As China grapples with the consequences of its devastating earthquake, it finally also has begun to confront the destabilizing forces that are bubbling up from beneath its economic landscape.

Last week, several key Chinese officials, typically not known for their candor, conspicuously noted the need to both stimulate domestic consumer spending and to bring down roaring inflation. While at first blush these two goals might appear mutually exclusive, China’s leaders do have a “magic bullet” that can hit both targets at once.

The Easy Way vs. The Hard Way

A stronger currency, commensurate with China’s increased economic strength, will simultaneously tamp down inflation and enable Chinese consumers to buy more goods and services. However, for reasons not entirely clear to me (or few others, for that matter), China’s leaders are resisting this simple-and-beneficial solution.

By prodding China’s citizens to spend more, the country’s leaders say their goal is to decrease the nation’s dependence on exports. If China’s consumers, who currently save 50% of their incomes, saved less, more of the nation’s production output would be consumed domestically and China would be much less vulnerable to downturns in its overseas export markets.

Without a vibrant domestic market, over-leveraged Americans will apparently remain China’s most important customers.

A strengthened yuan would lower the real costs of goods for domestic consumers and allow the Chinese themselves to compete more evenly with consumers in other nations to whom they currently send the fruits of their labor. As goods become more affordable in China, the Chinese will naturally consume more. A rising yuan would therefore kill two birds with one stone: It would reverse recent consumer-price increases and it would induce Chinese consumers to buy their own products.

If the Chinese were to follow such a sensible path, the consequences here in America would be immediate and severe. By allowing China’s currency to appreciate, that country’s monetary authorities would no longer need to buy and remove as many dollars from the open market, producing an immediate reduction in the demand for U.S. Treasuries, mortgage-backed securities and other U.S. dollar-denominated debt. The result in America would be a simultaneous increase in both consumer prices and interest rates. Such developments would only compound the problems already rippling through our economy.

To spur domestic spending absent such currency rebalancing, Beijing must instead rely on the nominative, simulative effects of inflation. By further expanding its money supply and allowing those increases to be passed on to workers in the form of higher wages, China will ensure that its consumers will have more yuan to spend and, hence, will use that cash to buy more “stuff.”

Such a policy, however, while having a strong impact, will only solve one problem by aggravating the other.

The Savings vs. Spending Debate

By penalizing savers through the erosive effects of inflation, China would discourage savings and jeopardize one of the true sources of its rising standard of living. Contrary to the economic hocus pocus propagated on Wall Street, in Washington and at American universities, economies grow not as a result of consumer spending, but as a result of savings. So-called “underconsumption” is the true source of prosperity because it engenders capital formation, which lies at the root of sustainable economic growth.

Here, too, the implications for Americans are dire. In effect, China’s consumers are spending only half their incomes and are lending much of the rest to us; so we’re effectively enjoying the “current” consumption that China’s frugal consumers have opted to defer.

That’s a big help right now. But think about this: As China’s consumers spend more, America’s consumers will simply be forced to consume less.

Low prices and rich consumers are a potent concoction that is sure to soothe China’s roaring economy while raising the living standards of its hardworking citizenry. It’s a simple solution that only an economist can miss.

Source: As China’s Consumers Start Spending More, U.S Consumers Will Begin to Feel the Global Economic Squeeze