Cost of unleashing China's currency

Congress has become obsessed with the Chinese currency. Forty-two members recently demanded formal action against China under Section 301 of the 1988 Trade Act. The Bush administration rejected that, so a powerful group of lawmakers is proposing a bill that would make China vulnerable to antidumping penalties for alleged currency misalignment. Major presidential candidates have advocated heavy tariffs on imports from China if it fails to appreciate its currency.

Why is this happening? US job losses in manufacturing industries and the trade deficit with China – which amounted to about $230 billion last year according to US government calculations – have put many American elected officials under pressure to do something.

Congressional critics say China's undervalued currency is the root of the problem. While China's currency may well be undervalued, the fundamental causes of the job losses and the trade deficit actually lie elsewhere. Sometimes solutions that seem like common sense and draw popular support turn out to be ineffective when examined more closely.

It's true that low-wage Chinese workers have taken jobs from Americans and that cheap Chinese imports have pumped up the trade deficit. But three other factors explain the state of US-Chinese trade:

•The low savings rate by Americans means the US will continue to have a large global trade deficit. Forcing Chinese currency appreciation will just shift the deficit to other countries.

•When Congress focuses on the currency issue, it is addressing the least important source of the US trade deficit.

•If Congress pressures the Inter-national Monetary Fund to censure China regarding its currency, the IMF might be obligated to censure the US for its domestic economic policies that are a more important cause of its global trade deficit.

China's exchange rate is a very small factor in US job losses in manufacturing. US productivity gains are far more important. Jobs lost to China and other countries are compensated by job gains elsewhere in America's flexible and growing economy. In fact, US unemployment is remarkably low in spite of the trade deficit.

Critics of China's currency system need to be careful what they wish for. Appreciation of its currency will not reduce America's global trade deficit by much and it will create few if any US jobs.

Completely freeing China's currency and capital flows could backfire. China has the equivalent of more than $4 trillion deposited in relatively weak banks earning barely more than 2 percent after taxes. Freeing China's currency and capital flows would allow some of this money to flow to safer and more lucrative uses in other countries, causing the Chinese currency to depreciate.

Conversely, if China suddenly stopped intervening in the foreign exchange market, it might trigger a sharp short-run decline in the international value of the US dollar and drive up US interest rates. That could cause a housing market collapse and a recession.

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