President Barack Obama said on Wednesday China and Asia would be a huge market for U.S. exports going forward but it would be important to address currency rates to ensure American goods were not facing a disadvantage. "One of the challenges that we've got to address internationally is currency rates and how they match up to make sure that our ... goods are not artificially inflated in price and their goods are artificially deflated in price," Obama told senators from his Democratic party.Stripping aside the rhetoric, what Obama is saying is that the U.S. would be better off if the dollar weakened against the yuan. This is nothing but shoddy thinking. A weaker currency can never make an economy stronger. A weaker currency may make U.S. exports cheaper, but a weaker currency also makes imports more expensive. Devaluing one's currency is thus a fool's game, since it benefits one segment of society (exporters) but harms everyone else (consumers, who have to pay more for the imported goods they purchase).
China made a perfectly rational decision to start pegging its currency to the U.S. dollar in 1995. Targeting its currency is the mainstay of Chinese monetary policy, and that is perfectly acceptable, so long as you understand and accept that under a targeted exchange rate regime, the economy is forced to adjust if the exchange rate chosen is too strong or too weak. If the currency is pegged at a rate that is too weak (as Obama is alleging) then imports will be too expensive and inflation will tend to rise, and the price of goods and services will rise until the currency's artificial cheapness is offset. In the long run, pegging one's currency at a low level will only result in inflation and perhaps a temporary boost to exports.
The Chinese central bank first started targeting the yuan/dollar exchange rate in 1994; thus the economy has had 16 years to adjust. It's noteworthy that the Chinese have already revalued the yuan against the dollar significantly, by almost 28%, since 1994. It's highly unlikely, therefore, that the yuan is being pegged at a level that is artificially low. And even if it were, the passage of time will inevitably erode whatever "advantage" that is supposed to give to Chinese exporters.
The biggest problem the Chinese face with their exchange rate regime is that the currency they have chosen as a standard (the U.S. dollar) has suffered extreme changes in value against the other major currencies of the world. It does the Chinese little good to peg their currency to a standard that fluctuates, and in fact it only creates problems for its economy. For example, the dollar rose some 50% from 1995 to 2002, lifting the yuan with it, and that was the proximate cause of the deflation that China suffered from 1998 through 2002. The dollar subsequently lost over one-third of its value from 2002 to 2008, and this helps explain why Chinese inflation rose from zero in early 2003 to almost 9% in 2008. The main reason the Chinese have revalued their currency against the dollar is because the dollar has lost about 20% of its value against other major currencies since 1994.
The result of this so-called currency "manipulation" is a yuan that has been more stable relative to other currencies, and to gold, than the dollar. This stability, coupled with massive foreign currency reserves, has made the yuan a rock of stability. Revaluing the yuan would only make sense if the U.S. were to allow the dollar to continue to fall against all currencies. Is a dollar devaluation really what Obama wants? I hope not.
UPDATE: Just to be clear, I'm saying that the only way the Chinese are going to revalue the yuan against the dollar is if the U.S. first devalues the dollar against other major currencies.