Before I begin, let’s start with a few basic macro-economic foundations. A country can either control its interest rates or its currency. It cannot control both at the same time. When you increase interest rates, you make investing in your country more appealing to foreigners and your currency rises.

China has a mostly fixed exchange rate with the U.S. This means that Chinese monetary policy is essentially decided by the Federal Reserve. The problem is that given its growth rate and where it stands in the business cycle, China needs much higher interest rates than it currently has. Given the current growth and inflation rates in China, the current rates are much too low and extremely expansionary – essentially akin to putting gas on a burning fire.

If you don’t control your monetary policy, there are still a few things you can do to slow down your economy. You can run a government budget surplus and if you happen to run large parts of the banking system (most Chinese banks are at least partly government owned), you can try to make lending more difficult – by introducing risk adjusted returns based lending systems as opposed to allowing lending based on political connections.

Announcements like the ones made yesterday are basically saying: we are going to push hard on the brakes because there is way too much liquidity in the economy. It makes perfect sense for the markets to have reacted the way they did in light of the announcement.

Whether or not the Chinese government succeeds in slowing down its economy is still up in the air. I am a bit skeptical. The central government in the end does not really influence bank lending policies, especially in the provinces far from Beijing and Shanghai. Moreover, facing some discontent by workers and farmers left behind by the growth on the coast, it’s unclear that the Chinese government will successfully reign in its spending.

The much simpler solution would be to increase short term rates, let the currency float and introduce more competition to the banking system to make sure lending was based on returns rather than political connections. Moreover, a rising currency would have a few benefits: it would make foreign goods cheaper and therefore hold down inflation and it would bring oil prices down as oil is still priced in US dollars.

In other words, China should take control of its monetary policy and let its currency float – not because some idiots in the US think that will solve the US current account deficit, it won’t – but because it’s in China’s best interest to do that. Given the inherent conservatism of the Chinese government, I bet it’s the direction they are moving in, but that they will just do it slowly over the course of a few years.

Brief non-sequitur: I am not saying that currency boards and fixed rate exchange rate systems are always bad. They have a time and place – especially if a country is facing hyper inflation or can’t be trusted not to keep the printing presses running (e.g.; Argentina in the early 1990s). The problem is that over time if the fixed exchange rate is too high relative to the real exchange rate, you can get massive speculative runs on the currency – which when the central bank runs out of foreign currency reserves – leads to a devaluation, a floating currency and often a recession (e.g.; Argentina 2000, UK ejected from the ERM in 1992). Conversely, if the fixed exchange rate is too low you get massive inflows of capital, over investment and asset price inflation (e.g.; China right now).