What if China began a gold standard tomorrow?
November 4, 2007
By “tomorrow” I mean tomorrow: Monday, November 5, 2007. The first question is: what is an appropriate yuan/gold parity? I would choose something within 10% of today’s present value, which is about 5,600 yuan/oz. of gold. Obviously, you don’t want the yuan to make some kind of 20% move overnight. You don’t want a yuan cheaper vs. gold than it already is. You might want a yuan higher vs. gold than it already is, closer to a long-term average, but that would exacerbate the rising-yuan effect that already exists. Also, the process of raising the yuan’s value would take some time. Thus, for our purposes, let’s assume that the new peg is at 5,600 yuan/oz. of gold.
This value is somewhat lower (cheap yuan vs. gold) than the historical averages, and thus China would tend to experience some inflation, in line with what is already happening there, as the economy gradually adjusted to the 5,600/oz. yuan value. Thus, the no-inflation/low-interest rate advantages of a gold standard would not be immediately forthcoming. However, over a period of years, China would indeed enjoy those advantages, into the indefinite future.
The process by which China would maintain the yuan/gold peg, as we should know well by now, is base money adjustment. It is not necessary for China’s government to stockpile gold bullion. It is only necessary to adjust base money such that the yuan’s value remains at its gold parity. China is already doing much the same thing anyway, with its present crawling yuan/dollar peg, and certainly Hong Kong has much experience with currency board-type base money adjustments, so there shouldn’t be too much new to learn there.
Technically, that’s all there is to it. But there are some complications, in today’s world.
At present, the US dollar is sinking in value against gold at quite a clip. The euro, yen and other currencies have been rising against the dollar, but falling somewhat vs. gold. If China pegged to gold while other currencies were falling in value dramatically, then the forex value of the yuan vs. the dollar or other major currencies would rise dramatically. The Swiss franc played this role somewhat in the 1970s. We could see the yuan go from around 7/dollar to 4/dollar, 2/dollar, or even 1:1 with the dollar. In that case, the yuan price of gold would be 5,600 yuan/oz. and the USD price of gold would also be 5,600/oz.
Historically, when the world’s major currencies are devalued (the British Pound in 1931 and the US dollar in the 1970s), it is politically difficult for other countries to remain pegged to gold due to the “beggar thy neighbor” trade effects of devaluation. If Japan had stayed on the gold standard in the 1970s, with the yen pegged at 12,600/oz. of gold, the yen would have gone from 360/dollar in 1970 to an apex of 14.8 yen/dollar in 1980! Imagine the trade consequences of that!
China is in a rather better position than, say, Germany, in an environment of dollar decline because it is already a low-cost producer. Thus, China’s industries could withstand a move from 7/dollar to 4/dollar or so without undue pain and suffering. However, a move to 2/dollar or even 1/dollar would probably bring some cries of pain from industrialist types — especially if there were comparable moves in the euro and yen.
Remember, what we are talking about here is not a “rise in the yuan” but a stable yuan value, pegged to gold, while everyone else is devaluing. Big difference.
At this point, there could be cries that the new gold standard policy is “deflationary” because, due to the forex effects, there would tend to be downward price pressure within China as industries in all the devaluing countries undercut domestic prices. I know it’s hard to imagine anyone undercutting China’s prices, but at 2/dollar or 1/dollar, it would happen. There’s nothing genuinely deflationary about pegging to gold, but this “beggar thy neighbor” effect of devaluation can create negative price pressures and economic difficulties.
At the same time, Chinese exports to elsewhere would become much more expensive, and the Wall Street economists would say that “China is exporting inflation to the U.S./eurozone/Japan!” However, this wouldn’t get too much political traction because politicians have been very happy with a rising yuan/dollar.
Of course the IMF, World Bank, investment-bank economists, academics, newspaper op-ed pages, foreign ministries of finance, etc. etc. would all dogpile on China’s government with their idiotic theories of this or that, and would probably suggest, or even demand, some sort of policy shift with catastrophic consequences. Fortunately, most Asian governments are wise to the toxic “advice” given to them by Westerners, especially the IMF, as they witnessed the results firsthand during the Asian Crisis and the communist bloc’s Shock Therapy (Shock Demolition is more like it) programs in the 1990s.
I bring this all up to show that China’s bureaucrats may have to deal with all sorts of funny problems. In today’s world, all is not necessarily smooth sailing once a gold standard is implemented. The gold standard itself would work just fine at its task — to maintain a stable currency value. However, just the idea that a country aims for a stable currency via the gold standard would likely drive many people insane.
We have been talking about a situation in which the dollar, euro and yen all devalue pretty much together. However, if China showed some leadership, maybe the other governments wouldn’t be so anxious to follow the U.S. down the devaluation hole. If the euro and yen remained relatively stable vs. the yuan, such that only the dollar was losing value rapidly, then many of the forex effects would be lessened. Indeed, the U.S. government itself, a rather decrepit and corrupt institution, may decide to find some way of not devaluing, and in this way China would lead the world onto a stable monetary system.
Unless the euro and yen (and possibly the dollar) were also pegged to gold, the yuan would become the world’s premier currency. If the U.S. government still showed no interest in managing its currency properly, the presence of a super-high-quality alternative (the yuan) would lead everyone around the world to dump dollars indiscriminately. This could drive the dollar into oblivion, if the Fed didn’t know how to properly reduce base money supply in response to collapsing demand. I doubt the U.S.’s bureaucrats are capable of that sort of skillful monetary management. They tend to be arrogant to the point of being uneducable.
What could be done to mitigate the potential forex/trade consequences of sticking to a stable currency while everyone devalues? A 20% across-the-board import tariff might be appropriate, especially if the tax hike was accompanied by lower taxes elsewhere. However, tariffs tend to be very unpopular internationally, and could be met with retaliatory tariffs. That could get ugly quick.
Unfortunately, in today’s environment of extreme ignorance, even the most well-meaning governments have to deal with secondary difficulties. I hope this discussion prepares them a bit for what could ensue.
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$800 gold! Woo hoo! Nice for us precious-metals investors, although pretty much nobody comes out ahead in such a devaluation. Since last year I’ve been talking about a quick move to $1,000+ once the $735/oz. level was breached. It looks like things are working out that way.
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Very gold-friendly op-ed in the FT last week, from the former Finance Minister of El Salvador and the director of international economics with the Council on Foreign Relations. So, you see we aren’t the only ones. Here it is: pro-gold op-ed in the FT