Krugman Blaming the Victim for the Crime
Henry C.K. Liu
This article appeared in AToL on January 6, 2010 and in New Deal 2.0 on January 4, 2010


A year-end (December 31, 2009) opinion piece by NY Times Op-Ed Columnist Paul Krugman with the title: “Chinese New Year” contains errors of fact and flaws of logic. But the most egregious fault of the piece is Krugman’s approach of blaming the victim for the crime.  
To begin with, the supposedly clever pun: “Chinese New Year”, which one would expect more as a headline for the National Enquirer than a serious newspaper, will fall flat to Chinese ears because Chinese New Year does not fall on the first day of the Western calendar year. This year, Chinese New Year falls on February 14, 2010. It would be the 4,408th year since Chinese civilization began keeping calendar records. Year 4408 is the year of the tiger in the 12-year zodiac cycle in the Chinese lunar calendar. People born under the sign of tiger are supposed to be sensitive, given to deep thinking and capable of great sympathy. Unfortunately, Professor Krugman’s piece on Chinese New Year exhibits little of the above attributes.
Krugman wrote in his article that “China has become a major financial and trade power. But it doesn’t act like other big economies. Instead, it follows a mercantilist policy, keeping its trade surplus artificially high. And in today’s depressed world, that policy is, to put it bluntly, predatory.”
What is Mecantilism
In the current global international finance architecture based on fiat dollar hegemony, mercantilism cannot be pursued by any trading nation beside the US, the issuer of the fiat dollar. Mercantilism is a term tied historically to a national policy on international trade conducted with specie money backed by gold. A mercantilist trade policy aims at winning gold with trade surpluses to provide more domestic investment to keep the surplus country more prosperous and more competitive in international trade. Fiat dollars, unlike gold, cannot be spent outside of the dollar economy. China’s dollar trade surplus is denominated not in gold, but merely in paper that the US can print at will. Dollars cannot be spent inside China without first being converted to Chinese currency, a move that would cause inflation in China since the wealth behind this new money has been shipped to the US in exchange not for real wealth but for paper.
Historically, the processes of globalization have always been the result of state action, as opposed to the mere surrender of state sovereignty to unregulated market forces. Adam Smith published Wealth of Nations in 1776, the year of US independence. By the time the constitution was framed 11 years later, the US founding fathers were deeply influenced by Smith’s ideas, which constituted a reasoned abhorrence of trade monopoly and government policy in restricting trade.
What Smith abhorred most was a policy known as mercantilism, which was practiced by all the major powers of the time. It is necessary to bear in mind that Smith’s notion of the limitation of government action was exclusively related to mercantilist issues of trade restraint. Smith never advocated government noninterference of and tolerance for trade restraint, whether practiced by big business monopolies domestically or by other governments internationally.

Historically, a central aim of mercantilism was to ensure that a nation’s exports remained higher in monetary value than its imports, the trade surplus in that era being paid only in specie money (gold-backed) as opposed to fiat money. This trade surplus in gold permitted the surplus country, such as England in the 18th and 19th centuries, to invest in more factories to manufacture more efficiently for export, thus bringing home more gold. The importing regions, such as the American colonies, not only found the gold reserves backing their currency depleted, causing free-fall devaluation (not unlike that faced today by many emerging-economy currencies), but also wanting in surplus capital for building factories to produce for export. So despite plentiful iron ore in America, only pig iron was exported to England in return for English finished iron goods.

In 1750, when the Americans began finally to wake up to their disadvantaged trade relationship and began to raise European (mostly French and Dutch) capital to start a manufacturing industry, England decreed the Iron Act, forbidding the manufacture of iron goods in America, which caused great dissatisfaction among the prospering colonials.
The Meaning of Laissez Faire
Smith favored an opposite government policy toward promoting domestic economic production and free foreign trade, a policy that came to be known as “laissez faire” (because the English, having nothing to do with such heretical ideas, refuse to give it an English name). Laissez faire, notwithstanding its literal meaning of “leave alone”, meant nothing of the sort. It meant an activist government policy to counteract British mercantilism.
The history of the development of the US economy is one of government protection of US industries against stronger foreign competitors and government restriction of domestic monopolies. This trend continued until after the US replaced Britain as the global economic hegemon after World War II. Government intervention in US foreign trade and antitrust measure in domestic trade built the US economy into a global power.
Neo-liberal free-market economists are just bad historians, among their other defective characteristics, when they propagandize “laissez faire” as no government interference in trade affairs. Currency hegemony of course is the most fundamental trade restraint by one single government.
A Strong Dollar is in the US National Interest

Since the end of the Civil War, a strong-dollar policy has been viewed by all administrations to be in the US national interest because it keeps US inflation low through low-cost imports and it makes US assets expensive for foreign acquisition.
This arrangement, which former Federal Reserve Board chairman Alan Greenspan proudly called US financial hegemony in congressional testimony, has kept the US economy booming in the face of recurrent financial crises in the rest of the world, at least until the current crisis. It has distorted globalization into a “race to the bottom” process of exploiting the lowest labor cost and the highest environmental abuse worldwide to produce goods for export to US markets in a quest for the almighty dollar, which has not been backed by gold since 1971, nor has it been backed by economic fundamentals for more than a decade.
Before the emergence of dollar hegemony through which it became possible to finance the US trade deficit with a US capital account surplus, Federal Reserve Chairman Paul Volcker had to raise Fed funds rate to an all-time high of 19.75% on December 17, 1980 to curb US stagflation caused by a rising trade deficit. Five years later, in 1985, Volcker and Treasury Secretary James Baker III engineered the Plaza Accord to force the Japanese yen up against the dollar to curb US trade deficit with Japan, promptly pushed the Japanese economy into sharp deflationary depression from which Japan has not yet fully recovered.
During the Plaza Accord negotiations, Baker famously told his Japanese counterpart that “the dollar is our currency but your problem.” In 2010, this statement is no longer operative. The weakening dollar has reverted to being fundamentally a US problem.  It is a puzzle why Krugman, a Nobel laureate economist, is now trying to jawbone the dollar further down against the Chinese yuan.
Financialization of the Global Economy
Financialization of the deregulated global economy through excessive debt and structured finance speculation supported by fiat dollar hegemony has detached asset values from underlying economic fundamentals to form financial bubbles. The adverse effects of this type of globalization on the developing economies are obvious. It robs the people of the meager fruits of their exports and keeps their domestic economies starved for capital, as all surplus dollars from export must be re-invested in US sovereign debt instruments to prevent the collapse of their own domestic currencies.

The adverse effects of this type of globalization on the US economy are also becoming clear. In order to act as consumer of last resort for the whole world, the US economy has been pushed into serial debt bubbles fueled by unsustainable over-consumption and fraudulent accounting. The unsustainable and irrational rise of US equity prices, unsupported by revenue or profit, had merely been a devaluation of the dollar. Ironically, periodic adjustments in US equity prices, known to the public as market crashes, merely reflect a trend to return to a stronger dollar, as it can buy more deflated shares.

Overcapacity Caused by Wage Stagnation

The world economy, through technological progress and deregulated markets, has entered a stage of overcapacity in which the management of aggregate demand is the obvious solution. Yet we have a situation in which the people producing the goods cannot afford to buy them and the people unfairly receiving the profit from goods production cannot consume more of these goods. The size of the US market, large as it is, is insufficient to absorb the continuous growth of the world’s new productive power in the emerging economies.
For the world economy to grow, the whole population of the world needs to be allowed to participate with its fair share of consumption. Yet neoliberal economists and monetarist policymakers continue to view full employment and rising fair wages as the direct cause of undesirable inflation, which is deemed a threat to sound money.
Demonizing China is not a Policy Option
Professor Krugman should know that demonizing China for its monetary policy, which under dollar hegemony is fundamentally a reactive derivative response to of US monetary policy, serve no useful purpose. Instead of pushing China to revalue the exchange value of its currency upward, he should be pushing both China and the US to raise domestic wages aggressively. Until US workers doing the same work are not paid more than their Chinese counterparts, US-China trade cannot be balanced. The preferred solution is for Chinese wages to increase at a faster rate than US wages and not for US wages to decrease. Cooperation on the front is urgently needed in US-China bilateral trade talks.
Trade Needs Not to be a Zero Sum Game
Mercantilism is a trade theory that assumes international trade to be a zero-sum game. In such as game, a trading nation’s prosperity is dependent on increasing its procession of capital in the form of gold through trade surplus denominated in specie money. The theory has since been invalidated first by Adam Smith’s trade theory of absolute advantage and later by Richardo’s trade theory of comparative advantage.
Adam Smith (1723-1780) argues that a country should produce and export commodities for which it has an absolute advantage and import commodities from countries that have absolute advantage in producing other commodities. Such terms of trade will benefit both trading partners by expanding both economies. Protectionism works against such mutual benefits.
The theory of comparative advantage as espoused by British economist David Ricardo (1772-1823) asserts that trade can benefit all participating nations, even those who command no absolute advantage, because such nations can still benefit from specializing in producing products with the lowest opportunity cost, which is measured by how much production of another good needs to be reduced to increase production by one additional unit of that good.
Ricardo’s theory reflected British national opinion in the 19th century when free trade benefited Britain more than its trade partners. However, in today’s globalized trade when factors of production such as capital, credit, technology, management, information, branding, distribution and sales are mobile across national borders and can generate profit much greater than manufacturing, the theory of comparative advantage has a hard time holding up against measurable data.
Today, in a global financial market operating under fiat dollar hegemony, the world’s interlinked economies no longer trade to capture Ricardian comparative advantage, only to capture fiat dollars to service their fiat dollar debts.
Mercantilism not possible under Dollar Hegemony
Mercantilism cannot be pursued by any nation in a world trade regime denominated in fiat dollars which has not be backed by gold or other species since President Nixon took the dollar off gold in 1971. Dollar hegemony is a geopolitically-constructed peculiarity through which critical commodities, the most notable being oil, are denominated in fiat dollars. The recycling of petro-dollars into other dollar assets is the price the US has extracted from oil-producing countries for US tolerance for the oil-exporting cartel since 1973. After that, everyone accepts dollars because dollars can buy oil, and every economy needs oil. OPEC had no option except to accept payment for oil in fiat dollars not backed by gold.
Oil and Gas Imports
US consumption has been fairly constant in the past few years. In 2007, about 13.7 million barrels were imports daily and only 5.9 million barrels from OPEC. At $100 a barrel, the aggregate oil bill for the US comes to $2 billion a day, $730 billion a year, about 5.6% of 2007 US gross domestic product (GDP). About 50% of US consumption is imported at a cost of $1 billion a day, or $365 billion a year. Oil and gas import is the single largest component in the US trade deficit, not imports from Japan or China. And unlike low-price import from China, oil import at high oil prices contributed directly to US inflation. This is one of the main reasons why a strong dollar is in the US national interest.
Dollar Hegemony
Dollar hegemony separates the trade value of every currency from direct connection to the productivity of the issuing economy to link it directly to the size of dollar reserves held by the issuing central bank. Dollar hegemony enables the US to own indirectly but essentially the entire global economy by requiring its wealth to be denominated in fiat dollars that the US can print at will with little short-term monetary penalties.
World trade is now a game in which the US produces fiat dollars of uncertain exchange value and zero intrinsic value, and the rest of the world produces goods and services that fiat dollars can buy at “market prices” quoted in dollars.  Such market prices are no longer based on mark-ups over production costs set by socio-economic conditions in the producing countries. They are kept artificially low to compensate for the effect of overcapacity in the global economy created by a combination of overinvestment and weak demand due to low wages in every economy. Such low market prices in turn push further down already low wages to further cut cost in an unending race to the bottom.  Thus China, together with other exporting developing countries, is essentially a victim of global trade under dollar hegemony. If the developing economies could find a way to shift export towards their domestic market, their economies would all be better off.
The higher the production volume above market demand, the lower the unit market price of a product must go in order to increase sales volume to keep revenue from falling. Lower market prices require lower production costs which in turn push wages lower. Lower wages in turn further reduces demand. To prevent loss of revenue from falling prices, producers must produce at still higher volume, thus lowering still market prices and wages in a downward spiral.
Export economies are forced to compete for market share in the global market by lowering both domestic wages and the exchange rate of their currencies. Lower exchange rates push up the market price of imported commodities which must be compensated by even lower wages in the export sector. The adverse effects of dollar hegemony on wages apply not only to the emerging export economies, but also to the importing US economy because companies will seek higher profit through cross border wage arbitrage. Workers all over the world are oppressed victims of dollar hegemony which turns the labor theory of value up-side-down..
Under fiat dollar hegemony, exporting nations compete in global market to capture needed dollars to service dollar-denominated foreign capital and debt, to pay for imported energy, raw material and capital goods, to pay intellectual property fees and information technology fees, all denominated in fiat dollar. Moreover, their central banks must accumulate fiat dollar reserves to ward off speculative attacks on the value of their currencies in world currency markets. The higher the market pressure to devalue a particular currency, the more fiat dollar reserves its central bank must hold. Only the Federal Reserve, the US central bank, is exempt from this pressure to accumulate dollars, because it can issue theoretically unlimited additional dollars at will with monetary immunity. The fiat dollar is merely a Federal Reserve note, no more, no less.
Dollar hegemony has created a built-in support for a strong dollar that in turn forces the world’s other central banks to acquire and hold more dollar reserves, making the dollar stronger, fueling a massive global debt bubble denominated in dollars as the US becomes the world’s largest debtor nation. Yet a strong dollar, while viewed by US authorities as in the US national interest, in reality drives the defacement of all fiat currencies that operate as derivative currencies of the dollar, in turn driving the current commodity-led stealth inflation masqueraded as growth as long as wages stay stagnant.
When the dollar falls against the euro, it does not mean the euro is rising in purchasing power. It only means the dollar is losing purchasing power faster than the euro. A strong dollar does not always mean high dollar exchange rates. It means only that the dollars will stay firmly anchored as the prime reserve currency for international trade even as it falls in exchange value against other trading currencies from time to time.

Structural Unemployment
In recent decades, central banks of all governments, led by the US Federal Reserve during Alan Greenspan’s watch, had bought economic growth with loose money to feed serial debt bubbles and to contain inflation with “structural unemployment” which has been defined as up to 6% of the work force to keep the labor market from being inflationary. Central banking has mutated from an institution to safeguard the value of money to ensure wages from full employment do not lose purchasing power into one with a perverted mandate to promote and preserve dollar hegemony by releasing debt bubbles denominated in fiat dollars every time the economy falters.
Another effect of mercantilism is that the trade deficit countries will face deflation as the gold-backed money supply shrinks. Between 1770 and 1812, European trade exported bullion to pay for goods from Asia, thus reducing the money supply and putting downward pressure on prices and economic activity. This is the reason why inflation was low in the English economy until the Revolutionary and Napoleonic wars when paper money began to circulate widely.
Under dollar hegemony, the US put a new wrinkle in this relationship. The US since 1971, with the dollar de-linked from gold, has been able to print additional dollars without inflation because of low-price imports from China while the Chinese trade surplus dollars are reinvested in US capital accounts. The dollar began to lose exchange value in the last two decades since 1987 as the Fed under Greenspan began to print more dollars than low-price Chinese imports could neutralize their inflationary effect. This was the cause of the recurring debt bubbles that burst every decade: the 1987 crash, the 1997 Asian financial crisis and the 2007 debt crisis.
China’s History of Monetary Victimization
Copper, silver and gold had been the component metals in China’s tri-metal monetary regime throughout its long history. Cloth, grain, cattle, pearls and jade, along with precious metals, had also been used as media of exchange in ancient times. The Sung dynasty issued the first paper money in 1023. Silver had been used increasingly widely as currency in China since the 15th and 16th centuries with imports from the increased silver production in the Americas as a result of a Chinese trade surplus with the West.

Around 1564, Mexican silver coins began circulating widely in Chinese coastal trade towns such as Guangzhou and Fuzhou as payment by Portuguese traders for Chinese exports. By the 18th century, China was operating on a de facto silver standard monetary regime.

The 19th-century reversal of China’s foreign trade from surplus to deficit was due to Western opium smuggling starting from 1820. Up to that time, China permitted very little foreign trade and what legitimate trade that did take place amounted to only an insignificant portion of the Chinese economy. This illegal opium trade was denominated in silver until China ran short of silver after two decades, after which the legalized but immoral opium trade was denominated in porcelain that steadily fell in price because China could produce porcelain easier than it could produce silver, albeit Chinese export porcelain was increasingly produced at inferior quality compared to that produced for the more discriminating domestic market. Monetary defacement occurred even in porcelain when it became a unit of account.

Maria Alejandra Irigoin in her paper: “A Trojan Horse in 19th century China? The global consequences of the breakdown of the Spanish Silver Peso Standard”, observes that until the 1640s, silver trade was essentially driven by large differences in the gold-silver ratios between Spanish America, Europe and China, allowing a substantial arbitrage gain to be realized by intermediaries. After 1825, China's balance of silver trade with the West became negative due to the illicit opium trade.

According to Irigoin, between 1719 and 1833, 259 million silver pesos, or 6,321 tons of silver, entered China to pay for Chinese goods. That is the equivalent of 421.4 tons or 135.5 million ounces of gold at the universal silver/gold ratio of 15/1. For comparison, as of January 2007, gold exchange traded funds held 629 tons of gold in total for private and institutional investors.

Of the 6,321 tons of silver, 62% was introduced after 1785 and a full 30% after Spanish American independence, usually dated as 1810. Importantly, the structure of the silver trade was different before and after 1785. Up to that date, English intermediation accounted for about 50% of silver inflow to China since 1719, French for 20% and Dutch for 15%. After 1785, the US became progressively the main provider of silver to China. Around 1795, North American merchants provided 28% of Chinese silver inflow to pay for Chinese goods. By 1799 the US share had risen to 65% and after 1807 American intermediaries accounted for a full 97% of silver inflow into China.

This one-way trade denominated in silver grew steadily until the late 1820s. It experienced a short-lived high point in 1834-36 after which date it declined strongly and only staged a timid recovery after 1853. The US trade deficit with China did not start in the 1990s. It began in 1800. The only difference between the two dates is that in 1800, the US had a steady supply of silver from Mexico and after 1990 the US has a steady supply of fiat dollars.

Despite Chinese discouragement of foreign trade, China had always enjoyed a trade surplus until 1834. Chinese flow balance of silver had been positive all through history and became negative only after 1826, 10 years later than the inversion of the overall balance of trade of China due to the opium trade. This was because the sliver deficit from the illicit opium trade was at first cancelled by silver inflow from Russia in exchange for Chinese silk, porcelain and tea. Russia earned silver in the trade boom during the Napoleonic wars.

The massive smuggling of opium led to increasing silver imbalance for China after 1819. Similarly, Chinese silver inflow still exceeded outflow until the mid-1820s because the US sent more silver into China than opium-smuggling English merchants extracted from there to Bengal, Calcutta and finally to London.

A spurt of silver demand from China occurred in the first half of the 18th century, when the Chinese exchange rate of silver to gold was still 50% higher than the bimetal exchange rate in Europe. This offered opportunity for European arbitrage with China’s huge population and market growth.

Irigion notes that the historiography of trade globalization has long recognized the role of demand for silver in the Chinese economy as the foundation in the establishment of intercontinental trade between the Americas, Europe and Asia since the 1600s. Silver from Spanish America reached Europe through the trade of both Spanish licensed merchants and northern European interlopers from whence it continued to flow to China within the organized trade of the European chartered companies, primarily the English and Dutch East India Companies.

At the same time, a second route of silver flows was established within the Spanish colonial trading system. This directly linked Spanish American production areas in Peru and Mexico to Manila in the Philippines through the famous Manila galleon, which sailed regularly from Acapulco to the East. The monetary changes in Spanish America in the wake of Spanish American independence impacted upon this trade. The revolutionary wars in Spanish America and the implosion of the Spanish empire led to a fragmentation of the previously unified monetary regime, which resulted in the production of coins of different quality, fineness and weight. Irigion argues that this change, entirely exogenous to the Chinese market, resulted in falling demand for Spanish American pesos in China.

Thus it qualifies the conventional historiography that stresses the role of opium imports in allegedly reversing the flows of silver bullion to and from China in the early 1800s, even though it does not altogether negate the financial impact of opium smuggling.

Evidence supports the conclusion that monetary conditions exacerbated the negative effect of opium smuggling on Chinese national finance. The outflow of silver from China that began in the early 1800s coincided with the collapse of silver prices in the international market as Western countries adopted the gold standard and demonetized silver.

Silver was leaving China in huge quantities while the price of silver was falling in the international market, making the Chinese trade deficit more expensive in local currency terms. Yet while the price of silver fell in the international market, its price rose in the Chinese domestic market in relation to copper, accelerating and exacerbating import trade inflation in the Chinese economy through domestic price deflation.

This monetary collapse inflicted great financial damage on China’s peasantry. While peasant income was denominated in copper coins, their tax obligation to the imperial court was denominated in silver coins, because the imperial government's trade deficit was denominated in silver. The scarcity of silver created by the massive outflow pushed the domestic silver price sky-high in terms of copper coins.

A similar monetary disadvantage is now hurting American workers, whose wages are denominated in falling dollars with dwindling purchasing power for critical imports such as oil. The only different is that for 19th century China, the damage was forced on the Chinese peasantry by foreign imperialism, while in the US, the damage on US workers was done by their own government’s monetary and trade policy that allowed US transnational corporation to profit from activities that hurt US workers.

International bimetallism greatly disadvantaged the Chinese silver-based export economy and domestic bimetallism greatly disadvantaged the copper-based finances of the Chinese peasantry. Chinese peasant populists would have a similar incentive to promote a copper-based monetary regime against a silver standard in China as the US populists did with fighting for a silver-based monetary system against the gold standard in the US. But until the Chinese Communist Party gained control of the governmental apparatus of the Chinese nation, there was no official defender of the Chinese peasantry.

China suffered a protracted economic recession all through the 19th and 20th centuries as it came into commercial contact with the West. This two-century-long recession reduced China from being the world’s richest economy to one of the poorest. It was the result of the structural double monetary disadvantage of international bi-metallism of gold and silver superimposed on the silver-based monetary system of the Chinese foreign trade sector. This took place in a world monetary regime that was shifting toward the gold standard, which greatly disadvantaged the Chinese domestic bimetal monetary system of copper and silver.

This double disadvantage fatally wounded the Chinese economy, causing the decline of a highly developed culture with a continuous history of four millennia and halted its further development for more than seven generations over two centuries. The bankrupt economy reduced Qing imperial China to a failed state unable to defend itself from aggressive Western imperialist powers, and even after the nationalist bourgeois revolution of 1911, until the founding of the People’s Republic, when China adopted a socialist path for its economy.

Even after the 1911 bourgeois revolution that established the Republic of China under the Guomindang (Nationalist Party), when China followed a petty bourgeois free-market system, she was unable to shake off Western imperialism to free the nation, once the most prosperous in the world, from semi-colonial economic status.
Beside economic exploitation, the British East India Company, to gain political support from the Church of England for colonialism, also adopted aggressive evangelistic policies on behalf of Christianity. The deep hostility between Catholicism and Protestantism was buried within British imperialism. Many British empire-builders were Scots, who brought with them Scottish Catholicism to the non-white British colonies. The Act of Union of 1707 united the kingdoms of England and Scotland and transferred the seat of Scottish government to London. Henceforth England and Scotland were known as the United Kingdom.

The Company methodically destroyed monasteries and suppressed indigenous culture in Buddhist Tibet, which together with the launch of the Opium Wars to protect immoral opium smuggling, caused deep-rooted anti-Western xenophobia in all Asia that lingers on even today and makes a travesty of belated Western grandstanding on religious freedom, human rights and rule of law for centuries to come.

The pound sterling, created in 1560 by Elizabeth I, as advised by Thomas Gresham, brought order to the monetary chaos of Tudor England that had been caused by the "Great Debasement" of coinage that led to a decade-long debilitating inflation beginning in 1543 when the silver content of a penny dropped by two thirds to become mere fiduciary currency. The exchange rate of British coins collapsed in Antwerp, where English cloth was sold in Europe.

The Bank of England was founded 1694 with the pound sterling as the currency of account. All coins in circulation were then recalled by the Royal Mint for re-mint at a higher standard. Sterling unofficially moved to the gold standard from silver as a result of an overvaluation of gold in England that drew gold from abroad in exchange for a steady outflow of silver, notwithstanding a re-evaluation of gold in 1717 by Isaac Newton as Master of the Royal Mint.

The de facto gold standard continued until its official adoption following the end of the Napoleonic Wars in 1816. The gold standard lasted until Britain, along with several other trading countries, abandoned it only after World War I in 1919. During this period, the pound was generally valued at around US$4.90. Britain tried to restore the gold standard in 1925 without success despite support from the US central bank, which contributed to the 1929 crash on Wall Street that immediately spread to world markets to cause a global depression.

A century earlier, the currencies of all other major Western countries in 1821 were either bimetallic or specie-backed paper money. This meant that Britain operated within a floating exchange rate system for most of the 19th century, although for much of this time, when the silver/gold ratio stayed close to the common mint ratio of 15.5/1, the floats were tightly constrained within a narrow band. The 19th century gold standard was supported by government incentives and government ability to adhere to it due to lower borrowing costs (on average 40 basis points) when loans were denominated in currency backed by gold, especially in London, the center of international finance at the time.

Hence large borrowers, such as the newly independent US, had a strong incentive to also adopt the gold standard. By 1870, the main core countries of the gold standard had been deeply engaged in international trade for decades, led by British promotion of free trade. Consequently their respective domestic price levels were similar and their differences changed only slowly, putting less strain on their balance of payments. Trade deficits were difficult to sustain and trade would slow as deficits mounted until balance of payments were restored.

British promotion of free trade under the gold standard took place in an era when new discoveries of gold in the Americas, Australia and South Africa allowed Britain to run a trade deficit while still funding substantial investment in colonies overseas. This was because gold was steadily devalued on expectation of more gold entering the market, and the resultant defacement was expected to be corrected as the economy expanded faster than the rate of gold production. It was a classic example of the positive effects of the quantity theory of money when money supply expansion did not come from official defacement of currency even as gold was devalued.

Pound Sterling Hegemony Replaced by Dollar Hegemony

Earlier in the 19th century, Britain had to run a trade surplus in order to invest overseas. An increased supply of gold translated into an increase in money supply to boost economic growth globally after the middle of the century. Overseas income in turn acted as counterbalance against temporary adverse trade flows and balance of payments and thereby reduced the need for aggressive moves in interest rates.

Globally, wealth was flowing to England from the rest of the world even as England incurred persistent trade deficits. This is the same principle behind dollar hegemony today that allows wealth to flow into the dollar economy controlled by the US even as the US incurs persistent trade and fiscal deficits.

The key difference is that the dollar today is not protected against devaluation by expansion of the US economy, since the Federal Reserve when under chairman Alan Greenspan had resorted to devaluation of the dollar through increasing the money supply as a device to stimulate serial economic bubbles. The global dollar economy is now treating the US economy was a colony. But the global dollar economy is not controlled by China, but still by the US financial elite. China needs to understand that there is no future in participating in a global trade regime with the dollar as reserve currency. Further, China should resist the US call for it to be a “stake holder” in the global dollar economy if China does not wish to fall victim again to colonialism, albeit a new form of neo-imperialism.

The ever-widening spread of a multilateral trading system also reduced the need to settle trade deficits in gold by early 20th century. In 1910, Britain ran a combined trade deficit of 107 million pounds with three large regions: continental Europe, the US and the great plain nations of Canada, Australia and Argentina. But she partially offset that deficit with a 60-million pound trade surplus with the non-white British colonies of India, British Caribbean and Africa. In turn, these non-white British colonies had trade surpluses of 40 million pounds with continental Europe, the US, and the great plain nations. The British trade surplus with semi-colonial China was not even included in these numbers.
The Chinese economy had been victimized by British sterling hegemony in the 18th and 19th centuries. In similar ways, the Chinese economy has again been victimized in the last three decades by foreign trade under fiat dollar hegemony. Thus Krugman’s attack of alleged Chinese “predatory mercantilist” trade policy is in essence blaming the victim for the crime of neo-imperialism. Had China denominated its export in its own currency, the Chinese economy would be in a much better shape today.
Even then, Kruman inaccurately described China’s currency today as “pegged by official policy at about 6.8 yuan to the dollar.” To appease US demand, China abandoned a fixed yuan-dollar peg in 2005 for a managed float against a basket of currencies within a band and at a crawl rate (BBC). Since then, the Renminbi (RMB) has appreciated by about 20% against the dollar. When the yuan was pegged exclusively to the dollar, it lost value relative to other currencies when the dollar fell, as it did between February 2002 and 2005. Thus not withstanding the US accusing China as a currency manipulator, the US was in reality the main manipulator of its own currency and indirectly of the Chinese currency as well through the Chinese currency’s position as a derivative of the manipulated dollar.
In November, 2008, in response to serious and abrupt adverse impacts on the Chinese export sector from the global financial crisis that originated from the US, China let it currency depreciate modestly by market forces. This development was misinterpreted by many Western economists as a shift in Chinese foreign exchange policy. Since then, the Renminbi (RMB) has traded in a narrow band against the dollar, leading some Western economists to argue that a de facto peg has been restored. Between 2005 and 2008, despite the gradual appreciation in the Renminbi, China has continued to record large current account surpluses with the US, leading some economists to conclude that the trade imbalance between the US and China was not caused primarily by exchange rates.
US-China Confrontation not a Solution
Krugman concludes that the US needs not be afraid to confront China on trade issues. He argues that since “short-term interest rates are close to zero; long-term interest rates are higher, but only because investors expect the zero-rate policy to end some day, China’s bond purchases make little or no difference.” He claims “that for the next couple of years Chinese mercantilism may end up reducing US employment by around 1.4 million jobs.” Thus Krugman, quoting Paul Samuelson, rejects “the claim that protectionism is always a bad thing, in any circumstances. If that’s what you believe, however, you learned Econ 101 from the wrong people — because when unemployment is high and the government can’t restore full employment, the usual rules don’t apply.”
Krugman warns China by concluding that “the very mild protectionism it’s currently complaining about will be the start of something much bigger.”
Paul Samuelson and Joseph Schumpeter
On the issue of protectionism, Krugman is correct but for the wrong reasons. Protectionism works to protect weak national industries and only indirectly protects against loss of jobs. Instead of quoting Samuelson, Krugman might have been more persuasive by quoting Joseph Schumpeter. According to Schumpeter’s theory of creative destruction as expressed in his Capitalism, Socialism and Democracy, jobs are regularly destroyed by innovations and replaced by new, more productive jobs. Schumpeter is frequently quoted by Greenspan who selective leaves out the part that, according to Schumpeter, socialism will eventually replace capitalism (chapters 11 -14).
The US is losing jobs to China because US trade policy encourages cross border wage arbitrage. Even if China did not exit, US transnational companies would ship low-paying job off shore to other low wage countries. But these jobs are mostly unskilled jobs at wages that no US workers would accept.  In the long run, a strong innovative industrial base with rising wages is the best guarantee for full employment. Until US trade policy focuses on this economic truth, blaming China may make US workers feel good, but it will not solve job loss problems that are fundamentally created by US trade policy.
The Difference between Protectionism and Economic Nationalism
Krugman needs to understand the difference between economic nationalism and protectionism. The cure for cross border wage arbitrage is through allowing the efficiency market hypothesis to function in the global labor market, to bring wages in low wage economies such as China’s up to wage levels in the advanced economies for equal work. Unfortunately, on this issue which cries out for international cooperation, there is still no progress and is glaringly absent in WTO trade negotiation and bilateral strategic and economic dialogues and summits. What the global economy needs now is global full employment with rising wages achieved through coordinated economy nationalism. It does not need the myopic rationalization of obsolete protectionism, even if it is buttressed by quotations from Samuelson.

January 4, 2010