It’s certainly no secret that I’ve been a huge critic of China’s Dollar peg. I’ve argued for a long time that it creates economic distortions that are very unbeneficial to the average Chinese citizen; as well as causing some harm to external economies, such as the United States.
In the past, I’ve focused a lot on how this policy creates overproduction. It’s easy to see why this is the case, given that the most obvious result of the currency peg is a massive oversupply of real estate and other fixed assets, which have given rise to the concept of entire newly-constructed “ghost cities”. Yet, let’s not forget about the other side of the equation: underconsumption.
Currencies and Pegs
A currency peg isn’t necessarily detrimental to a nation, but it can become a very tricky balancing act. A small nation or an economically weak nation might adopt a US Dollar peg in order to convince foreigners to invest capital there. It could also help create some stability for a smaller nation. However, a currency peg can also be a very dangerous instrument, since it is, more or less, a price control. Not only is it a “price control”, but it’s a price control that affects the price of every single good and service in an entire national economy!
When a nation creates more wealth and becomes more productive, the natural market reaction is for the currency to strengthen. This is simple to understand in a straightforward example. Let’s say I’m a factory owner in an island economy, governed by an independent King. I own all the land on the island and there are no other businesses. Given this, we are heavily reliant on exporting our one and only product: widgets. We are also heavily reliant on imports from other nations.
With my current machinery, I can produce 1,000 widgets, for $2 profit each. That means I can earn $2,000 income from my property each year. Now, let’s say a brilliant inventor creates a new manufacturing process that allows me to produce more widgets and at a lower price, and now I can produce 2,000 widgets for $1.5 profit each. Suddenly, I can earn $3,000 income from the exact same property! Assuming the amount of currency in circulation stays the same, and all other factors remain equal, then it stands to reason that the currency must strengthen in order to compensate for this economic gain.
But let’s say the King implemented a currency peg and left it unchanged after the productivity gain. The problem with this peg is that it prevents the above process (wealth capture) from occurring, so while the technological and productivity gain might be made, the currency peg might actually prevent the currency from strengthening. So instead of being able to use my greater wealth created from this productivity gain to pay workers more and buy more things for myself, I’m actually required to “export” away my productivity gain to other nations.