The House Ways and Means Committee has just approved a bill that would attempt, albeit modestly, to crack down on Chinese currency manipulation, a key cause of America’s trade deficit. The Ryan-Murphy currency bill (HR 2378) would allow the Commerce Department to treat currency manipulation as an illegal subsidy for the purpose of calculating countervailing duties intended as retaliation. This bill has to be passed by the full House of Representatives and then the Senate before becoming law, but already the prophets of doom are squealing about the dangers of starting a trade war with China. They are wrong.
How does China manipulate its currency? Mainly by preventing its exporters from using the dollars they earn as they wish. Instead, they are required to swap them for domestic currency at China’s central bank, which then “sterilizes” them by spending them on U.S. Treasury securities (and increasingly other, higher-yielding investments) rather than U.S. goods. As a result, the price of dollars is propped up — which means the price of yuan is pushed down — by a demand for dollars which doesn’t involve buying American exports.
The amounts involved are astronomical: China’s accumulated dollar-denominated holdings amount to $2.4 trillion, an astonishing 40 percent of China’s GDP. The China Currency Coalition estimated in 2005 that the yuan was undervalued by 40 percent; past scholarly estimates have ranged from 10 to 75 percent. China has in the past allowed token appreciation of the yuan, but nothing serious. As a result, China is now responsible for 83 percent of America’s non-oil trade deficit.
Doomsayers argue that American retaliatory tariffs on Chinese exports would be met by Chinese tariffs on our own exports, producing a cycle of retaliation that would choke off trade between the two nations. It is an easy disaster scenario to imagine, especially if one believes the utter myth that such a cycle is what happened during the Great Depression due to the Smoot-Hawley tariff of 1930. But this is actually unlikely, for a number of reasons.
For a start, there is the fundamental fact that China is unlikely to engage in catastrophic escalation because they, not we, are running the surplus, so they are the ones with something to lose. (China’s exports to the U.S. are more than four times America’s exports to China.) The only way a deficit nation can “lose” a trade war is by having its trade balance get even worse. Given that the U.S. trade balance is already outlandish, it is hard to see how this could happen.
Of course, China has other cards up its sleeve, like threatening to dump its massive dollar reserves. But doing so would carry enormous costs for Beijing. For a start, beginning to sell these reserves would reduce the value of the large reserves they would still be holding. Furthermore, this would depress the value of the dollar — exactly the opposite of their currency manipulation strategy. Then there is the awkward problem of what China would do with all the money it would get by selling off its dollars. There just aren’t that many good alternatives for parking that much money. The Japanese don’t want their currency used as an international reserve currency (and will stymie anyone who tries), and the euro has huge problems of its own right now. Assets like gold and minor currencies are volatile or in limited supply. Other assets, like American or European real estate or corporate stocks, are, by definition, denominated in dollars or euros, so this wouldn’t get around the currency problem.
Similarly, China could threaten to stop buying U.S. Treasury debt (which would spike American interest rates), but is constrained by the fact that this would reduce the value of the $840 billion or so that it already holds. This action would also lower the price of the dollar by abandoning China’s key lever for pushing it up. Furthermore, the U.S. could retaliate by revoking the tax exemption of interest on foreign-held Treasury debt, established in 1984 by Treasury Secretary Donald Regan. (As a true hypothetical doomsday scenario, we could even suspend interest payments on the debt, though this would be irresponsibly disruptive and is thus extremely unlikely in peacetime.)
The fundamental reality is that the United States is already in a trade war with China. In the real world, as opposed to the fantasy of laissez faire economics, international trade is adversarial. This doesn’t mean that there aren’t win-win aspects to it — there are — but it does mean that there are enough win-lose aspects to it that nations need to actively defend their own economic interests. This active defense is known as “mercantilism,” and it is a game China has been playing for decades now while the U.S. pretends the game doesn’t even exist. (Ironically, the U.S. was itself founded as a mercantilist country, though we’ve forgotten.)
Right now, America is in an economic war of attrition with China, in which our enormous trade deficit inexorably, year by year, has two effects: first, it reduces America’s net worth by piling up debt and selling off American assets, and second, it grinds down America’s industrial base by driving American companies out of business. If America does nothing, we will remain stuck in this war, and will continue to lose it. This is a costly outcome in its own right for the U.S., and its cost must be weighed against any imagined dangers of a trade war.
It is inevitable that the present trading relationship between the U.S. and China cannot go on forever. At some point, America’s ability to run gigantic deficits must end due to a prolonged slide or sudden crash in the value of the dollar. Unless God or Santa intervene to prop up the dollar by giving America free imports forever, an end to the current imbalance will come — whether we or the Chinese want it to or not. But the longer we wait for this inevitable readjustment of currencies to basic economic laws of gravity, the more traumatic the adjustment will be.
The longer we wait, the bigger the decline in the dollar and the greater the likelihood that it will come as a sudden and destabilizing shock, rather than a managed, more gradual adjustment. It follows that those who are trying to avoid doing anything on U.S.-China currency problems are merely postponing, by a few years at best, the inevitable and making it worse when it finally comes. This is the height of irresponsibility, and therefore they, not we, are the ones risking economic debacle. Kowtowing to China today is economic appeasement and involves the same equation as political appeasement did in the 1930s: a few more years of relative quiet with a bigger explosion at the end.
Furthermore, this issue is bigger than China alone. How America deals with Chinese currency manipulation will set the precedent, and establish or destroy America’s credibility, for dealing with a long list of other nations that have been playing currency games. China is merely the most blatant and politically sensitive case. For example, Japan has recently moved to weaken the yen to preserve its competitiveness, and Brazil has talked about weakening the real. Singapore, Taiwan, Malaysia and Indonesia have also been identified as currency manipulators. Germany continues to enjoy an underpriced currency by being on the euro, a “blended” currency that is too strong for the weaker economies in the EU and too weak for the stronger ones.
Strong action now on all foreign predatory practices, including currency manipulation, is the order of the day. Congress should stop listening to the alarmists before the alarm bell really rings on America’s economic future.
Ian Fletcher is the author of Free Trade Doesn’t Work: What Should Replace It and Why (USBIC, 2010, $24.95) An Adjunct Fellow at the San Francisco office of the U.S. Business and Industry Council, a Washington think tank founded in 1933, he was previously an economist in private practice, mostly serving hedge funds and private equity firms. He may be contacted at firstname.lastname@example.org.