According to U.S. Treasury Secretary Timothy Geithner China eventually will decide it needs to adopt a flexible currency exchange rate policy. Sorry, Mr. Secretary, it won’t. It is not that adopting a flexible currency exchange rate is against China’s national interest. On the contrary, there are many benefits to China that would flow from revaluation.

As was pointed out in a previous comment in Alrroya, China’s failure to adopt a flexible exchange rate is a political decision, not an economic one. While I agree that this is correct, I do not believe that it has much to do with Chinese leader’s annoyance with international pressure or foreign relations. I believe that it represents something far more serious, the inability of a political system to change.

The revaluation of the renminbi is not something that should be looked at in isolation, but part of something much larger. China has pursued a policy that has been very successful helping the country achieve an astounding rapid development. Although there are many elements, the basic concept has been growth based on investment over consumption and export over domestic consumption.

All government policies, all laws, all regulations distort economic behavior. When the rules change, so does the game. Understanding exactly in what ways the distortions will affect economic behavior is exceptionally difficult. In the United States in the early 1990’s, the Congress passed a law to cap ever rising executive salaries. This resulted in the creation of alternative forms of compensation like options. These were supposed to align management’s interests with those of shareholders. Often they had the reverse effect when management manipulated both earnings and options.

In emerging markets the effect of policies, laws and regulations can have an even more disastrous effect. In Russia a rent-seeking bureaucracy utilize these mechanisms to invent new ways of extracting bribes and robbing businesses. Law and policy can function in two ways. It can limit the state or it can extend the power of the state. In Russia the state bureaucracy is supreme. Since there is no mechanism to limit its power, there is no reason for rent seeking bureaucrats to curb their plundering of wealth from natural resources or administrative interference in the market.

Market distortions create winners and losers. In the US, the rules regarding executive compensation became a spectacular windfall for the management in many companies. In Russia, the rules provide enormous benefits to the bureaucracy and government officials. The losers in the US have been shareholders. In Russia the losers are businesses, economic growth and most of the population. Obviously the winners have powerful economic incentives to maintain the present system.

China has a similar problem. A revaluation of the renminbi would hurt exporters often state owned and their employees. Their costs would go up and their revenues would go down. A Chinese exporter must pay for labor, utilities, rent, and any local inputs in renminbi. Most of Chinese exports are valued in dollars. So the value of anything that the exporter sells would go down relative to his costs. Another group that would lose from revaluation would be any company that has stockpiled goods or commodities priced in dollars. For example, Chinese state owned companies at various times have stockpiled both copper and oil. If the renminbi were revalued, the value of their stockpile would immediately decline.

In contrast, the winners in the Chinese economy would be just about anyone else. In a global economy, much of what we have or use comes from international trade. So although China is a huge exporter, it is also a huge importer. For example, all of the imported food, high tech products, oil and many natural resources that China uses would immediately decrease in value.

The Chinese have stated that a cheap renminbi has allowed western countries to have low inflation, low living cost, and a higher standard of living. But as Professor Michael Pettis of Peking University points, out a cheap renminbi “implicitly taxed Chinese household consumption to subsidize Chinese manufacturing and employment growth, it also implicitly taxed US manufacturers in order to subsidize US consumers. American consumers got cheaper (foreign) goods, American manufacturers had to compete against lower (foreign) prices.”

Professor Pettis goes on to state that the main effect of a revaluation would be a shift of wealth from the Chinese government, the manufacturing sectors, infrastructure investment, and real estate developers to Chinese households. Exactly!!

The people with the power in China have done very well with the present set of rules and that is a large problem. They see no reason to change and so won’t. So don’t expect a major revaluation of the renminbi any time soon.

The recession has caused major disruptions in the economic fabric of world trade. The genius of market economies is that they can adapt to almost any change provided the rules can change too. The renminbi is a problem, but the policy and the inability to change it represents is a greater problem for both China and the world.