China, the U.S., politics and exchange rates

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When it comes to exchange rate policies, it’s often hard to tell the difference between a conservative Republican and a liberal Democrat. Especially in a tough economy, both sides of the political aisle tend to get exchange rate economics wrong.

The political class might be forgiven in this instance as many economists, business executives, and Wall Street types get it wrong as well.

Take China, for example. The U.S. has long had a trade deficit with China. In 2010, the U.S. deficit in goods trade with China was $273 billion. This deficit angers various politicians, who usually blame China’s yuan exchange rate with the dollar. U.S politicians are good at accusing China of currency manipulation to keep the yuan’s value low so as to promote exports and limit imports.

As reported by Dow Jones Newswires, House Minority Whip Steny Hoyer (D-MD) declared in early September: “The manipulation of currency by China and by others that makes their goods cheap to sell in America … that’s not consistent with the rules; it’s not fair to our workers, and we want to make sure that we turn that around.” In January, Treasury Secretary Tim Geithner called China’s currency “substantially undervalued.”

And in September 2010, U.S. Rep. Dave Camp (R-MI), then the ranking member and now the chairman of the House Ways and Means Committee, voted for the Currency Reform for Fair Trade Act. That legislation, re-introduced in the current Congress by Rep. Sander Levin (D-MI), would make it possible to slap tariffs on goods from “foreign countries with fundamentally undervalued currency.” At the time, Camp said, “We all agree that China’s currency is fundamentally misaligned and that China must take prompt action to allow market forces to determine the value of its currency.”

How do politicians and their appointees know the yuan is undervalued? Well, um, they just do. After all, look at that trade deficit.

But no reason exists to think that exports and imports should balance between particular nations. Given the realities of our respective economies, Americans purchase lots of goods produced at lower cost in China, while far lower incomes among the Chinese mean they buy fewer goods we produce, such as in the high-tech arena. At the same time, though, China is the third largest goods export market for the U.S.

Also, since the U.S. ran trade surpluses with nations like Brazil, the Netherlands and Singapore in 2010, should those nations call on the U.S. to adjust the dollar to fit their political desires? But that’s exactly what the U.S. wants from China. U.S. politicians really aren’t against China currency manipulation per se. Quite the contrary, they just want China to manipulate the yuan in a way deemed advantageous to the U.S.

But what about China allowing the yuan to float freely and letting market forces determine its value? This is the big fiction about exchange rates. Sure, currencies are traded, but no true free market in currencies exists because governments create money, and reduce or expand the supply of money according to policy desires. It’s a “dirty float.”

Of course, the Federal Reserve has been doing its part to reduce the value of the dollar over the past few years by running monetary policy so expansive that it is without historical precedent. But the benefits of a devalued currency in terms of boosting exports tend to be very short-lived as prices adjust, while the threat of inflation rises and a diminished currency hurts investment. No nation has ever devalued its way to prosperity.

When the dollar is strong, it means that investors see the U.S. as a sound investment, a place of economic growth and low inflation. It’s no coincidence that slow growth over the past decade, in particular during the past nearly four years, has occurred along with a decline in the value of the dollar, and inflation has risen over the past year-plus.

All of this talk about manipulating the yuan-dollar exchange rate comes from faulty economic thinking on trade. Trade deficits are assumed to be negatives. In a September 5 Washington Post letter to the editor, for example, Scott Paul, executive director of the Alliance for American Manufacturing, asserted, “Addressing currency manipulation would help to reduce our massive $273 billion annual trade imbalance with China and could, according to the Economic Policy Institute, create as many as 2.25 million U.S. jobs while reducing our budget deficit by $71.4 billion annually.”

That’s simply absurd. As data have long shown in the U.S., trade deficits grow during good economic times, and usually shrink in a poor economy. That makes sense, as individuals and businesses boost import purchases as the domestic economy grows and foreigners invest more in the U.S. to profit from growth. In the end, international trade and investment occur between individuals and businesses across borders — not between nations.

U.S. policymakers should stop trying to devalue the dollar compared to the yuan, or any other currency, and instead create a climate for economic growth and low inflation. The result will be a stronger dollar and bigger trade deficits, and those are positive developments reflecting a re-energized U.S. economy.

Raymond J. Keating is the chief economist for the Small Business & Entrepreneurship Council, and author of Warrior Monk: A Pastor Stephen Grant Novel.