China Crisis – Or Opportunity?

“These congressmen claim they are the white knights defending the interests of the American people, but in fact, they are nothing more than a bunch of baby-kissing politicians.” You’ve got to love Xinhua, the official Chinese news agency, for its colourful rebuttal of American sabre rattling, led by Democrat Senator Chuck Schumer, over alleged manipulation of the exchange rate of the Chinese currency, the renminbi. Xinhua may even be right.

First of all, let’s be clear that China is manipulating the value of its currency to keep its exports competitive. China holds massive dollar reserves and these reserves are growing as it continues to run a massive trade surplus. The sluggish U.S. economy, by contrast, is failing to make much headway in narrowing its trade deficit by exporting more, since the dollar has actually appreciated in value against most world currencies since the crisis of 2008. It is also clear that this situation cannot continue forever – the U.S. cannot keep financing domestic consumption with foreign credit indefinitely.

The problem is that trying to bully China isn’t going to work as a strategy for changing things. Indeed, it is fraught with dangers. Chinese currency manipulation is nothing new – popping over to Beijing to have a moan was just as much a part of Treasury Secretary Hank Paulson’s schedule as it is for his successor, Tim Geithner. The difference is that today the U.S. economy is struggling, which has upped the political ante.

Enter Senator Schumer, who is leading demands in Congress for the U.S. to take unilateral action by imposing restrictions on Chinese imports (a stance that has even won plaudits from trade guru Paul Krugman). It is this that provoked Xinhua’s robust reaction.

While American indignation is understandable, the lessons of history that we discuss in The Road From Ruin suggest that this muscular policy is missing the point and could backfire spectacularly.

First, however, the (semi) good news. Twenty-five years ago the U.S. economy was struggling to recover from a recession, impeded by a failure to get the rest of the world to buy its products, with Japan and Germany in the role now played by China of running big trade surpluses. Under a deal, known as the Plaza Accord of 1985, the world’s leading industrial economies agreed to work together to drive down the value of the dollar to rebalance global trade. The policy achieved its immediate objective (the dollar fell so far that co-ordinated action was required two years later to push it back up again) but, in the end, it had little impact on the U.S. trade deficit.

Twenty-five years is a very long time in global politics. The Cold War had not yet reached its surprise denouement and the U.S. was still the unrivalled capitalist superpower. Japan and Germany did not really have any choice but to give in to U.S. demands and, for both countries, an invitation to help out the American economy was a promotion on the world stage.

China today does not have the same incentives to give in to U.S. demands, not least because it is America’s main creditor. And creditors will always blame their debtors. That is exactly what America did in the 1920s and 1930s as European nations struggled to cling to the Gold Standard, torn between the imperative to slash their debts to maintain the value of their currencies against gold and the need to keep spending to stop their economies stalling entirely. The result of that impasse was the collapse of the Gold Standard and a global trade war that worsened the global recession, harming everyone. Sabre-rattlers beware.

So what can be done? First, we need to understand China’s behaviour. The policy of undervaluing the renminbi is, in part, driven by the false economic philosophy of mercantilism that associates building up currency reserves with economic success (fuelled by the powerful export lobby). China’s strategy might also be looked at as a rational response to an irrational world. The leaders of many of the emerging economies of Asia, not just China, took two lessons from the financial crisis of the mid 1990s. First, that borrowing dollars to finance their development exposed their economies to turbulence coming out of decisions made in Washington to suit the needs of the domestic U.S. economy. Second, that the U.S.-dominated IMF and World Bank could not be relied upon in times of crisis.

It was in the crucible of this crisis that the strategy of export-led growth for emerging economies was forged. In a sense this defies economic logic – by keeping the value of their currencies low to run trade surpluses countries such as China have forced their own, poor, citizens to pay the price of economic development rather than the rich citizens of America. Yet policy-makers decided that this was the least-worst option, as long as the American-controlled dollar remained the basic unit of currency for international finance.

At the G20 summit in April 2009 China put forward its own solution to the global financing problem – a new global reserve currency to replace the dollar – which has the support of Nobel Prize winning economist Joseph Stiglitz.

So far, this idea has made little headway but it is, potentially, a massive win-win for the U.S. and China. The dollar’s position as the global reserve currency massively distorts its value. This may seem like good news at the moment, since the willingness of the world to hold dollars is protecting the U.S. from speculative attacks on its currency over the country’s deteriorating fiscal position. The downside, of course, is that this drives up the value of the dollar, fuelling America’s competitiveness problem.

The U.S. economy would, in the long term, benefit from playing by the same rules as everyone else. Moreover, if a deal on a global reserve currency ended the currency manipulations of countries such as China, that too would be a boon.

The bottom line is that a new global financial architecture is inevitable – the world cannot continue anchoring its finances to the currency of its biggest debtor. China’s advocacy of a global reserve currency is an acknowledgement that the status quo is not sustainable (if America owes you a billion dollars America has a problem, if America owes you a trillion dollars you have a problem). There are misguided patriotic and short-term reasons for politicians like Senator Schumer to persist with their populist hectoring. Eminent economists like Krugman should not be so short-sighted: it is time for the ‘white knights’ of economics to refocus the debate on ideas that could really make a positive difference.

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