A “huge tsunami” of economic instability will engulf the globe’s financial markets if China bows to international pressure to switch the yuan to a free-floating currency, warns Australia’s treasurer. For America: higher interest rates, a falling dollar and soaring inflation may be about to smack home like the biggest wave since the Great Depression.

When China floats the yuan, it will be “a wild ride,” Peter Costello, the Australian treasurer, warned. “That will set off a huge tsunami that will go through world financial markets.”

For years, China has run a massive trade surplus with America—running into the trillions of dollars. Many U.S. officials feel the reason for this, at least in part, is the fact that China has kept its currency undervalued in relation to the dollar.

Normally in free-market conditions, when a country has a huge trade surplus its currency would appreciate compared to the country with the trade deficit. In this case, the yuan should have increased and the dollar decreased in value. Thus, the theory goes, Chinese exports would become more expensive and American exports would become more affordable, and consequently the trade relationship balance out.

However, Chinese officials, realizing a good thing, decided to artificially keep the yuan pegged to the dollar—so as the dollar’s value dropped, so did the yuan’s. Chinese exporters maintained their advantage and China continued to collect the billions it gained in trade with the U.S.

The interesting part comes in with what China did with all its surplus trade dollars.

Instead of spending them, which would have allowed the dollar to fall and the yuan to rise, it invested vast amounts of them into U.S. treasuries (which is the primary way they pegged the yuan to the dollar). These purchases, which have gone on for years and years, propped up the value of the dollar. Without Chinese treasury purchases, the dollar would have fallen in value long ago.

It is true that since 2005, China has moved to a floating-dollar peg, allowing the yuan to slightly rise against the dollar (approximately 10 percent). However, when compared to other currencies such as the euro, the Canadian and Australian dollars, or even Thai bahts, some of which have appreciated in excess of 40 percent during that time frame, the yuan’s appreciation is insignificant.

The marginal strengthening of the yuan verses the dollar is why many American officials feel that little improvement in Chinese-U.S. trade has occurred, and is why they keep pressuring China to let the yuan float freely.

However, a free-floating yuan will have very serious consequences.

“The day they decide to float their currency you are going to get huge reversals of financial flows around the globe, which will affect all exchange rates, that’s why I compared it to a tsunami,” said Costello. “All flows of capital they have been sending to the U.S. might reverse ….”

Those reversals of financial flows will not only work to drive the dollar lower, but would also have huge consequences on the way of life in America.

Paul Craig Roberts, who was assistant secretary of the Treasury under President Ronald Reagan, put it this way: “When China’s currency ceases to be undervalued, American shoppers in Wal-Mart, where 70 percent of the goods on the shelves are made in China, will think they are in Neiman Marcus. Price increases will cause a dramatic reduction in American real incomes. If this coincides with rising interest rates and a setback in the housing market, American consumers will experience the hardest times since the Great Depression” (American Conservative, July 4, 2005).

The approaching wave may be almost ready to break.