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Advising China

GB Geo-Blog

Advising China

Two op-ed pieces in the New York Times on Monday focused on the need for China to allow its currency to appreciate against the U.S. dollar. Paul Krugman, a professor of economics at Princeton, hoped that President Obama and his Chinese hosts “engage in some frank talk about currency policy. For the problem of international trade imbalances is about to get substantially worse. And there’s a potentially ugly confrontation looming unless China mends its ways.”

Niall Ferguson, a history professor at Harvard, commented: “renminbi revaluation would reduce the risk of potentially serious international friction over trade…Unless China’s currency is revalued, we can expect an uncoordinated wave of defensive moves by countries on the wrong side of Chimerica’s double depreciation.”

Both Krugman and Ferguson are ignoring important factors. Ferguson does so because he is a historian pretending to be an economist. Krugman does so because he is an economist espousing the conventional wisdom of economists.

The Chinese Government recognizes that trade frictions are likely, and has hinted that it is prepared to allow its currency to appreciate but under its control and to limited degree.

An appreciation of the renminbi against the U.S. dollar will not do much to improve the U.S. trade balance. Both Krugman and Ferguson believe that the key to U.S. companies being able to compete with their Chinese counterparts is cost. In effect, both are implicitly saying that wage rates and other costs in the U.S. are at least 30% or more too high. But they do not advocate wage cuts, or tax cuts, since these recommendations would run counter to their liberal leanings. Instead, they favor the “painless” alternative of a depreciation of the U.S. dollar.

Two problems: An appreciation of the renminbi will lead to a shift in supply from China to other countries in Asia. The geographic origins of exports to the U.S. would change, but not necessarily their aggregate volumes and values. Neither would the U.S. economy grow more rapidly, nor would the unemployment rate fall more quickly.

Second, U.S. companies must compete on factors beyond price. Innovation is the key to the competitiveness of the United States. U.S. policies focused on encouraging innovation and risk taking (not the type practiced by private equity firms and hedge funds) would contribute much more to the long-term health and prosperity of the economy than any appreciation of the renminbi. The greater threat to the U.S. is the goal of China to upgrade its economy into those sectors where U.S. companies currently have an advantage: pharmaceuticals, aerospace and technology. China will heavily subsidize these sectors and this will pose the greatest threat for a trade war.

Krugman and Ferguson ignore that the growth of China played a critical role in dampening inflation during the past 15 years, allowing interest rates to be quite low. Low inflation rates and interets rates contributed to strong growth in the U.S. and elsewhere.

Krugman and Ferguson also ignore the Chinese position altogether. Yes, there is the risk of trade sanctions against Chinee companies and products. But despite China’s dramatic record of growth, income per capita levels in China are less than 10% of the U.S. levels. There are enormous disparities in income levels between rural and urban China. Rural Chinese are poor both in absolute and relative terms. This poverty is driving many to the cities.

China has an enormous unemployment and underemployment problem. If it cannot maintain very high levels of productivity growth to narrow the income gap between itself and the U.S., and high rates of real economic growth to generate the jobs needed to absorb the unemployed, social unrest is inevitable.

China is in a period of transition, but one that is fraught with risks. China also has learned that currency markets can be very volatile and unstable (Brazil has intervened to stem the flow of “hot” money and the sharp appreciation of its currency). Allowing its currency to float freely most likely would create enormous problems as speculators run amok.

Thus, China’s policy of periodic and controlled appreciations of its currency is probably the best approach for China. and likely the best alternative for everyone else. Live with this reality and turn down the rhetoric.


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