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Section: Daily Dispatches

The End of Bretton Woods II Is Near;
The Problem is China, Not the Dollar

By John Brimelow
Monday, November 22, 2004

NEW YORK -- The bad news: The world is drifting into a
major currency crisis like the collapse of the Bretton
Woods agreement and the subsequent inflationary
upheavals of the 1970s.

The good news: It can be handled -- if the market is
allowed to work.

According to the deluge of commentary on the dollar,
America has a balance of payments problem and the
world has a dollar problem: A major dollar decline will
have to be accommodated.

This is quite wrong. What everyone has is a massive
Chinese undervaluation problem. Any exchange rate
discussion that fails to start with this fact is fatuous.

In 1993, China fixed its currency, the yuan, at
$1 = Y8.28.

Since then, capital and technology have poured into
China. It has built up foreign exchange reserves more
than tenfold, to almost $500 billion, an expansion
almost unmatched in history.

Yet the decline of the dollar in the past two years has
effectively dragged down the pegged yuan another 35
percent against the major currencies -- exactly the
reverse of what should have happened, given China's
exporting success.

"Economic miracles" like China's are actually not
unprecedented. Germany had one in the 1950s. But
accommodating "economic miracles" in a fixed
exchange rate system invariably causes problems.
This is what eventually destroyed the Bretton Woods
system of fixed rates, negotiated after World War II,
which lasted almost 30 years.

China has been allowed to operate on a covert Bretton
Woods system since 1993. By keeping its currency
artificially low, it has been practicing "exchange rate
mercantilism" -- concentrating productive capacity in
its own hands to the detriment of the world economy
(and ultimately its own consumers).

It is time to recognize that this must be ended.

Otherwise, any decline in the U.S. dollar simply gives
further advantages to Chinese exports. This is now
causing serious problems for other countries,
particularly in the Third World.

Under the various types of gold standard, of course, this
distortion could not have happened. The huge inflow of
resources would have inflated the Chinese economy
and eroded its competitive advantage.

Under Bretton Woods, distortion didn't happen either.
When a "fundamental disequilibrium" developed, vigilant
statesmen in the other counties took action to force

Why this has not happened this time in the case of
China is an interesting question.

Partly, it is because most economic theory in the
English-speaking world developed under fixed rates.
Furthermore, the English-speaking countries did not
generally practice predatory currency policies.

Some countries did, of course -- Japan spectacularly
undervalued its way out of the 1930s slump. But they
were minor cases, not on the policy radar screen.

My pet conspiracy theory: The Chinese have been
extremely successful in co-opting elements of the
American economic establishment.

The Treasury likes a reliable buyer of U.S. paper. So
does Wall Street. Importers of Chinese goods are
happy. American businessmen with plants in China
resist change. Buyers of Chinese consumer goods
do not complain. American diplomats dislike
offending this powerful and notoriously touchy

But now, China's policy is harming countries, in Europe
and elsewhere, where the leadership really cares about
the overall national interest.

These foreign leaders will provide the political will that
U.S. leaders have not. The Chinese perpetual motion
machine will be confronted and contained.

The beneficiaries of the Chinese undervaluation free lunch
had better prepare for change. That means importers and
distributors of Chinese goods (think Wal-Mart), sellers of
paper (think U.S. Treasury) and anyone who likes stability
(relative prices will shift -- possibly triggering inflation,
depending on the Fed's reaction.)

The collapse of the Second Bretton Woods system will
be sweeping and disruptive.

But ultimately it will be beneficial for the world at large --
and U.S. manufacturers in particular.


John Brimelow follows gold and international equities for
Aegis Capital Corp. in New York. He is the brother of
Peter Brimelow, a CBS MarketWatch columnist.


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