Mundell: Yeah. I have great gratification just to see it. I thought it would be almost necessary for Europe, a very good thing for Europe, and it's proven to be so.

ST: Does it matter that China is diversifying out of US treasuries and into other asset classes . . . for example, investing in the private equity group Blackstone before its IPO? What effect does that have? Does it mean anything?

Is it something we should be watching?

Mundell: I think what China has done is to inaugurate a new system of sovereign wealth funds, which are being talked about now and generalised and recognised as an important thing. China didn't invent this. Countries like Venezuela and others earlier on had funds when they had big oil reserves or something like that. China's the first in the non-oil category.

Also in the background in the 1960s, countries like Canada had a Canada development fund they could use for national purposes in some way. What makes China's significant is the huge power that China has. It has huge size.

So I think it's something that people are going to have to watch. They'll have to look and see how this goes.

ST: Is that something you think may be the trigger for a greater backlash than the '80s or early '90s like the backlash against the Japanese acquisition of trophy assets?

Mundell: I think the Chinese recognise that they have to be careful to do this in a non-political way, to put a non-political face on this. The way they've done it with Blackstone is partly that. They haven't brandished it. They're not going to flaunt this.

Of course you'll have private advisers who will want to make some publicity and make a big thing of it, but I think the Chinese government is not going to want to do that.

But certainly control of a trillion dollars of US assets itself is a very substantial amount.

I think it has that big an effect on the bond market, for example. China can now carry out open market operations in the United States. It can carry out American monetary policy by its own activities.

ST: That's interesting. Is that something that will increase or decrease as China diversifies into other asset classes? Will China's effective open market power over US monetary policy increase or decrease?

Mundell: My guess is that what they're going to do is increasingly use marginal amounts . . .

not to slow down or keep their own reserves and then call these something else. Put a different name on these so they don't count as reserves. So nominally they have only 1.2 or 1.3 trillion in reserves. Then they'll have another set of funds they will take for further increase of that.

You may remember that China took $45bn of its reserves and used it to dress up the assets of the Bank of China and the China Construction Bank . . . they divided it in half and gave them $22.5bn each. And that was one use they made of that. We're going to see a lot of countries that are in a position do that sort of thing . . . maybe Russia. If they have the power to do it, they might use it for some monopolistic purposes, in ways that. . . you think of the takeover funds that companies have. Take $10bn, $20bn, $30bn, it's a huge amount. But we're dealing with $200bn or more with China.

I think we just have to watch this. It's unprecedented. We don't know which way it's going to go. I believe China wants to be thought of as, to use someone else's phrase, a responsible stakeholder, and use that to operate. China now knows it does have the power to impact on the system and needs to use that in an advisable way.

They're certainly not going to do what some adviser suggested, to dump [US] treasury assets if Americans become more protectionist. That would be so stupid if they did it, I can't believe they would ever be that stupid.

The American power with respect to China is so enormous, to cut off the source of trade surplus of China, you cut off the gravy train that's making all of this possible.

ST: You think China should not allow its currency to appreciate against the US dollar, certainly not by 40%. Do you think, even if it wanted to, the US could force China to do this, or is it really China's decision?

Mundell: The US has the power itself to buy RNB and put the RNB up where it wants . . . put the dollar back down to 5 1/2, which it was at before 1994. It could do that. But in the process it would have to collect its own quantity of these, and that would itself be a substantial amount and it would be inflationary to do it.

In other words, if it bought RNBs this would create an equivalent amount of reserves in the United States. They could turn around and try to sterilise it . . . with bonds or something else . . . but it would be a mess.

If they did this, it would be a monetary war.

Small countries can fix the exchange rate, but the big country can't do it. The US could fix the Canadian collar, Mexican dollar [sic];

it can keep those currencies higher if it wanted to. It could do the same with China. I just can't imagine the US ever doing it. It would totally disrupt the global monetary system, and the history of the US as the centre of the global monetary system.

ST: Do you think that US policy-makers look back at the Plaza Accord, and think, it kind of worked out nicely for us. It effectively took out Japan, a competitor on the global stage for 20 years, more. In your speech you were hedging whether you thought it was intentional. Do you think China has absorbed a lesson from that?

Mundell: I think that both in the case of Japan and China it's a stop-China policy . . . cut China off at the knees. There was a view in the administration . . . there was for a long time in the 1990s . . . that if the US has to fight another war it will be with China. Better to do that now before China becomes too powerful. No reason to deal with China with a velvet glove.

A confrontation wouldn't do any harm. Better to have a confrontation now than 25 years from now. It's a view, people have held that. That view, it's a model of the world, and it's not an incoherent model, as long as there's a single superpower, as long as the US is a benign superpower, that's the best the world can have. If you had China in the position of the United States it would never be a good world.

You could never trust China to act in the way the United States acts.

ST: You mentioned that between the 1950s and the 1970s, exports from Japan grew while exports from Britain fell. If there is to be a loser in that equation from Chinese exports. . . when you see German factories bought and moved lock, stock and barrel to the banks of the Yangtse. Is there a risk that Europe will be the main loser from China's rise?

Mundell: The Germans have a great machine tools industry. They don't think they're going to have much of this in 10 years' time . . . it's all going to China. Germany has been the great beneficiary of these machine tools exports. But these machine tools are producing the materials by which they will be replaced.

By the way, I don't think that Germany is likely to be, in the long run, the loser. Germany has enough freedom and flexibility that they'll find other things to do. They'll be able to evolve. It will be a weaker economy but it will remain one of the top economies, not in absolute size but in efficiency.

ST: At a recent Asia Society conference, you predicted that the dollar era would last another 100 years. But this morning you talked about the euro and the dollar being a bipolar system. So are the next 100 years a shared era between the dollar and the euro?

Mundell: The euro, in terms of total size, is of equal importance to the dollar in some ways.

But remember, in the long run, the European economy is not going to grow like the American economy. It's the end of population growth . . . at least for a while, until that resumes. And the older population doesn't pick up the new technology and grow innovations as rapidly as others.

Also Europe can't defend itself. It's not completely independent. It's still part-attached to the United States. Nato is what makes the Euro, in a curious way, strong. As long as Europe has Nato it has no problems of defence.

If they ever gave that up and decided it was no longer important, in the future the euro would go down. Europe is vulnerable because it's not completely independent. Like Japan, it depends on the American defence.

ST: What about Ireland? After years and years of very fast growth, Ireland is now going through a transition of its own. It is no longer a low-cost manufacturing base. Land is no longer cheap. Labour is no longer cheap. Is there anything to be learned, in terms of what's happening here after the phase of fast growth, about what might happen in China, say 10 or 15 years from now? People already say the deflationary effect [on world prices of manufactured goods] has tapered off, that the cost of manufacturing is creeping up. . .

Mundell: First, from the Irish standpoint. The Irish miracle is magnificent. After 1,000 years of having half or one-third the per-capita income of the UK, it has now surpassed that.

This is a great thing, what's happened to Ireland. The problem is, once you've achieved that success, and you become rich again, you get like everybody else. You are no longer unique.

China's still unique. China's got a base . . .

it'll run out of skilled labour . . . but it has the ability. There's very low investment in education . . . like India too, very foolish, because you really need more education so that those older people are going to be able to survive in the cities, without government support). So that's the problem.

The education system is very low, and it's going to take time to correct that, and it's going to be very difficult to do.