Commentary Type

Patience and the Currency Wars

Op-ed in the National Interest


What a curious world we live in. Communist leaders in Beijing desperately need capitalist growth to maintain political control. They fear anything that might slow their export engine—an engine that has delivered nearly 10 percent growth year after year. They adore what Professor Ronald McKinnon of Stanford has to say: Don't change the peg between the dollar and the yuan, because on that path lies more than a decade of misery, just as Japan has suffered since 1990. And, by the way, Chinese leaders love the prestige and power that comes with a treasure trove of $2.7 trillion in foreign-exchange reserves. From Beijing's perspective, all is well in the Middle Kingdom.

But not from Washington's perspective. President Obama desperately needs at least 4 percent growth to bring unemployment below 8.5 percent in time for the 2012 election. But in 2011, fiscal stimulus will give way to fiscal consolidation, even assuming the Bush tax cuts are extended, since the pump priming delivered by the American Reinvestment and Recovery Act (ARRA) is fast winding down. Perhaps Ben Bernanke's aggressive expansion of the Fed's balance sheet—known as quantitative easing (QE)—will deliver 4 percent growth, but these are uncharted waters. Call me an optimist, but never before in American history has so much money been thrown at a struggling economy. Obama does not want to commit his political fortunes entirely to the graces of Bernanke's Fed. And he is smart enough to know that even if Nobel laureates Paul Krugman and Joseph Stiglitz call for more government spending twice on Sunday, the Congressional choir is just not listening.

What to do? Preach patience and push China to revalue the yuan. According to William Cline's arithmetic, a 15 percent revaluation of the yuan (from 6.66 yuan to the dollar to 5.66 yuan to the dollar) might reduce the US trade deficit by $60 billion and take 500,000 American workers off the unemployment rolls. In fact, if all foreign currencies were revalued by 10 percent against the dollar (meaning a 10 percent devaluation of the dollar), that might reduce the US trade deficit by $180 billion in a couple of years, and cut unemployment by 1.5 million workers—a drop of about 1 percent in the unemployment rate. That's pretty appealing to the Obama White House. Bernanke's QE policy has already dropped the dollar by around 10 percent since the beginning of 2010, and more of the same could bring the dollar down another 10 percent, back to its level in 2000.

But while QE can devalue the dollar against currencies that float—like the euro, the yen, the Canadian dollar, and many others—it won't change the dollar/yuan relationship as long as Beijing is determined to maintain its peg and go on accumulating foreign exchange reserves. What can the White House do about China? For starters, it has dispatched Treasury Secretary Timothy Geithner to preach reason and revaluation, both bilaterally and in G-20 confabs. It can call, yet again, for a reduction of global imbalances. It can suggest targets—such as current account surpluses of no more than 4 percent of GDP—a number that would require China to reduce its trade surplus (in 2010, perhaps 6 percent of GDP).

But diplomatic jaw-jaw goes only so far when it runs up against the perceived interests of Beijing's leaders and Shanghai's exporters. To be sure, as the dollar drops against the Brazilian real or the Indian rupee, those leaders add their voices to the call for yuan revaluation. But some Washington voices call for sterner medicine. Trade sanctions, starting with the countervailing duty passed by the House of Representatives in late September, and escalating to an across-the-board tariff of 30 percent on imports from China are favored remedies among the Washington hawks.

To me, the blunderbuss approach makes no sense. Nor, so far, has it appealed to President Obama or Secretary Geithner. Washington has lots of issues with Beijing: Iran, North Korea, South China Sea, Taiwan, and more. Elevating the currency dispute above everything else will provoke a hostile response and slow constructive engagement on other files. Missteps by Washington and Beijing could inflict severe damage to the world trading system, with little improvement in the US trade balance.

Instead, my recommended approach is slow and steady pressure—with a view toward changing China's calculation of its own best interest. Here's my favorite idea: tax the earnings on Chinese official holdings of dollar assets—essentially telling China that a foreign-exchange hoard of $2.7 trillion is quite enough. This would take several steps, but that's an advantage, because each step will keep the currency question alive, but not on the front page. First the United States would give notice that the US-China tax treaty will be terminated, effective January 1, 2012. Then the Congress would pass an exception to existing statutes, allowing the secretary of the treasury to impose a withholding tax of up to 30 percent on interest and dividends paid on official holdings of US dollar assets by a government that maintains a seriously undervalued currency and a substantial current account surplus. Combined with verbal pressure from other countries, and more QE from Bernanke's Fed, this prospect might persuade Beijing to slowly but surely revalue the yuan.

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