Tripler, let’s start with the idea of trade.
There are ships. We load stuff like big industrial equipment onto the ships and send them sailing over the ocean. At the other end, China unloads the industrial equipment and loads up plastic toys for Happy Meals. The ships come back. Assuming the value of the industrial equipment is the same as the value of the plastic gewgaws, we’re gravy. There’s a trade balance. You can say that China sends us cash, and we send the same amount of cash back. Ah, but what if the total value of the toys is greater? What if there’s a trade deficit (as is the case now) and China sends us more stuff than we send them? Then the Chinese have extra dollars hanging around. They didn’t buy enough of our stuff to close the trade balance, which left them with more greenbacks, which is what we have to offer them. Well, they don’t want dollars. They want RMBs, the people’s currency, to buy stuff back home.
For most world currencies, the next step is simple. They take their dollars to the foreign exchange market and get their native currency. But now it’s a supply and demand situation: there’s an extra supply of dollars, trying to buy up the native currency. The value of the dollar would drop against that currency.
And that should, in ideal situations, lead to a new balance.
For the next round of trade, as the ships go and come back, the dollar wouldn’t be as strong. That means people in the US couldn’t afford to buy as much foreign stuff, while those folks abroad could afford even more US stuff since the dollar is so weak. In this case, we would expect to see the trade balance shrink automatically. A new equilibrium is reached, as it were. Every time there are extra dollars sloshing around, those dollars should depress the US currency and thus make US exports more competitive for the next round.
But China does something different. They have strict money controls. Their currency isn’t freely exchanged like the other major currencies. What the Chinese government does, essentially, is take all those extra dollars and stick them in a sock drawer. A very big sock drawer. So instead of having the US currency lose value to the RMB on the open market, the relative exchange rate between the countries is kept within relatively well-defined boundaries determined by the Chinese government. The RMB does not appreciate. It stays “undervalued”. Understand here: To keep the RMB fixed at a relatively stable value against the dollar, the value “pegged”, the Chinese government must be willing to buy up all those extra dollars sloshing around.
And that’s what they’ve done. Chinese dollar holdings are huge. Their sock drawer is the size of Rhode Island. They have gobs and gobs and gobs of dollars (or really, dollar-denominated assets). This means their currency stays cheap, and their factories can continue to churn out those gewgaws at low prices that we like so well in the US. Meanwhile, US goods are more expensive than they would otherwise be, which makes it hard to sell them in China. This is an unbalanced situation, and US officials would like them to kindly knock it the fuck off.
I am, of course, oversimplifying. But the main thing to keep in mind is that the Chinese sock drawer is a form of government-mandated savings. And if the Chinese government ended its currency manipulations, but each and every Chinese citizen kept private savings in their own tiny sock drawers, that collectively added up to the size of Rhode Island, then nothing much would change. By saving money instead of trading it on the international exchange–whether it’s government mandated reserves or voluntary private savings–the dollar wouldn’t decrease in value. But eventually, we know they’re going to spend their cash. A trillion bucks isn’t doing anybody any good if it stays in the drawer. Eventually it has to come out and play.
That’s the basic story. The US wants China to stop storing so damn many dollars so that the RMB appreciates in value more quickly, but for now, the Chinese want to maintain a friendly money situation for their factory sales.
There are other wrinkles, like that their capital controls allow them to increase domestic interest rates even while their currency is undervalued, but let’s stick with this for now.
This is assuming no deflationary pressure. That’s the norm, but it is not always the case.
If you look at a different situation, like the Great Depression, there was a series of devaluations as the major economic powers dropped their gold pegs. But this was very beneficial, and that was true even when other countries followed suit. The faster the countries devalued, the quicker they recovered from the Depression. And the current world situation is quite comparable to the Depression in many ways. The Fed, ECB, and BoJ could all stand some collective (not necessarily “competitive”) monetary loosening.