Thomas Palley

In the early 1980s the U.S. suffered record trade deficits and severe de-industrialization as a result of an overvalued dollar. Those problems were tackled by the 1985 Plaza accord – an agreement between the U.S. and its major trading partners – which depreciated the dollar, reduced the trade deficit, and helped keep the economic expansion going.

Today, there is an urgent need for another exchange rate accord, but the changed composition of U.S. trade means it must involve new partners – particularly China. The problem is that China has refused to cooperate, while many U.S. policymakers are afraid of taking action to compel co-operation. They believe that either there is nothing the US can do or that the costs of action outweigh the benefits. They are wrong on both counts.

The trade deficit matters because it drains spending from the economy. This has contributed to manufacturing decline, and it has also made for a weak and unbalanced economic expansion. Instead of creating investments and jobs at home, debt-financed spending leaks offshore leaving the U.S. financially burdened without any lasting capacity gains.

East Asia accounts for forty-five percent of the trade deficit, and China alone accounts for over twenty-five percent. Not only is the deficit with China the largest with any major industrial country, it is also the most unbalanced and fastest growing. Indeed, today’s deficit with China substantially exceeds the peak total deficit of the 1980s. Yet unlike our trading partners back then, China refuses to recognize the problem. And fearing loss of international competitiveness to China, other East Asian economies also resist exchange rate adjustment.

China’s refusal to adjust threatens the U.S.’s economic future. Near-term, there is a danger of a debt-driven recession; longer-term, the U.S. will have to compete globally with an atrophied industrial base. China is also placing unfair adjustment burdens on those that do play by the rules, including emerging Eastern Europe and Latin America. The global economic system is based on cooperation, but China has refused to adjust despite compelling evidence of gross imbalances. Put bluntly, China has become the mercantilist fox in the liberalized international trading coop.

One cost to the U.S. of an economic dispute with China stems from reliance on Chinese imports. These are predominantly consumer goods, and consumer price inflation would rise, lowering living standards. Big box discount stores like Wal-Mart that source from China, would be hurt and would scream. So would multi-nationals who produce in China. But global production is highly mobile and can be shifted to other countries, which would quickly diminish costs to consumers.

A second concern is that China will sell its massive holdings of US Treasury bonds, spiking interest rates. However, this can be avoided by having the Federal Reserve step in and buy the bonds, which the Fed can do because it has unlimited capacity to create money. The Treasury can also place a temporary hold on disruptive sales. Though there would surely be some financial turmoil, it can be handled by coordinated action involving the Federal Reserve and Wall Street as was done with the 1998 collapse of the hedge fund, Long Term Capital Management. And if China decides to repatriate its bond sale proceeds, that will lower the exchange rate, which is the name of the game.

For China, the costs of a dispute are much higher. One third of Chinese exports go to the U.S., whereas only four percent of U.S. exports go to China. Restricting U.S. market access for even a brief period would shut China’s factories, causing massive unemployment. And massive unemployment could quickly trigger civil unrest, something China’s Communist authorities deeply fear given their fragile control.

Moreover, restricting U.S. market access would also cause foreign direct investment in China to dry up. Such investment is key to China’s growth strategy, providing jobs, manufacturing capacity, and technology transfer. Nor would it likely return to pre-dispute levels, since China’s reputation for reliability would have been dented, making companies fearful of future repeat interruptions.

Make no mistake, trade wars are costly for all involved, and it is far better to resolve disputes by negotiation. But that said, a U.S. – China trade war would have far greater costs and consequences for China than for the United States. This is of critical significance. China’s policymakers are rational and can do the math. It means they will quickly seek a negotiated settlement if confronted by a credibly exercised U.S. threat of a trade war that avoids national pride entanglements. Congressional trade legislation that sanctions China for its exchange rate manipulation by imposing tariffs is the perfect vehicle for this. Legislation along these lines has been proposed by Sens. Schumer and Gramm, and by Reps. Hunter and Ryan.

Today’s cost-benefit equation decisively favors the U.S., but that balance is shifting. The U.S. is losing manufacturing capacity, and becoming more dependent on Chinese imports. In 2005, the U.S. trade deficit with China grew twenty-five percent. Meanwhile, China’s manufacturing capacity and sophistication are increasing. Time is therefore on China’s side.

This entry was posted on Thursday, February 16th, 2006 at 4:49 pm and is filed under China. You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.