When the G-8 ministers meet at Sea Island next month, they invariably will discuss the adjustment of currencies to economic imbalances.  In particular, they will ask Japan why they intervene so much to alter the value of the yen.  They also will grumble at the virtual stability of the Chinese currency against the U.S. dollar. 

In anticipation of such complaints, the Chinese Finance Ministry addressed this subject with a group of international journalists a week ago..  The increased inflation currently developing in China as well as reductions in tariff restrictions required to be in compliance with World Trade Organization guidelines were mentioned as already creating a de facto 8 to 9 percent revaluation in the Chinese currency.

Not surprisingly, most of the journalists were confused by coupling inflation and WTO required changes with currency valuations. 

In fact, the Chinese position was correct.  More open trade and domestic inflation both lead to increased demand for imports and reduced competitiveness of domestic producers.  However, they are wrong to assume that these changes preclude a currency revaluation.  To the contrary, they almost demand one.

Economic systems have natural tendencies to regain balance.  If quantities demanded are too high, prices rise until either some consumers find alternatives or so much purchasing power is exhausted in buying the good that other economic activity suffers.  This leads to rising unemployment and lost paychecks until the excess demand vanishes. 

There are exceptions to this tendency.  They usually occur when the adjustments to the imbalance undermine the foundations of an economic system.  For example, banks may collapse or bankruptcies may rise so high that even worthwhile projects are being ignored by lenders. 

However, those depression type outcomes do not normally occur.  (Indeed, many economists believe policy failures as well as system failures are needed to create a true depression.)

Nevertheless, if tariffs, regulations, or central bank intervention prevent normal price adjustments from removing economic imbalances, then alternative adjustments will develop.  If an increasingly competitive economy does not allow the market to change its currency, then assets will flow to that country.  This will push up prices of resources and eventually spawn domestic inflation.  Ultimately, an asset bubble and rising inflation will create a rising risk to economic stability. 

This increasing risk to stability is where the Chinese economy is at the present time.  In other words,  rising inflation is a poor alternative to rising currency values for the Chinese economy.  The fact that inflation is continuing to rise in China indicates that the de facto revaluation remains far from sufficient to restore balance between the Chinese and other economies. 

Here is where someone ought to argue that if the Chinese want to provide cheap goods to our consumers, why should we worry?  Are they not subsidizing our households?

Of course they are.  But they also are undermining our manufacturers.  If the current relative currency values are the appropriate ones, then we should release resources in our now inefficient industries so they can be redirected to greater value for our economy.  (I acknowledge that some towns will lose their economic base and substantial investment may lose value more rapidly than if no international competition existed.  Economic transitions are not pleasant.)

However, if those currency differences are not appropriate, some of our industry may disappear despite being viable if currency values had not been distorted by government controls.   

Moreover, the major problem is that only if market forces are permitted to determine currency values will we get some inkling of what values are appropriate. 

We now can say with some assurance that the current value of the yuan is not appropriate because Chinese inflation is growing faster than world inflation.  Indeed, Chinese inflation is beginning to push up world prices because of this currency distortion. 

(If prices should have changed but didn’t, that is a distortion.  Fixed prices that are wrong become distorted when changing economic conditions make those prices wrong.)

Frankly, the Chinese Finance Ministry is absolutely wrong in waiting for Chinese inflation to effectively revalue their currency.  By the time that happens, inflation will be blossoming world-wide, otherwise viable industries will have disappeared, and the imbalances in China itself will have threatened a serious economic correction. 

I hope they really understand what the costs of currency price fixing can be to their country and to the world.