To fight the recession that began in 2008, the Fed cut interest rates to 0.25% to stimulate the economy. This rate change did little, so “Quantitative Easing” began. The definition of QE is: “The practice of increasing the supply of money in order to stimulate economic activity “, aka printing money. Currently there is reason to believe another massive round of quantitative easing will occur before the end of the year.

Where does Keynes come into the picture? Why is his name being pulled through the mud by critics of stimulus spending? Keynes revolutionized economics during the great depression in his paper “General Theory” which argued that aggregate demand rather than aggregate supply drives economies. Therefore government stimulus during economic downturns is required to achieve full employment, which in turn will increase aggregate demand. Sounds like Keynes would support the US in its stimulus attempts to save the country, right?

Wrong. Keynes never believed in the current system. Have you asked yourself why the USD is the world reserve currency? It dates back to the Bretton Woods conference in 1944. The system was originally setup with the USD as a world reserve currency; however, the USD was convertible to gold ($35/oz). This system broke down in 1971, when the convertibility of gold was suspended by Nixon. Keynes was at this conference and proposed a radically different system that was designed to put the world on a path to sustainability. He proposed a new supranational currency called the Bancor.

The Bancor would be used to facilitate trade between nations and be governed by the International Clearing Union. Bancors were backed by a barter system; however the value was expressed in gold ounces. The goal of this system was to put all nations on a level playing field by requiring them to balance imports and exports. A country would export goods and receive a credit in Bancors and when they imported they would pay with Bancors. To keep this system in equilibrium any nation with a high amount of debt or credit would pay interest, discouraging the hoarding of Bancors.

Keynes never believed that one nation should control the world reserve currency and could foresee the problems we are suffering today. His proposal for a sustainable system by ensuring every country’s trade account is balanced was shot down by his powerful American counter parts at the Bretton Woods conference. Why isn’t the current system sustainable? An economist by the name of Robert Triffin explained in the 1960’s that a nation that governs the world reserve currency faces a fundamental dilemma between domestic growth and international growth. Even though the USD cannot be converted into gold anymore, on March 29^th 2009 the head of the Bank of China cited the Triffin Dilemma as to why the USD cannot remain the world reserve currency.

The current stimulus practices of the US government are not Keynesianism, because Keynes believed in a sustainable system where trade and international currencies were backed by something rather than nothing.

New Reality Slowly Setting In

It is no surprise that China’s political and economic power has increased dramatically over the last decade. But what is surprising is the lack of recognition from governments and citizens of the western world that China wields substantial power during current negotiations. This new reality can be seen from the United States Congress and the White House’s continued pressure for a faster Renminbi appreciation which has been effectively ignored by China. The major reason for China’s delay is because many developing nations do not agree with the United States’ low interest policy. Keeping interest rates at 0.25% has caused investors looking for a higher return to turn to developing nations for investment. The huge inflows of capital are causing rampant inflationary pressures. Needless to say, the United States government is not easily getting their way, since many would agree that the power lays with the creditor not the debtor. Therefore United States’ attitude towards China (at least publicly) has a long way to go to catch up with the new economic reality.

Largest Foreign Creditor: China

To save US economy from the brink in 2008, the United States government had to take unprecedented actions. The five trillion dollar explosion of public debt from 2007 to 2010 was financed by the Fed as well as foreign creditors. China’s US treasury holdings have almost doubled to $750 billion since 2008, surpassing Japan as the largest holder of US debt. In December the Federal Reserve past China as the largest holder of US treasuries as the FED’s balance sheet increased from approximated $800 billion in the middle of 2008 to over $2 trillion by the start of 2009 (Rosenbaum, 2010). With the growing public debt not being addressed in the United States, China has expressed the need to diversify their foreign investments in other currency denominated assets (Reuters, 2011).

Eurozone Support

As one of the major creditors of the world, China has been providing support to another important trade partner, the Eurozone. This initiative has helped diversify foreign reserves by purchased sovereign bonds from countries such as Greece, Portugal, and Spain. Portugal and Spain had bond auctions on January 12^th and 13^th which went better than expected based on China continued commitment to help stabilize the region (Narioka, 2011). Prior to the auctions, Japan also has pledged to support the Eurozone by purchasing European Central Bank notes that are raising capital for the European Union’s financial-aid fund.

What happens if Renminbi is adjusted?

Is the Renminbi undervalued? If so, by how much? Is China manipulating the Renminbi? Is the Fed manipulating the USD through quantitative easing measures? Who is right and who is wrong? These questions are going to be avoided since there are many arguments from around the globe in support and defense of every position one could take. Therefore, a hypothetical thought experiment is proposed. Suppose the Renminbi is 10% undervalued, and considering that Tim Geithner, the U.S. Treasury Secretary, has recently stated that the Renminbi is “substantially undervalued”, this estimate is reasonable (Katz, 2011).

What are the implications of an adjustment? From the United States government’s perspective, an adjustment will make Chinese exports more expensive on the world markets and therefore increase competitiveness of the United States’ export sector. This would in turn increase jobs in the United States which have scarcely recovered since the 2008 downturn. This linkage between an undervalued Renminbi and unemployment rate in the United States has been exploited by Government officials and media which has lead to a rise in anti-China sentiment. There is little discussion surrounding the ramifications of an appreciated Renminbi; remember in economics there is always a trade off.

What Manufacturing Base?

The US employment in the manufacturing sector is at 1950’s levels (St Louis Fed, 2009). Most multinationals left the United States in search for lower manufacturing costs in the developing world. Since the 2000 almost five million jobs have be lost in this sector. How long will it take the United States economy to recapture manufacturing investment and train new workers? The expectation of quick and dramatic increase of employment after the Renminbi peg is lifted has greatly been overstated. This is not to say that an increase in jobs will not occur, but it will take years for investment in factories to translate into a sustainable job growth.

No Such Thing as a Free Lunch

The less desired implication of a reevaluation is simply inflation. Basing this analysis on the assumption of a 10% undervalued Renminbi, the purchasing power of Americans with respect to China will decrease by 10%. Take the world’s largest retailer as an example; Wal-Mart imports the majority of goods from China. This in turn allows the Americans to purchase inexpensive goods as a direct result of China undervalued Renminbi. A 10% increase in prices at local Wal-Mart stores will adversely affect the already struggling low and middle class. Considering the fact that over 14% of all Americas are currently enrolled in the Supplemental Nutrition Assistance Program (aka food stamps), this inflationary pressure will have dire consequences for the majority of the population (Food and Nutrition Services, 2011). This inflationary pressure will be felt also in Canada as price increases will occur for all imported Chinese products. It should be now clear why this side of the story is much less communicated, as it would result in awareness of the true cost of a Renminbi reevaluation.

Works Cited

Food and Nutrition Services. (2011, January 5). SUPPLEMENTAL NUTRITION ASSISTANCE PROGRAM: NUMBER OF PERSONS PARTICIPATING. Retrieved January 14, 2011, from SUPPLEMENTAL NUTRITION ASSISTANCE PROGRAM: http://www.fns.usda.gov/pd/29SNAPcurrPP.htm

Katz, I. (2011, January 13). Geithner Says China Must Boost ‘Undervalued’ Yuan. Retrieved January 15, 2011, from Bloomberg: http://www.bloomberg.com/news/2011-01-12/geithner-says-china-must-move-to-prop-up-substantially-undervalued-yuan.html

Narioka, K. (2011, January 13). Euro Falls Against Dollar And Yen; Spain Auction Eyed. Retrieved January 14, 2011, from Wall Street Journal: http://online.wsj.com/article/BT-CO-20110113-700301.html

Reuters. (2011, January 9). Central banker urges China to cut U.S. debt holdings: report. Retrieved January 15, 2011, from Reuters: http://www.reuters.com/article/idUSTRE7090W120110110

Rosenbaum, E. (2010, December 15). Fed Surpasses China in Treasury Binge. Retrieved January 14, 2011, from The Street: http://www.thestreet.com/story/10948075/fed-now-the-largest-holder-of-us-debt.html

St Louis Fed. (2009). Graph: Employees on Nonfarm Payrolls: Manufacturing (MANEMP). Retrieved January 15, 2011, from St Louis Fed: http://research.stlouisfed.org/fred2/graph/?s[1][id]=MANEMP

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