January 21, 2011

This is pure speculation, but China could be preparing to go on to a gold standard.  To accomplish this, first they would need to get gold into the hands of the population -- they have moved to do that.  Next they would need to accumulate more government gold reserves -- they are doing that.  And finally they would need to raise reserve requirements to about 20 to 25%.  They just announced they were raising reserve requirements to 20% -- one of the highest in the world, and one that is close to gold standard reserve ratios.


If China is attempting this, they will first need to establish a convertible international currency, which would take years, if not decades to accomplish. China has no free market, no currency convertibility, in or out of the country, and it has a primitive third world banking system. They have tied their currency to the dollar and are paid in dollars. But they may be making moves toward the goal of establishing an international convertible, independent currency. 

People use dollars world wide because America is trustworthy.  Can China whose government hacks computers, steals secrets, and has a military capable of taking over the civilian government in a week, really be considered trustworthy? The question has arose lately in the pentagon over who actually is in charge in china -- the civilian government or the military?  Any acceptance of a Chinese currency held world wide, will be problematic, and take years to establish a reputation of trust.

If China chooses to go on gold, they may try to expedite things.  They are already linked to the dollar. A fixed exchange rate to the dollar, and one tied to gold, could be the fastest way to achieve an independent currency.  If the world’s two largest economies, and the two biggest trading partners in the world established a gold treaty where all trade is defined in a fixed price of gold, and to each other, and convertible on demand; other countries could follow if they wished.  China could also choose to go it alone and demand to be paid in gold without a formal treaty.  However, such a move could prove very disruptive.

The conditions would have to include convertibility on demand, and a free flow of goods and money among the nations that chose to participate.  This would require ending their protectionist policies, such as capitol controls, and the import and export restrictions now being imposed by China, or any other nation that participated.  An attempt at anything less than a free exchange of money and goods will fail.  But, the attempt itself would result in a substantially higher price of gold.

It would be a long road to this end -- decades probably -- but it is possible. The problem, however is that China is a communist country and their motives are control and domination.  They will not allow their people the kind of freedom conducive to a gold standard.  They have a history and heritage of militant behavior, and yet, they also have a history of, and the desire to, be paid in hard money

In the 1800's China was a major exporter of goods, just as it is today.  Problems arose when they refused to allow their citizens to import goods, fearing any contact from the outside world.  The Chinese government wanted control over its people, and in their view imports were contaminated by "western values.”

China was on a silver standard then, and they demanded payment for all exports in silver.  England, who loved Chinese goods, bought them gladly.  The problem came when, after years of importing, England noticed they were losing silver and it was not returning.  This caused a deflation in England, as the money supply declined, and led to recession.

England knew there was one commodity the Chinese could not resist.  It was opium.  The sale of opium to China eventually led to the return of silver to England, resulting in a return to prosperity for their country.  This led to a mild deflation in China.  This could not be tolerated by China, and during the next two decades, China and England fought two wars, known as the Opium Wars. China was no match for England's vast Navy and lost the war.

China is, and always has been, a mercantilistic nation.  It uses protectionist policies to export as much as possible and import as little as possible.  Whether on a gold standard or a fiat standard, these policies are doomed to failure, just as they failed 150 years ago, under the international silver standard.

Many confuse money with wealth.  They call China rich because it holds trillions in reserves.  They forget that money is a claim to wealth, not actual wealth itself.  Wealth is the goods produced.  By hoarding claims to wealth, China is preventing its citizens from using them to buy foreign goods, which would raise their standard of living.

It matters little what China does with its money, if it does not allow its citizens the freedom to import.  Look at mercantilist Japan for example.  Most commentators take it as a given that a strong currency should be a monetary objective. Or that export surpluses would lead to prosperity.  Wrong. Neither assumption is true. The Yen has increased in value every year I can remember going back to the sixties. At that time it was 365 yen to the dollar. Today it is 80 yen to the dollar.  Would anyone really want to have spent the last two decades in Japan's economy? 
Even though Japan’s currency has appreciated by a huge amount against the dollar, the Japanese have seen a continuous fall in their standard of living.  Japan has continuously run trade surpluses.  Yet, Japan is not better off for it, and it is all due to its trade policies of protectionism.  Japan has the strongest currency in the world, one of the biggest trade surpluses year after year, yet its standard of living has been declining for decades as their currency has been appreciating.

Let this point not be lost when insisting that the US must have a strong dollar and run trade surpluses to return to prosperity. We hear a lot of this, but it misses the point. What gives rise to a nation' increasing  standard of living is not a strong currency, but a market oriented currency and free trade.  A stable dollar is the objective. Equilibrium in trade among nations is the objective. The natural money flows produced by trade among nations always results in a mild rise and fall in purchasing power in the relative values of all national currencies. It is the artificial increases and decreases in currencies, and the artificial trade barriers erected by nations, that have led to most of our problems.

China has a choice if it wants to improve its monetary system and solve its chronic trade imbalances.  China can pursue the failed policies of its past, or join those nations that tend toward free markets and free trade.  If not, China will soon be following in the footsteps of Japan.