States now confronts its greatest economic
challenges since the Great Depression. In addition to resolving crises in financial
and housing markets, trade deficits with China
and on oil must be addressed for the U.S. economy to achieve robust
Fixing credit markets and energy policy are largely domestic
challenges, whereas recalibrating trade with China
requires cooperation from Beijing.
However, such cooperation requires fundamental changes in Chinese industrial policies
and a departure from maintaining an undervalued yuan to spur industrial
and Currency Policies
Since the late 1970s, China has transformed from a
centrally-planned economy dominated by state enterprises to a public-private
economy highly responsive to global market opportunities.
has accomplished dramatic growth and modernization by empowering town and
village enterprises, private businesses and foreign-invested enterprises, and delegating smaller, though still
significant, roles to national state-owned enterprises. Exports are critical to this
In addition to exploiting comparative advantages in
labor-intensive manufacturing, China
has applied industrial policies and regulation on foreign investment to ensure
the rapid development of priority industries where it may lack the resources, technology
and a comparative advantage.
For example, China
lacks adequate metallic resources to produce large amounts of steel
competitively, and modern capital equipment and technology were initially purchased
on global markets. Yet, China
exports steel even when transportation costs to destination markets are greater
than total labor costs in those markets. Similarly, China
should be importing many more automobiles to meet its requirements, but Beijing encourages foreign automakers to assemble cars and
source parts in China,
and to transfer technology to indigenous firms.
maintains an undervalued yuan that makes exports cheaper in foreign markets and
imports more expensive at home. The Chinese
government persistently purchases dollars and other currencies with yuan to
suppress its value, rather than permitting market forces to determine its value.
It converts those purchases into U.S. Treasury securities and foreign assets.
In 2008, Chinese monetary authorities purchased more than
$400 billion in U.S. and
other foreign currencies-this was about 10 percent of China's GDP and
25 percent of its exports. China
holds about $2 trillion in foreign exchange reserves, mostly in U.S.
Undervaluation subsidizes exports and protects domestic
industries from import competition, and contributes importantly to trade
deficits in the United
States and other countries. The Chinese
people consume 10 percent less than they produce to finance China's large trade surpluses and production that
exceeds consumption in the United
States and elsewhere.
The rapid pace of modernization and productivity growth in China should
rapidly drive up the dollar value of the yuan; however, in 1995, the Chinese
government pegged the yuan at 8.28 per dollar.
In July 2005, China adjusted this peg to 8.11 and
announced the yuan would be aligned to a basket of currencies. Subsequently,
the yuan still tracked the dollar quite closely, falling slowly to 6.83 it July
2008. Since, the yuan has fluctuated closely around that value-essentially, China has
repegged the yuan.
From 1995 to 2008, the annual U.S.
trade deficit with China
grew from $34 to $266 billion, accounting for
virtually all of the increase in the U.S. non-oil deficit from $44 to
Trade Deficits and U.S.
Imported oil petroleum contributes significantly to the U.S. trade
deficits. From 1995 to 2008, the petroleum deficit increased from $34 to $386
billion. This huge deficit is caused primarily by the failure to impose higher
mileage standards on automobiles, implement other fossil-fuel saving
technologies, and to develop U.S.
domestic oil and gas resources.
Together, imports of oil and from China
account for 90 percent of the U.S.
trade deficit, and that deficit has averaged more than 5 percent of GDP over
the last five years.
In theory, increased imports of manufacturers from China and petroleum should shift U.S. employment
from import-competing industries to export activities. Since export industries
create about 10 percent more value added per employee and undertake more
R&D than import-competing industries, this would raise U.S productivity and
GDP growth. Those are the expected gains from expanding trade based on comparative
Instead, large trade deficits shift U.S. employment from
trade-competing industries into nontrade-competing industries. Trade-competing
industries create at least 50 percent more value added per employee, and spend
more than three times as much R&D per dollar of value added, than
nontrade-competing industries. By shifting labor and capital into
nontrade-competing industries, chronic trade deficits have reduced U.S.
economic growth by at least one percentage point a year, or about 25 percent of
potential GDP growth.*
Lost growth is cumulative. Had trade deficits been significantly
smaller over the last two decades, U.S. GDP would likely be $3 trillion or 20
percent greater than it is today.
Trade Deficits and
Dollars spent abroad cannot be spent on U.S. goods and
With the trade deficit at 5 percent of GDP,
Americans must spend 105 percent of what they earn, or the supply for U.S. goods and services exceeds
the demand, inventories of new homes, cars and other goods
mount, layoffs result, and the economy slips into recession.
During the recent economic expansion, purchases of U.S. securities by China,
Middle East oil states and other foreign
investors kept interest rates low on long-term bonds, even when the Federal
Reserve raised its target rates on short-term paper. This permitted U.S. financial
institutions to offer homebuyers and consumers very attractive term mortgages and
other consumer loans. Many Americans spent more than they earned, and this kept
the economic expansion going. When the credit bubble burst, consumer demand
collapsed and the economy fell into recession.
Certainly, inappropriate lending standards, and aggressive
marketing of loans packaged into securities to private and foreign investors,
financial institutions permitted the bubble to occur.
Even with lending and securitization practices reformed and
credit markets restored, the demand for U.S. goods and services will not again be
adequate, and the U.S. economy cannot again achieve robust and sustainable
growth, unless either consumers spend
more than they earn and Americans finance it all by borrowing from abroad or the trade deficit is significantly
reduced to redirect more U.S. spending to domestic suppliers of goods and
The $789 billion stimulus spending approved by Congress will
help lift demand for U.S.
goods and services, temporarily, and help the economy recover. Essentially,
government spending and borrowing from foreigners is replacing consumer spending
and borrowing to prop up aggregate demand.
However, once the stimulus spending is through, consumers
must again borrow and spend more than they earn to sustain demand for U.S.
goods and services and keep the recovery going, or the trade deficit must be
reduced significantly. Otherwise demand will flag and the recovery will
To reduce the trade deficit, the United States will need several
strategies to reduce dependence on foreign oil. The increase in automotive
mileage standards to be implemented by 2016 and Obama Administration
initiatives to develop alternative energy sources will help. However, abundant
domestic oil and gas resources remain untapped, and with oil likely to head
above $100 or even $150 a barrel, these resources will be needed in addition to
conservation and alternatives to fossil fuels.
Regarding nonenergy trade, no solution is possible without
recalibrating trade with China,
and that requires revaluing the yuan dollar exchange rate to a level consistent
with more balanced trade. That entails raising the value of the Chinese yuan, administratively
or letting market forces revalue the yuan to a level that does not require
Chinese monetary authorities to consistently purchase and accumulate dollars
and other currencies to sustain its value.
The United States
has engaged in high level talks with China since negotiations for its
entry into the World Trade Organization. Most recently, the Strategic Economic
Dialogue was launched in 2007.
Throughout this process the United
States has encouraged China
to more substantially raise the value of the yuan, which would require Beijing to purchase fewer
dollars and other currencies to sustain its value. Instead, China has increased its foreign
exchange market intervention as the gap between the official value of the yuan
and its fundamental value has widened. This has exacerbated the damage to the U.S. economy and China's other trading partners.
States has three broad policy options to
First, the United
States could bring a complaint in the World
Trade Organization. China's
currency policy policies create a WTO illegal subsidy on exports, and subvert
the benefits its trading partners expected when they acceded to China's entry
into the world trade body.
Were the United
States to bring such a suit, other WTO
members would likely join the petition. If they prevailed, either China
would have to stop intervening in currency markets, or face tariffs--approved
by the WTO and imposed by WTO members participating in the complaint--to
redress the trade imbalance. Those tariffs would be strictly temporary and
removed when China
complied with the WTO decision, ended currency market intervention, and let the
yuan rise in value.
Second, the United States,
consistent with its WTO obligations may impose tariffs on imported goods that
receive government subsidies, if those goods harm U.S.
industries when they enter U.S.
markets. Until 2006, the United States
did not apply the subsidy and countervailing duty law to commerce with China,
but in a case regarding imports of Chinese paper, the Bush Administration changed
that policy. However, in addressing the domestic industry's petition, the Bush
Administration denied application of the subsidy and countervailing duty law to
Bills sponsored by Senators Jim Bunning (R-KY) and Debbie Stabenow
(D-MI) in the Senate and by Representatives Tim Ryan (D-OH) and Tim Murphy
(R-PA) would make more likely the subsidy implicit in an undervalued currency
were included in the computation countervailing duties in both dumping and
subsidy cases, when a "fundamental and actionable misalignment" is present.
Such circumstances would be determined by a standard consistent with
International Monetary Fund guidelines.
Third, Americans need to accommodate to the fact that China is much
less a market economy, either by design or by policy, than North American and
Western European economies.
Its financial system may not be able to sustain an unmanaged
floating exchange rate; however, China can manage the value of the
yuan at 4 as easily as it does 6.8. In fact, it would be a lot easier to manage
a value closer to balance of payments equilibrium.
Simply, the United States could offer China an opportunity,
with a hard deadline, to manage down its trade surplus with the United States,
either through meaningful and complete currency revaluation-complete means
raising the dollar value for the yuan to a level that reduces China's trade
surplus to zero-or through other mutually acceptable changes in China's
declines, the United States
should simply tax dollar-yuan conversion in proportion to its official and
surrogate currency market interventions. The United
States should impose a tax equal to the quarterly value
intervention divided by its exports of goods and services. China would
then have a strong incentive to reduce and then stop intervening.
does not reduce and eliminate intervention and chooses for the United States
to tax currency conversion, then the benefits from a revalued yuan of higher
prices for Chinese imports that should go to Chinese businesses would instead
go into the U.S. Treasury. If China
reduces and then eliminates one-way intervention and lets its currency rise to
a value that balances trade, Chinese businesses would capture those benefits in
the form of higher dollar prices for their goods.
Eliminating the trade deficit with China by eliminating or at least
redressing currency manipulation would have a much greater stimulus effect on
the economy than the stimulus spending approved by Congress. It would
permanently increase aggregate demand for U.S. goods and services, whereas
the benefits of the stimulus spending are temporary. As importantly, it would
restore incentives for the efficient use of labor and capital that free trade would
Affirmative policies to redressing the trade deficit with China would not
be protectionist. China's
currency policies are protectionist, and efforts to obtain a revision of these
policies would restore balance to their trading system and permit both
economies to grow and prosper, consistent with their resources and comparative
*Peter Morici, The Trade Deficit: Where Does It Come From
and What Does It Do? (Washington, DC: Economic Strategy Institute, 1998).
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