How easy is it for any policy maker to deliver a ‘common prosperity’ for the people while maintaining a stable exchange rate? You might think that this is a question of no practical import for those seeking to preserve the purchasing power of their savings but is more a question for politicians. However, financial history suggests that for savers there are, in the long-term, few more important questions.
Finding the right answer to this question is particularly important today because the President of China, Xi Jinping, has made it clear that his key political goal is now ‘common prosperity.’
Since 2004 I have run a course called The Practical History of Financial Markets ([www.didaskoeducation.org](http://www.didaskoeducation.org) ), soon to be available in an online version), which is based upon feedback from experienced fund managers on what they consider to be the key issues that investors need to understand. Based upon their feedback we teach that the key factor behind both returns from bonds and equities is changing inflationary expectations. You really should care whether President Xi can reduce China’s very high debt levels and redistribute wealth without the flexibility to control the price of money, the quantity of money and the rate of inflation. If he needs those powers, can he regain them without moving to a flexible exchange rate? If he has to move to a flexible exchange rate to meet his own political goals, what does this mean for global inflation and asset prices?
Politicians have not always considered a common prosperity to be worth pursuing. In the 19th century only property owners tended to get the vote and, not surprisingly, they favoured a hard currency, in most instances a gold standard, that reduced the prospects of inflation destroying the purchasing power of their wealth.
This changed in the 20th century as men without property and eventually women got
the vote. The gold standard and the orthodoxy promoting hard money disappeared. In the democratic era politicians needed the flexibility of monetary policy to attempt to redistribute wealth. In an era when independent central bankers held the reins of monetary policy, inequality of wealth has increased primarily for reasons associated with lower interest rates and higher asset prices. There is now a backlash against their stewardship of money and the low inflation they delivered, with some help from some major structurally deflationary forces.
Across the world governments are taking control of the price and supply of money in pursuit of goals not dissimilar to those they pursued post WWII. Total non-financial debt-to-GDP ratios are at all-time highs and the growth of nominal GDP needs to be pushed higher while the growth in debt needs to be constrained. The wealth impact is to move real purchasing power from savers to debtors and from old people to young people.
The social necessity of governments regaining control over the price of money, the quantity of money and also the direction of credit is clear to politicians and these powers are being taken back from central bankers. Can President Xi engineer similar outcomes but without controlling the price and quantity of money which requires moving to a more flexible exchange rate?
As I discuss in my new book (The Asian Financial Crisis 1995-98: Birth of The Age of Debt), countries with large current account surpluses and very high foreign reserves still can be forced to devalue their exchange rates. The Asian financial crisis of 1997 may have begun in South East Asia but capital flight from Taiwan, a country with a current account surplus equivalent to 3.0% of GDP and some of the highest foreign exchange reserves in the world, also forced a devaluation. Taiwan devalued because the cost of maintaining their exchange rate link to the USD was higher interest rates. Higher interest rates and their impact on economic growth and financial stability forced Taiwan to devalue its exchange rate.
President Xi can find himself with the same problem as a credit quality deterioration, a burgeoning Cold War and falling property prices lead to accelerated capital outflows. Will President Xi allow foreigners to have such an impact on Chinese monetary policy? How can Xi deliver ‘common prosperity’ if his exchange rate targeting regime passes power over monetary policy to forces he cannot control?
An understanding of how key political goals align with exchange rate policy and monetary policy has been essential for anyone seeking to preserve the purchasing power of savings, particularly over the past 100 years. The conclusion of this financial historian is that President Xi’s political goals are now incompatible with a stable exchange rate and thus savers should prepare for a devaluation of the Chinese currency.
