China Costs Keep Piling Up

Thomas I. Palley

May 02, 2007

Thomas Palley runs the Economics for Democratic and Open Societies Project. He is the author of  Plenty of Nothing: The Downsizing of the American Dream and the Case for Structural Keynesianism. His weekly economic policy blog is at www.thomaspalley.com.

After several years of patient negotiation , the U.S. appears to have taken a harder stance in dealing with its China trade deficit. In Congress there is talk of veto-proof legislation addressing China’s undervaluation of its currency, while the Bush Administration has imposed tariffs on coated-paper products to offset Chinese subsidies. Behind this shift is a dawning recognition that China is unwilling to reduce its surplus, and that reduces the policy choice to one of “pay now or pay more later.”
 
Today’s international trading system is a liberal order in which open exchange works well when all participants are market economies. However, it is widely recognized that individual countries can strategically game the system for their benefit at the expense of others. That is why the system needs rules and a spirit of cooperation. The problem is China has been admitted into the system but it is unwilling to play by the rules, in letter or spirit.
 
This unwillingness reflects political realities within China. China is strongly nationalist and prone to equate negotiation with external pressure. It remains an authoritarian country in which extensive state economic intervention is normal, and it is also beset by political divisions between hard and soft-liners that limit its ability to deliver on its WTO commitments.
 
In retrospect the 2000 U.S. decision to permanently open its markets to China seems poorly conceived. That decision was driven by manic optimism about globalization that pushed a biased benefit—cost calculus that ignored economic and political reality. The Clinton Administration naively argued that simply exposing China to market forces would transform it into a democratic ally, while U.S. multinationals lobbied heavily on China’s behalf seeing it as a profitable offshore production location.
 
The net result is that the U.S. is now stuck between a rock and a hard place. Either it must live with China’s gaming of the system that slowly erodes U.S. economic foundations, or it must adopt a tougher policy stance that even risks a costly trade war.
 
The downside of tougher policy is a trade war, which could be very disruptive. The upside is that it could spur a speedy negotiated settlement. Chinese policymakers are realists and likely recognize that China has more to lose from a trade war because it needs access to U.S. markets for its manufacturing sector and to attract foreign direct investment. Moreover, China is vulnerable to losses on its large holdings of U.S. financial assets.
 
Even if a trade war cannot be avoided, the U.S. still stands to benefit from tough policy because it is better to fix the problem now than later. Delay is costly. Larger trade deficits mean greater dependence on Chinese imports, along with further erosion of the U.S. manufacturing sector’s ability to replace those imports. Had the U.S. acted firmly five years ago, the costs would have been smaller and manufacturing healthier. Another five-year delay means further erosion of manufacturing and larger costs to any future trade war.
 
Inevitably, the new tougher stance has triggered accusations that the U.S. is engaging in protectionism. These accusations are based on faulty economics and fail to distinguish protectionism from legitimate economic self-defense.
 
Opponents claim that the trade deficit stems from lack of U.S. saving, not exchange rates. This argument misunderstands market economics. Reducing the trade deficit requires increasing exports and decreasing imports. That requires inducing foreigners to buy more U.S. made goods, and inducing Americans to “switch” their spending from imports to domestic made goods. Market economies accomplish this through changed relative prices. That calls for exchange rate adjustment that makes foreign goods more expensive for U.S. consumers and U.S. goods cheaper for foreign consumers.
 
The opposition to tough policy also comes wrapped in faulty economic history that blames protectionism and the Smoot-Hawley tariff for the Great Depression. Yet, the fact is Smoot-Hawley was passed in June 1930, after the Depression had already begun. Moreover, its economic effects were minor given the pre-existing high U.S. tariff structure of 34 percent, and small U.S. engagement in trade (less than 10 percent of GDP).
 
The reality is that the U.S. has delayed addressing the China trade imbalance problem for five years. That delay has harmed manufacturing, distorted the current economic expansion, and raised the costs of remedy. Further delay will do further injury and further raise the costs of future remedy. That is the inexorable logic of “pay now or pay more later.”