A Short Money Treatise for D.C. Dummies by Steve Forbes

A devastating trade war with China has once again been averted, thanks to some last-minute diplomacy. But the destructive idea behind this ongoing crisis is still there, which means the dispute will undoubtedly flare up again. Uncle Sam believes Beijing manipulates its currency, the yuan, to give China an unfair trade advantage. Washington claims that since China's economy has long been strong and growing rapidly the yuan should go up against the greenback as if it were a common stock experiencing a surge in earnings. This theory is preposterous, but it has a stranglehold on Washington policymakers in both the legislative and executive branches.

It's time to get back to basic economics. Money--both the paper and electronic varieties--is, in and of itself, worth nothing; it has no intrinsic value. It is a means--and a profoundly important one--of enabling people to more easily conduct transactions without having to go through the clumsy and utterly inefficient barter process.

For example, when we sell a subscription to Forbes we don't receive in return an endless variety of products (loaves of bread, goat cheese, hot dogs, shoes, blouses and neckties, etc.) or services (two hours of lawn mowing, etc.). We are paid in cash and can then determine for ourselves what products or services--such as a writer's salary--we pay for with that subscription fee. If policymakers could grasp that elemental concept, they'd save themselves and the world considerable grief and could then get down to the business of removing trade barriers between those who wish to do business with one another.

Money is a facilitator. It should be a fixed standard of measure, as are the minutes in an hour, inches in a foot and pints in a quart.

Coins, mainly gold and silver, were the first money that facilitated trade beyond an immediate village or compact community, whose members would previously have used seashells or some other indigenous items. Coins had intrinsic value, which is why they were accepted beyond their community of origin. It was the pioneering use of coins, for example, that enabled Athens to become the commercial and cultural center of ancient Greece.

Coins are bulky and therefore can do only so much to ease and encourage commerce, hence the need for paper currency, financial instruments and today's electronic versions. This brings us to the chronic problem of how to ensure that money is not manufactured beyond the needs of a free marketplace, which is why the gold standard was established.

Alas, the notion arose in the late 19th and early 20th centuries that if wise men could have "flexibility" in issuing money without the constraints of its being tied to the supply of gold, or even silver, they could rid us of financial panics, the business cycle and other human ailments! John Maynard Keynes and others thought that if the economy looked to be slowing you should just churn out more money, like putting more logs on a flickering fire, and do the opposite if things looked to be overheating. But manipulating the amount of money or the cost of it, à la the Fed's fixing interest rates, gets in the way of prosperity. It does not facilitate prosperity but retards it. There is no way a handful of people--wise or unwise--in government and central banks can second-guess what markets made up of billions of people might need. We are living through a disaster that is the result of the latest Greenspan/Bernanke attempts to guide our economic destiny through central bank operations.

Imagine if the government decided to increase the number of minutes in an hour from 60 to 70. You can hear policymakers congratulating themselves: "People will work longer at the same pay. This will be a boon to productivity!" Or if Washington increased the number of inches in a foot from 12 to 15: "Home buyers will thus get more house for the same price and that will stimulate home buying!" Preposterous? It's no more foolish than what we and other countries routinely do with our currencies.

But back to China. A decade and a half ago China fixed the yuan to the dollar. If there had been any mistake in the exchange rate it would have been flushed out in trade patterns fairly quickly. Again, to simplify: If you sell a bottle of wine for four loaves of bread but suddenly notice you're getting only two loaves, you'll adjust your price pretty quickly to ensure you'll get those four loaves again.

By fixing the yuan to the dollar Beijing outsourced its monetary policy to the Federal Reserve. And for this "manipulation" Washington politicians and policymakers are in a lather of outrage. This fixing of a measure of value has enormously facilitated commerce--and thus prosperity. During the last 15 years U.S. exports to China have increased 650%, China's exports to the U.S. almost 670%.

Adjusting a currency does not ultimately improve a trade balance. Look at Japan: The dollar has depreciated 70% against the yen since the 1970s, when we pressured Tokyo--as we are now pressuring China--to appreciate the yen in order to reduce our trade deficit with Japan. Result: Japan's exports have grown markedly, and our trade deficit is far greater today than it was 30 years ago. Make no mistake: Arbitrarily changing a currency's value is a form of protectionism. Instead of raising taxes on imports the same effect is achieved by changing prices through currency devaluation. In 1984 one dollar bought 250 yen. Say that a widget cost 250 yen (or $1). If what the dollar could buy dropped from 250 yen to 165 yen, then the price of the widget went up to $1.50. That's as good as a 50% tariff.

The notion that a trade deficit or surplus indicates anything about an economy's health is also mistaken. The U.S. has had a trade deficit with the rest of the world for some 350 years out of the 400-plus since Jamestown was settled in 1607. Focusing on deficits and surpluses ignores equally important flows of capital, as well as the phenomenon of supply chains and the intracompany trade that crosses borders.

Pressuring Beijing about its currency is a destructively futile exercise that could have ugly political ramifications and escalate into a trade war. The Smoot-Hawley Tariff of 1929--30 set off a global trade war that sank us all into the Great Depression. If not for that economic catastrophe, Hitler would never have come to power in Germany. If cheap money were the way to wealth, Zimbabwe and Argentina would own the world today.

We should instead focus on substantive issues, including various Chinese trade barriers to U.S. imports and getting China to open up its capital markets.