President Bush is not an intimate friend of the English language. He's a plainspoken man, who also plainly, and frequently painfully, tortures the mother tongue. And, regrettably, he's not a clone of Yogi Berra, providing comic relief as he gnaws on his rhetorical shoe leather. Thus, I was stunned a couple weeks ago when Mr. Bush cogently declared that China should pursue a "fair monetary policy." Had the President's tongue misfired, with his cue cards reading "fair currency policy," as Treasury Secretary Snow has been barking and bellowing, or did Mr. Bush really mean to say "fair monetary policy?"

I don't know. But I want to declare, for the record, that if President Bush actually meant to say monetary policy, not currency policy, I owe him an apology for belittling his linguistic mojo. A nation's currency policy is actually a subset of its monetary policy. Accordingly, President Bush was entirely correct to carp about China's monetary policy, if he has problems with China's currency policy.

Both the United States and China have fiat currencies, unbacked by anything except the sovereign's legal declaration that they are legal tender for all debts, public and private. In such fiat currency regimes, the sovereign has the ability to choose one of two goals for its monetary authority: stabilizing either the domestic purchasing power of the currency or the foreign exchange value of the currency. More technically, the sovereign can instruct its central bank to target either (1) the domestic price or quantity of its currency - a domestic interest rate or growth in the domestic money stock; or (2) the international price or quantity of its currency - its foreign exchange value, or growth in international reserves.

What a fiat currency country cannot do, however, is instruct its central bank to pursue all four available monetary policy targets: (1) a domestic interest rate, (2) the size of the domestic money stock, (3) the currency's foreign exchange value, and (4) the size of country's international reserves. By the laws of central bank plumbing, a fiat currency country's central bank can peg only one of these four potential monetary policy targets; once one of the variables is pegged, the other three become market-determined, unless constrained by regulatory structures.

A De Facto Monetary Union
In the United States, the Federal Reserve pegs the domestic price of money - the overnight Fed funds rate. In turn, growth in the domestic money stock, the foreign exchange value of the dollar, and growth in Uncle Sam's non-dollar reserves all adjust, via market forces, to be consistent with the Fed's chosen peg for the Fed funds rate. Accordingly, America does not have a currency policy per se, either strong or weak; America has a Fed funds policy.

In contrast, China has chosen to give its central bank a target for the foreign exchange value of its currency, pegged to the dollar. Conceptually, this implies that China cannot have a target for its domestic short-term rate, growth in its domestic money stock or growth in its foreign exchange reserves.

As a practical matter, this is not precisely correct, because China does not have an unregulated capital account or a fully private domestic banking system. Thus, China does retain some degree of control over variables besides the Yuan's pegged exchange rate versus the dollar. But these are technical matters, which should not obscure the essential reality of the matter: China does not have an independently determined domestic monetary policy, because China has chosen to peg its currency to the dollar, thereby importing America's monetary policy.

Indeed, it is not too much of an intellectual stretch to say that China is part of the monetary union called the United States - the 51 ^st state, if you will. Over the last ten years, the nominal value of the Chinese Yuan relative to the U.S. dollar has been as stable as the nominal value of the California dollar relative to the nominal value of the Alabama dollar. That's not to say that the real value of the Chinese Yuan, the California dollar and the Alabama dollar have been stable, because they have not. Inflation rates in the areas have been different, for both goods and services and assets, with the currency of the area with the highest "domestic" inflation appreciating in real terms versus the others. And China's inflation rate has been the highest, meaning the real value of the Yuan has appreciated versus both the California dollar and the Alabama dollar.

But not enough, apparently, President Bush has concluded: he wants a higher real value for the Yuan and he wants it now! Presumably, he and Mr. Snow have one of two potential paths in mind in their desire for "fair" Chinese monetary policy: (1) Kick China out of the de facto monetary union, requesting that it remove capital controls and pursue a domestic-driven monetary policy, in which case suppressed global demand for the Yuan would presumably be unleashed to take the Yuan higher; and/or (2) force China to execute a one-off revaluation of the Yuan within the context of a pegged exchange rate regime versus the dollar, forcing up the value of the Yuan. These two paths are not, of course, necessarily independent, as the second path could be viewed as a precursor to the first path.

It's All About Relative Labor Costs
Underneath all this monetary policy mumbo jumbo, of course, lies President Bush's real beef: He sees Chinese labor as too cheap in dollar terms versus American labor, in either California or Alabama. In this sense, the quibble that the President has with China's Wen Jiabao is as if the Governor of California demanded that the Governor of Alabama revalue up the Alabama dollar versus the California dollar, because the dollar price of labor in Alabama is too low versus the dollar price of labor in California, making Alabama an "unfair" competitor in attracting job-creating capital.

The Governor of California - congratulations, Mr. Schwarzenegger? - can't do this, of course, because California and Alabama are legally bound in monetary union, in contrast to the de facto monetary union between the United States and China. But assuming that it was legally possible, it could well make sense for the Governor of California to make such a demand of the Governor of Alabama: the political self-interest of the Governor of California lies in job creation in California, because only citizens of California, not of Alabama, vote in California.

To be sure, a hypothetical devaluation of the California dollar versus the Alabama dollar would be a small negative "terms of trade" shock for California consumers, raising the price of everything they buy from Alabama. But the negative impact would be very small and very diffused (I'm not sure what I buy personally from Alabama, except for pecans, for my second favorite pie after coconut cream!). Consumers would be unlikely to evoke their wrath at the ballot box, while the positive impact on those directly benefiting from the "protectionism" of a weaker California dollar versus the Alabama dollar would likely show their gratitude behind the curtain.

Thus, protectionism does make short-term political sense, even though economists universally agree that it is deleterious to the whole of society in the long run. In matters of democracy, the economist's long-run bad dream is frequently the politician's real-time nightmare. Accordingly, President Bush's demand that China pursue a "fair monetary policy" is nothing more than rational political expediency: macro protectionism for U.S. labor, whose higher productivity does not justify its higher dollar wage rate versus the dollar wage of China's labor.

It really is that simple. And, understandable. If I were politically advising President Bush - quite the stretch, of course, given that I'm a Democrat! - I would advise that he "pander" to American manufacturing, just as he is doing. The political calculus of protectionism - even if in the drag of currency devaluation - is asymmetrically positive. Workers that benefit know that they are among the chosen few and show their gratitude at the ballot box, while consumers that are hurt rarely know that they are being nicked, and even when they do, are unlikely to get wrapped 'round the voting booth curtain rod about it. Thus, President Bush's call for China to pursue a "fair monetary policy" may be politically craven, but is also politically smart.

But What About Interest Rates?!?!
But what if China gets wrapped 'round the axle of annoyance and quits buying so many dollar-denominated bonds, driving up U.S. interest rates, I hear some dear readers retorting. You have a point, I will concede up front, as it applies to market-determined interest rates. I submit, however, that the "threat" of a nearby calamitous increase in U.S. interest rates in the wake of more muted foreign buying is much more muted than many of you fear. And the key reason is U.S. monetary policy itself: American monetary and fiscal policies are openly geared to fostering a cyclical increase of inflation, or at a minimum, avoiding an "unwelcome" cyclical disinflation.

Thus, there is virtually zero risk that a revaluation of the Yuan - via a shift to a floating exchange rate regime, or a one-off revaluation in the context of a fixed pegged exchange rate regime - would invoke the Federal Reserve to hike its 1% peg for the Fed funds rate. Accordingly, any market-induced - foreign or domestic-driven - upward pressure on U.S. intermediate and long-term interest rates would/will be limited by the leash of the Fed's reflationary anchoring of the Fed funds rate at 1% .

Put differently, there is a limit to how steep the yield curve can get, if the Fed just says no - again and again! - to the implied tightening path implicit in a steep yield curve. Put differently still, if there is ever a good time for America to have a devaluationist currency objective, it is when the Fed is in a reflationist "accommodative" state of mind : willing to accommodate however large a deficit the fiscal authority wants to run, and willing to accommodate any upward pressure on domestic inflation that might arise from a weaker dollar and associated upward pressure on import prices.

In such a context, which could also be dubbed a magical Keynesian moment, the cost of "irresponsible" policies is very low. Indeed, in the famous words of Paul Krugman, a man with a sensuous relationship with the English language, the responsible course for policy makers, when facing unwelcome disinflation/deflation risks, is to "credibly commit to be irresponsible." Or paraphrasing another great man of words, Forrest Gump, reflation is as reflation does.

Snow's Real Job: Secretary of Monetary State
Reflation is indeed America's present objective, with America's putative "currency policy" aligned accordingly. But make no mistake: a fiat currency country cannot have a currency policy independent of its monetary policy. America only pretends that it does, with the Secretary of the Treasury acting as the chief spokesman for a policy that is, in the end, subservient to the power of the Fed's printing press, and how the Fed decides to use it. Right now, the Fed wants a reflationary decline in the foreign exchange value of the dollar, as a prophylactic against "unwelcome" disinflation.

The Secretary of the Treasury is not , however, impotent in currency matters; he just doesn't set America's currency policy, because there can be no such policy independent of the Fed's monetary policy. What the Secretary of the Treasury, and indeed, the President of the United States can do, and should do when appropriate, is play hardball with America's trading partners about their monetary policy. In some cases, this may involve direct criticism of another country's currency regime, as in the case of China, when the other country's monetary policy is pegging the foreign exchange value at a level that America doesn't like. In other cases, when other countries have floating exchange rate regimes, as the case with Japan, global jawboning from Secretary of the Treasury and the President can involve gripes about interventionist "smoothing operations" - to wit, about the amount of interventionist dirt in "dirty floats."

More broadly, both the Secretary of the Treasury and the President can rhetorically pound on other countries to pursue monetary policies that are as reflationary as America's, or to suffer the consequences: (1) disorderly rises for their currencies at the hands of more rhetorically-charged declarations of America's reflationary intent, and/or (2) sector-specific regulatory trade barriers. In either case, the unveiled, unvarnished objective is to protect jobs of American workers toiling in fields when foreign workers are willing to work more cheaply, at the cost of a negative terms-of-trade "tax" on American consumers. These are the bald facts of global monetary diplomacy.

And sometimes, it is indeed economically justified for America to use its clout to "force" the global reflationary results that it wants. Such is the case when there is (1) global excess capacity to produce goods and services that global consumers desire and want, while (2) other nations cleave to mercantilist monetary policies, resisting American diplomatic pleas to stimulate domestic demand. Such is the case at present. America's clout rests in its ability to credibly threaten to act "irresponsibly" in currency matters, courting a disorderly decline in the foreign exchange value of the dollar, exploiting the inherent proclivities of the currency markets to (1) overshoot purchasing-power-parity "fundamentals" and to (2) react excessively to the words of the Secretary of the Treasury (even though he has no access to the Fed's printing press).

Bottom Line
Global monetary policy chicken is a dangerous game, and America should play it only when other countries fear a disorderly rise in their currencies even more than America fears a disorderly decline in the dollar. Put more bluntly, this game should be played only when the threat of a disorderly increase in non-dollar currencies is likely to induce monetary policy easing in non-dollar countries, removing any pressure for America to tighten its monetary policy to "defend" the dollar. Such is the case now; actually, such has been the case for several years. Indeed, almost a year ago, I publicly advocated that America play precisely such a monetary policy game with its major trading partners, declaring that:

"The time has come for the Fed and the U.S. Treasury to join forces, with Alan Greenspan cutting short rates and Paul O'Neill explicitly declaring that a strong dollar is not in America's interest. It is also time for America to announce to its G-3 partners that a weaker dollar is not a problem to be solved, but an opportunity to be seized by Euroland and Japan to aggressively ease monetary policy, using all available means, including non-sterilized currency intervention to temper the dollar's fall, and monetization of private sector assets. Yes, my friends, it is time for G-3 Keynesianism, in an all-out preemptive war against deflation."

I dubbed the "plan" the Morgan le Fay Plan ¹, in honor of my Dutch Netherlands rabbit, who helped me conceive it. Shortly after we proposed it, President Bush (co-incidentally!) fired Treasury Secretary O'Neill, replacing him with Treasury Secretary Snow. Morgan and I are happy that Fed Chairman Greenspan and Mr. Snow have seen fit to implement the plan. We are even happier that President Bush has bought into the plan, now commenting publicly as to the need for other countries to pursue "fair" monetary policies. In this case, "fair" is reflationary. And while the President was targeting his barb at China, it applies even more to Japan and Euroland.
All of which is, of course, ultimately quite bearish for global bonds. Yes, I do know that! In the fullness of time, higher U.S. inflation will ineluctably be transmitted to higher U.S. nominal interest rates. But a nasty bear market in bonds awaits not the promise of G-3 reflation, but the results of G-3 reflation. Only then will the Fed seriously contemplate hiking the 1% Fed funds rate. Time is not yet full, and will not be so for some time, quite possibly years.

In the meantime, Treasury Secretary Snow's job is to maintain a pool of foreign central banks to buy the dollar all the way down, not as an act of kindness to America, but as an act of anti-deflation, money-printing necessity for themselves. And as necessary, it won't hurt to have President Bush contribute to the reflationary cause by reminding his head of state peers of the famous words of a Texas thoroughbred, the late, great Texan, Secretary John Connally, who said, when his global peers were carping at him about a falling dollar:

Paul A. McCulley
Managing Director
October 8, 2003
mcculley@pimco.com

¹ "Morgan le Fay Plan," Fed Focus, November 2002