Oh lordy. That would be the worst of both worlds.

The Wall Street Journal has a must-read on the subject,
The Yuan Scapegoat
The U.S. establishment flirts with a currency and trade war with China.

The battle concerns China’s decision to peg its currency, the yuan, to a fixed rate of roughly 6.83 to one U.S. dollar. To hear the American political and business establishment tell it, this single price is the source of all global economic problems. The peg keeps the yuan “undervalued” in this telling, fueling China’s exports and harming the U.S., Europe and everyone else. If the Chinese would only let the yuan “float,” it would soar in value, China’s export advantage would fall, and the much-despised “imbalances” in global trade would end.

President Obama has picked up this theme, calling last week for Beijing to adopt “a more market-oriented exchange rate” that “would make an essential contribution to that global rebalancing effort.” Less diplomatically, 130 Members of Congress sent a letter to Treasury this week demanding that unless China lets the yuan rise in value, the U.S. should impose tariffs on Chinese goods. Just what the world needs: a trade war.

At the core of this argument is a basic misunderstanding of monetary policy. There is no free market in currencies, as there is in wheat or bananas. Currencies trade in global markets, but their supply is controlled by a cartel of central banks, which have a monopoly on money creation. The Federal Reserve controls the global supply of dollars and thus has far more influence over the greenback’s value than any other single actor.

A fixed exchange rate is also not some nefarious economic practice rare in human affairs. From the end of World War II through the early 1970s, most global currency rates were fixed under the Bretton-Woods monetary system created by Lord Keynes and Harry Dexter White. That system fell apart with the U.S.-inspired inflation of the 1970s, and much of the world moved to “floating rates.”

But numerous countries continue to peg their currencies to the dollar, and with the establishment of the euro most of Europe decided to move to a fixed-rate system. The reason isn’t to get some trade advantage against their neighbors but to gain the economic benefits of stable exchange rates—and in some cases a more stable monetary policy. A stable exchange rate eliminates a major source of uncertainty for investment decisions and trade and capital flows.

The catch is that under a fixed-rate system a country yields some or all of its monetary independence. In the case of euro-bloc countries this means yielding to the European Central Bank, and for dollar-bloc countries to the U.S. Federal Reserve.

This is what China has done with its yuan peg to the dollar. By maintaining a fixed yuan-dollar rate, China has subcontracted much of its monetary discretion to the Fed in return for the benefits of exchange-rate stability. For more than a decade, this has served the world economy well, leading to an explosion of trade, cheaper goods for Americans that have raised U.S. living standards, and new prosperity for tens of millions of Chinese.

Read the entire article, with special attention to how a market solution may be the answer to the problem,

China’s build-up in dollar reserves is contributing to the world’s anger at China, and it represents a huge misallocation of global resources. Instead of letting its dollar reserves find their best private investment use, China uses them to buy U.S. Treasury bills or Fannie Mae securities.

One solution would be to make the yuan convertible, and let capital and trade flows adjust through private markets rather than the Chinese central bank. This is how Germany recycles its trade surplus. A one-time small revaluation to, say, 6.5 yuan to the dollar accompanied by convertibility would help with global adjustment while avoiding the perils of Japan-like deflation.

The Chinese government resists open capital markets because it fears less political control. At least at first a convertible yuan might also lead to a surge in capital outflows from China as Chinese companies and individuals diversified their currency holdings and investments. But over time, and probably quickly, markets would adjust and reach a new equilibrium. Convertibility would also increase the domestic pressure for China to further liberalize its financial system.

This is where the U.S. should put its diplomatic pressure, rather than on the exchange rate. Even better would be a joint U.S. Treasury-Chinese declaration on behalf of such a policy shift, which would give credibility to the new monetary arrangement.

It would be interesting to see the effect of a surge in capital outflows from China on the economies of our hemisphere, since the Chinese have been investing heavily in producers of raw materials, mines, and commodities. The dangers of volatility and political risk are holding back a lot of investments, but would the increase in outflow make investors less risk-adverse?

Either way, the answer does not lie in Keynesian-type solutions.