Because of the PBOC's commitment to defend the foreign exchange value of the yuan and prevent it from appreciating at a politically unacceptable rate, the monetary authorities are limited in their ability to use the bank interest rate to control inflation. Raising the rate would simply attract more capital that would have to be sterilized to control money growth-so reserve requirements and direct controls are used to limit bank lending.

Although the yuan has appreciated more than 20 percent against the dollar since July 2005, the rapid increase in foreign exchange reserves, which now total more than $1.8 trillion, implies that the yuan is still undervalued. For a capital-poor country like China to invest billions of dollars in low-yielding U.S. government debt is wasteful and risky, especially if the U.S. financial crisis becomes a fiscal crisis and inflation is used to reduce the real burden of the debt.

The longer China delays creating real capital markets and allowing relative prices, especially interest rates and the exchange rate, to be freely determined, the more costly the final adjustment will be. As Greenwood emphasizes, "[Sterilization] is no more than a temporary palliative, buying financial stability at the cost of real distortions." Fortunately, China's leaders appear to recognize that danger and are gradually relaxing capital controls, liberalizing interest rates, allowing greater flexibility in the exchange-rate regime, and lifting price controls. The most difficult, but most important, task will be to privatize state-owned banks and allow owners, not taxpayers, to bear the risk of loss. In this regard, the United States is not setting a very good example.

The present trend in the United States is to move toward market socialism and away from market liberalism. That departure from free-market principles could present China with a novel opportunity to become the world's largest capital market. To do so, however, would mean getting rid of what Adam Smith called "all systems of preference or of restraint" and allowing the "system of natural liberty" to emerge.

The way forward

Long before Adam Smith wrote The Wealth of Nations, China's great historian Sima Qian wrote The Biographies of the Money Markets, in which he advocated a laissez-faire approach to organizing economic life. Drawing on Taoist thought, he wrote, "When all work willingly at their trade, just as water flows ceaselessly downhill day and night, things will appear unsought and people will produce them without being asked. For clearly this accords with the way and is in keeping with nature."

The question of financial stability is ultimately one of balancing state and market. Government is necessary to protect persons and property and to enforce contracts. But if the state socializes risk while privatizing profits, the delicate balance of risk and responsibility will be upset. Instead of creating harmony, government intervention will negate the spontaneous market order and destroy the Tao of the market-undermining freedom and prosperity.

The global financial crisis that began in the U.S. housing market is not a failure of market liberalism, but of market socialism. Prior to central banks, the international gold standard worked spontaneously to bring about a balance between the demand for and supply of money. That system was not perfect, but it did help generate sound money, limit the size of government, and expand trade.

In theory, central banks can control the supply of paper money and prevent inflation, but will they have the political will to do so? Without effective constraints on central bank discretion, there is no guarantee that fiscal pressures will not lead to an abuse of the monetary authorities' power.

One should recognize that there are limits to monetary policy and to regulation. Policymakers need to recognize those limits and learn from the current crisis as well as past crises. Financial harmony requires a system based on private property in which owners, not taxpayers, bear the losses and capture the gains from investment decisions. All individuals seek to improve their lives. When that natural instinct is harnessed by a rule of law protecting persons and property, free trade will lead to mutual gain. China's quest for "social harmony" will be furthered by following the Tao of the market and adhering to the rule of law, not by rigidly adhering to a "socialist market economy."

Many great economists from Adam Smith to Vernon Smith have expounded on the spontaneous market order and its benefits for freedom and prosperity. The failure of central planning in the Soviet Union and elsewhere led China and other nations to make the transition from plan to market.

The challenge will be for China and other emerging market countries not to succumb to greater central planning of financial markets, but to structure incentives and institutions so that individuals can coordinate their saving and investment decisions efficiently through private free markets.