chinese reluctance to alter the inflow of purchasing power until its banks have been recapitalized to absorb all the insolvent government enterprise loans that make them so inadequate.  The injection of $45 billion into two of those banks earlier this week suggests that China is beginning to use trade surplus funds to strengthen their banking system.

When their banks are sufficiently supported by private investors, probably later this spring, the yuan may be allowed to fluctuate against the dollar. 

In the meantime, we should be careful to limit the further distortion that a falling dollar creates in the rest of the world because of the fixed yuan/dollar relationship.  We have had disorderly currency markets since mid-December.  (A disorderly market is not only one where prices change dramatically, but also one in which prices persist in changing only in one direction.)

So far, this administration is more concerned about an election than about good currency policy.  They may not be able to change the trend of the dollar, but they certainly can assure that the dollar does not fall too far  as speculators become emboldened by continued dollar declines almost every trading day.