China and the IMF: An Inflationary Love Story



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China and the IMF: An Inflationary Love Story

  • Harry Dexter White (left) and John Maynard Keynes at the inaugural meeting of the International Monetary Fund's Board of Governors

December 1, 2015

The ‘good’ news this holiday season comes from the IMF, as the Fund decided yesterday to include the yuan in the basket of currencies which underpins its Special Drawing Rights (SDR). From October 2016, China’s currency will determine by a weight of 10.92 percent (together with the pound, dollar, euro, and yen) the value of this special IMF international reserve asset.  The SDR is a hybrid currency asset, which can be traded only between national governments, central banks and the IMF. Its official role is to provide member countries with supplemental reserves (when foreign exchange reserves are depleting) to enable them to stabilize the exchange rate.

The media focused on the geopolitical implications of this move, and on China’s rise as an economic superpower. But the more troubling issues have been conveniently overlooked. As Mises used to sarcastically remark to his students, “one doesn’t talk of the international problem in terms of inflation… one says there is not enough ‘liquidity’, not enough ‘reserves’” (Mises 2010, 78).

The real role of the SDR is to allow members to cover up a domestic inflationary episode which results in a rapid depreciation by indirectly buying its currency on foreign exchange markets. The simple reason for foreign reserve drains following domestic inflation is Gresham’s Law, where bad money drives out good money out of the economy. In a world of fiat fluctuating currencies, the difference between good money and bad money is not one of nature (gold vs paper) but of degrees of inflation, from less (think Swiss francs) to much more (such as Zimbabwean dollars). If countries expand money supplies at comparable rates, fiat currencies do not fluctuate abruptly—hence the political appeal of flexible exchange rates compared to a gold or fixed exchange standard. But a relative over-expansion of the domestic money supply—or an acceleration of its effects—can deliver a foreign exchange crisis, and this is one of the last remaining checks on the level of monetary inflation a central bank can engage in.  

It is in these cases that the IMF intervenes. The mechanism is simple: just like individual commercial banks are provided with liquidity in the event of a bank run by drawing on the national pool of reserves, the IMF protects central banks in a currency crisis by reshuffling other members’ foreign exchange reserves. In other words, the IMF acts as central banks’ lender of last resort, and has proven very active since the financial crisis in 2008.

For China, IMF’s seal of approval on the yuan as reserve currency will most likely calm down investors with regards to the recent turmoil in Chinese financial markets, and postpone some of the otherwise inevitable consequences of their monetary policy. For the IMF, this is an important move in making its SDR more liquid (as legal tender is domestically), which would pave the way for “expanding the issuance of notes in regular intervals irrespective of a need for supplementary resources” (IMF 2011, 11). The Fund could have accomplished the same goal by including any other traded currency in its basket, but here it is important to remember that the yuan is still tied to the dollar, which in fact gives the U.S. currency a larger discretionary power to steer the global economy through its exchange rate policy. And this is definitely coming in handy as the QE is running out of steam and a devaluation of the dollar might be the next thing on Yellen’s list.

The short term plan, therefore, is to remove any remaining checks on fiat inflation at an international level, and to allow the deficits of sovereign debtors to soar. The long term plan, outlined openly in the IMF study mentioned above, is to make SDR the global paper money: “if the perceived safety of other global assets were to decline, Fund-issued SDR securities could be a potential anchor off which to price risk throughout the system… if there were political willingness to do so, these securities could constitute an embryo of global currency” (IMF 2011, 12)

According to Murray Rothbard, what these plans amount to

is no less than an internationally coordinated and controlled world-wide, paper-money inflation, a fine-tuned inflation that would proceed unchecked upon its merry way until, whoops!, it landed the entire world smack into the middle of the untold horrors of global runaway hyperinflation (Rothbard 2006, 317).

Whether these plans will ever come to fruition is too soon to tell. But it’s worth noting that the determination of monetary authorities to accomplish them is as high now as it was in 1944, and before that in 1914. ‘The best laid schemes of mice and men… leave us nothing but grief and pain.’

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