A few weeks back a favorite finance writer of mine, Michael Pettis of Peking University, posted during a lull in the Eurozone crisis about some of his predictions for the coming decade. Regular visitors to his site would see that many of these were ideas he had touched upon before and was simply rehashing for the reader’s benefit. One prediction that caught my eye was what he wrote about trade policy in the United States:
As unemployment persists, and as the political pressure to address unemployment rises, the US will, like Britain in 1930-31, lose its ideological commitment to free trade and become increasingly protectionist. Also like Britain in 1930-31, once it does so the US economy will begin growing more rapidly – thus putting the burden of adjustment on China, Germany (which will already be suffering from the European adjustment) and Japan.
That someone might come to this conclusion during these days of acrimony between American politicians and Chinese policymakers is not really that surprising. We’ve been hearing for a while from certain US politicians that the low exchange of the yuan against the dollar is to blame for the trade deficit, and thus US unemployment, between China and America. It is also not surprising that during a time of increasingly volatile markets (commodities especially) and massive global excess supply that the low growth, highly-indebted countries may wish to cut off from the global market to increase growth at home. One might be able to make another argument that in a situation of sagging productivity in Western labor markets, protectionism might preserve jobs that would otherwise be moved out of the country during this time.
The historical comparison might seem a little too convenient, but as it would seem today, Mr. Pettis’ prediction is coming true. the US senate is currently opening debate over whether or not to pick up the cause of labeling China a currency manipulator, allowing the United States to impose certain sanctions aimed at reducing the (perceived) artificial edge Chinese goods have in the American market. If anyone remembers, this type of legislation was already tried about a year ago to no avail and I’m not sure how many people expect that outcome to change this time around. Labeling China a currency manipulator would be a bold move by US policymakers as it has the potential to encourage the Chinese government to begin making its move towards freer markets on a faster timeline. It could also backfire tremendously.
Since the financial crisis many countries, afflicted by either low growth (Japan) or a huge influx of foreign investment (Brazil is an example), have undertaken policies ranging from capital controls to pegging exchange rates in order to remain competitive on the world market and to quell inflation. Most recently, Switzerland has joined what is being a “currency war” in an attempt to stop its currency’s massive appreciation against the dollar. Any look at a graph of the Swiss franc versus the dollar will show you the change in policy. If the United States were to start issuing sanctions against what it calls currency manipulators (what do you call QE2, Mr Bernanke?) China, and other interventionist governments (Japan, and Switzerland), might retaliate with sanctions of their own, thus escalating the currency war into a total economic “trade war.” We could see the admirable work done on increasing free trade over the last twenty years undone in twenty months by nations desperate to keep their goods and services competitive on the world market. In this hypothetical, Mr Pettis’ historical analogy seems rather apt.
Before you run to your basement and start canning beans, it’s important to mention that not everyone shares this view. No less an authority on protection economics than Paul Krugman, who won his Nobel prize studying international trade effects on economies like South Korea, posted today on his very popular op-ed blog about the virtues of a weaker currency for the US against China. You can read it for yourself, but he mostly focuses his argument on the possible benefits to the US labor market that could be gained by cutting the massive trade deficit the United States runs. Mr Krugman essentially argues for the United States to enter into the currency war, though he does suggest that the US “can’t and shouldn’t be equally aggressive” as other currency manipulators. I’m not really sure how effective this would be. If you look back to QE2 for a moment, the Fed was in essence printing money, which would normally have the effect of weakening the currency internationally. This did not happen as strongly as you might have expected. Instead, the investors took dollars at near zero interest rates from the US government and converted those into higher yielding assets in emerging markets. These “hot” inflows of money arguably had the effect of increasing inflation in the commodity market (remember $120 oil and $1800 gold?) and were what inspired Brazil to intervene more aggressively in its own capital market controls. In effect, expansionist American monetary did in fact escalate the aggressiveness of the currency interventionists.
I also have argued that a more rapid appreciation of the renminbi might help the Chinese economy make its shift towards consumption occur faster than it is now. With returns to investment rapid declining in China, the long readjustment will only be made worse by SOE’s taking on more debt in order to maintain the 10% growth rate that has become the norm there.
Fixed Asset Investment in China 1993-onwards
By giving more purchasing power to its consumer base, the Chinese government could help stamp out the high inflation levels present in consumer goods while simultaneously improving the average Chinese income with a stronger currency.
Unlike Mr Krugman, I don’t know how effective or helpful it would be for the United States to enter the currency war for fear that the whole affair would escalate out of control. Moreover I think it very unlikely, unfortunately, that Chinese politicians will make any major shift in trade policy before the leadership hand-over in 2012 in order to preserve continuity and stability. In the end the decision to appreciate lies with Chinese policymakers and not the US senate. Though in times of low growth protectionist sentiment is very easy to entertain, the potential costs of trade war far outweigh the benefits of of potential increase in employment.
Should China be labeled a currency manipulator? Definitely. But going further than that could have consequences lasting far beyond this election cycle. Let us hope that we do not, as Mr Pettis predicts, find ourselves repeating history.
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