China wagged a stentorian finger at the U.S. this week.  The People’s Republic is angered by our sale of arms to the Republic of China (Taiwan), by our interlocution with the Dalai Lama, but largely because they feel increasing pressure to float their currency, the renminbi.¹Â  As our largest creditor—China holds almost $1 trillion of U.S. Treasuries², nearly 12% of our public debt—this last vestige of communism believes they may lecture the last bastion of capitalism in defending a protectionist exchange policy.  They may have a point.

By borrowing heavily from China, have we left ourselves vulnerable to economic scolding?  Partly because of low labor rates and partly because the Chinese “peg” the renminbi to the dollar to artificially depress the apparent prices of their products, they run large trade surpluses.  In 2009, we exported $69 billion to China, but imported $296 billion—a deficit of $227 billion.³Â  In comparison, our trade with the European Union is balanced as the Euro floats freely against the dollar: $221 billion in imports, $281 billion in exports, for a deficit of $60 billion.⁴  The Chinese government absorbs the excess supply of foreign currency received by their exporters, and has accumulated a stash of $2.4 trillion in foreign reserves.⁵  Some of the influx is foreign direct investment—capital that is attracted by China’s high growth and a corporate tax rate of 25% compared to 35% in the U.S.

This purposeful combination of capitalism and central control contrasts with our confounding admixture of capitalist rhetoric belying government control or influence on much of our industry and the loss of focus of government’s role in a free economy.  At least the Chinese do socialism with no pretense.

The law provides that, semi-annually, the Treasury Department must identify any country that manipulates its currency “for purposes of preventing effective balance of payments adjustments or gaining unfair competitive advantage in international trade.”⁶  The next report is due on April 15, and 130 member of Congress have already written to Secretary Geithner advocating for the declaration.⁷  What happens next is unclear.  The law calls for the Treasury Secretary to negotiate with the offending country, but “shall not be required to initiate negotiations in cases where such negotiations would have a serious detrimental impact on vital national economic and security interests.”  Ay, there’s the rub: Geithner needs Chinese credit to fund his boss’s deficits.  Imposing punitive tariffs, as we have done selectively last year, may set off a trade war and aggravate the recession.

One may wonder why we would object to a country selling us products at artificially depressed prices.  Such an arrangement enriches our consumers.  Under normal conditions price dislocations correct themselves and excess reserves in the exporting country find their way back to the importing country by the way of investments, trade, or exchange of currency that results in price balancing.  These market mechanisms are averted in the current environment because the Treasury competes with private entities for those surpluses.  China’s unpegging the currency will be healthy in the long term, because it will allow markets to determine capital and trade flows.  In the transient period, unpegging will increase prices of Chinese products or substitutes for those products, and may raise interest rates as the Treasury begins to lose a source of cheap money.  Neither is politically desirable, yet pressure will grow for free floating currency from industries and labor unions who feel they are being disadvantaged.  Not all industries will benefit equally from an exchange readjustment because China will still have comparative cost advantage in many labor intensive sectors; but market-determined exchange rates are always better for free global trade.

As long as we are dependent on debt financing of public programs that seems deceptively painless and low cost, and on elevated consumption of cheap products to the detriment of saving and investment, and as long as China is willing to hold huge dollar reserves and buy Treasury securities, a tense economic and financial arrangement with China will exist.

Free trade should be fair trade, but confrontational dialog and retributive reactions (raising tariffs) hide weak domestic policy.  Pressure on China to float the renminbi should be accompanied by a more competitive business tax regime—to attract capital to our shores, and by a commitment to smaller, less intrusive government—to reduce our dependence on debt.  Putting America on sounder capitalist footing will immunize us against protectionism.

___________

[1] “China Talks Tough to U.S.; Premier Blames American ‘Trade Protectionism’ for Tensions Over Currency.” The Wall Street Journal, 15 March 2010, http://online.wsj.com/article/SB10001424052748703457104575121213043099350.html?mod=WSJ_hpp_MIDDLENexttoWhatsNewsSecond&mg=com-wsj

[2] U.S. Treasury, http://www.ustreas.gov/tic/mfh.txt

[3] Trade in Goods (Imports, Exports and Trade Balance) with China, Foreign Trade Statistics, U.S. Census Bureau, http://www.census.gov/foreign-trade/balance/c5700.html#2010

[4] Trade in Goods (Imports, Exports and Trade Balance) with European Union, Foreign Trade Statistics, U.S. Census Bureau, http://www.census.gov/foreign-trade/balance/c0003.html

[5] “China’s Reserves Expand.” The Wall Street Journal, 18 January 2010, http://online.wsj.com/article/SB10001424052748703657604575004501953577566.html

[6] “What US law on currency manipulation says.” Reuters, 12 March 2010, http://www.reuters.com/article/idUSN1218046820100312?type=usDollarRpt

[7] “U.S., China Up The Ante In Currency Policy Game.” The Wall Street Journal, 15 March 2010,  http://online.wsj.com/article/SB10001424052748703909804575124020434903644.html?mod=googlenews_wsj