Thomas I. Palley
February 09, 2006
Dr. Thomas Palley was chief economist of the U.S.–China Economic and Security Review Commission. Prior to joining the Commission, he was director of the Open Society Institute’s Globalization Reform Project. He has written for The Atlantic Monthly, American Prospect and The Nation magazines. He can be reached at
http://www.thomaspalley.com.In the early 1980s, the U.S . suffered record trade deficits and severe deindustrialization as a result of an overvalued dollar. Those problems were addressed in the 1985 Plaza accord—an agreement between the U.S. and its major trading partners—which depreciated the dollar, reduced the trade deficit and helped keep the economic expansion going.
Today, there is an urgent need for another exchange rate accord, but the altered composition of U.S. trade means it must involve new trading partners—particularly China. The problem is that China has refused to cooperate, while many U.S. policymakers are afraid of taking action to force cooperation. They believe that either there is nothing the U.S. can do, or that the costs of action outweigh the benefits. They are wrong on both counts.
The trade deficit matters because it drains spending from our economy. Spending drain, in turn, contributes to a manufacturing decline and the weak and unbalanced economic expansion. Instead of creating investments and jobs at home, debt-financed spending leaks offshore, leaving the U.S. financially burdened without any lasting capacity gains.
East Asia accounts for 45 percent of the trade deficit, and China alone accounts for more than 25 percent. Not only is the United States' deficit with China the largest with any major industrial country, it is also the most unbalanced and fastest growing. Indeed, today’s deficit with China substantially exceeds the peak total deficit of the 1980s. Yet unlike our trading partners back then, China refuses to recognize the problem. And fearing loss of international competitiveness to China, other East Asian economies also resist adjusting the exchange rate.
China’s refusal to adjust threatens the United States' economic future. Near term, there is a danger of a debt-driven recession; longer term, the U.S. will have to compete globally with an atrophied industrial base. China is also placing unfair adjustment burdens on those who do play by the rules, including emerging Eastern Europe and Latin America. The global economic system is based on cooperation, but China has refused to adjust, despite compelling evidence of gross imbalances. Put bluntly, China has become the mercantilist fox in the liberalized international trading chicken coop.
One cost to the United States of an economic dispute with China stems from reliance on Chinese imports. These are predominantly consumer goods, and consumer price inflation would rise, thus lowering living standards. Big-box discount stores like Wal-Mart that source from China would be hurt and would scream. So would multi-nationals that produce in China. But global production is highly mobile and can be shifted to other countries, which would quickly diminish costs to consumers.
A second concern is that China will sell its massive holdings of U.S. Treasury bonds, spiking interest rates. However, this can be avoided by having the Federal Reserve step in and buy the bonds, which the Fed can do because it has unlimited capacity to create money. Though there would surely be some financial turmoil, it can be handled by coordinated action involving the Federal Reserve and Wall Street, as was done with the 1998 collapse of the hedge fund Long-Term Capital Management. And if China decides to convert its bond sale proceeds back into Chinese currency, that will lower the exchange rate, which is the name of the game.
For China, the costs of a dispute are much higher. One-third of Chinese exports go to the U.S., whereas only 4 percent of U.S. exports go to China. Restricting U.S. market access for even a brief period would shut China’s factories, causing massive unemployment. And massive unemployment could quickly trigger civil unrest—something China’s communist authorities deeply fear, given their fragile control.
Moreover, restricting U.S. market access would also cause foreign direct investment in China to dry up. Such investment is key to China’s growth strategy—providing jobs, manufacturing capacity and technology transfer. Nor would it likely return to pre-dispute levels, since China’s reputation for reliability would have been dented, making companies fearful of future repeat interruptions.
Make no mistake, trade wars are costly for all involved, and it is far better to resolve disputes by negotiation. But that said, a U.S./China trade war would have far greater costs and consequences for China than for the United States. This is of critical significance. China’s policymakers are rational and can do the math. It means they will quickly seek a negotiated settlement if confronted by a credibly exercised U.S. threat of a trade war that avoids national pride entanglements. Congressional trade legislation that sanctions China for its exchange-rate manipulation by imposing tariffs is the perfect vehicle for this. Legislation along these lines has been proposed by Sens. Schumer and Graham, and by Reps. Hunter and Ryan.
Today’s cost-benefit equation decisively favors the U.S., but that balance is shifting. The U.S. is losing manufacturing capacity, and becoming more dependent on Chinese imports. 2005 data will show that the U.S. trade deficit with China grew 25 percent. Meanwhile, China’s manufacturing capacity and sophistication are increasing. Time is therefore on China’s side.
