Then as now all manner of polemics and rationalizations and the weight of established authority argued that governments should fix currency exchange rates, which are nothing more than prices, much like governments fix the price of sugar, curiously, to serve the greater good.

We hear about China's weak financial system, the pent up demand for dollars in China, and the need for exchange rate stability in developing countries. However, we should always be suspicious whenever tenured professors, who rarely endure the bracing winds of market competition, and politicians, who require significant financial support from those with deep vested interests in the status quo, argue that prices should be fixed and remain fixed forever.

The simple fact is China's financial system would be no more rickety or vulnerable if the yuan were re-pegged to a value consistent with underlying supply and demand than it is now.

As things currently stand, thanks to China's huge trade surplus and inward foreign investment, the demand for yuan well exceeds the supply in foreign exchange markets.

To maintain the yuan peg at 8.28 per dollar, Chinese monetary authorities purchase dollars in those markets rather than let its price rise to about 5 per dollar.

In turn, Chinese authorities purchases U.S. Treasuries and other securities to earn interest on their hoard, and sells yuan denominated bonds domestically to sterilize the liquidity these purchases create and head off inflation.

In the process, China has encouraged overinvestment in its export industries and excessive urban development, and created great stress in international oil markets (China manufactures exports with much poorer energy efficiency than do factories making similar products in the West); and this process suppresses U.S. long bond rates and exacerbates unemployment in U.S. and other industrialized-country manufacturing sectors. Together, these cause underinvestment in important Chinese domestic needs, like decent sanitation and water in rural areas and higher education. In the United States, this process has greatly contributed to the housing bubble.

One of the great accomplishments of the defenders of this alchemy -- such as many that have advised our president -- has been to effectively label as "protectionists" critics that advocate a market determined yuan.

What a novel idea for a Republican administration, campaigning for free markets is now a protectionist conspiracy!

Equally remarkable, these defenders of rigged markets have enlisted some in the conservative media to their cause, and some are campaigning that even modest revaluation would spell trouble. For example, Justin Fox wrote in Fortune (June 20) that even modest revaluation of the yuan would not be a credible policy and be destabilizing.

So what should China do now? Clearly, it would ease relations with the United States if it shifted its exchange rate to, say, 6 or 7 RMB per dollar. But once China revalued, its currency's peg to the dollar would no longer be nearly as credible. Pressure to keep revaluing the RMB upward would be incessant.

Right now, thanks to the yuan peg and inward investment, China must purchase dollars and other currencies at a pace equal to 12 percent of its gross domestic product and 33 percent of its exports. That represents an enormous loss of purchasing power and living standards for workers on export platforms, and those figures rise each year, making the potential for destabilizing pressure from within China very large. Also, those purchases, undervaluation and capital controls give rise to yuan hoarding that makes eventual revaluation more difficult with each passing day. The policy will loose credibility when the government can no longer sell ever larger amounts of yuan denominated bonds to sterilize all the liquidity it creates buying dollars with yuan it prints to sustain the peg.

A stated policy of revaluing the peg to a level that does not require consistent one-sided intervention -- i.e., large persistent purchases of dollars -- would be a credible policy. Revaluing in steps to 7, 6, 5 until that happens would work, if the Chinese government revalued the midpoint of its trading range on an annual or semiannual basis to accommodate further changes in the fundamentals behind the demand and supply for its currency.

What investors need to know is what the policy is. The clock on the wall does not have to have the hour and minute hands nailed in place to be credible; it just has to keep good time.

Remember, the exchange rate is nothing but a price. Sooner or later, when a government fixes prices someone gets hurt. Often many people get hurt in the end.

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