Restricting Trade with China will not hasten Economic Recovery

With the unemployment rate stuck at 9.5 percent, some economists, such as Richard Posner, maintain that we are experiencing a depression. Clearly we have not experienced much economic recovery, and the future does not look promising. Why has the US economy been recovering so slowly? Some economists, such as Paul Krugman, place part of the blame on China and other countries that are running large trade surpluses with the US. The US trade deficit soared to $49.9 billion in June and $26.2 billion of this deficit was with China. We also ran a $3 billion trade deficit with Germany in June, and Germany’s trade surplus rose 30 percent compared to 2009.

By undervaluing its currency, the Yuan, China is effectively taxing imports and subsidizing exports. This contributes to the US importing much more from China than it exports to China. Krugman says that this policy benefits China while hurting the US. He argues that the US should threaten to impose sanctions on China if it does not allow the Yuan to rise in value. This may result in a trade war between China and the US. Krugman believes that if conflict results in reduced trade between the US and China, Americans could actually benefit. He argues that because we are in such a severe recession, if the government restricts trade, more will be spent on goods produced in the US, more jobs will be created and we will be better off. This view of trade policy, of which most economists are critical, is known as mercantilism.

Krugman’s assessment of Chinese exchange rate policy is backwards. Rather than benefitting China, it makes Chinese residents worse off while benefitting Americans. For a detailed explanation of this, read the article on China’s currency manipulation by Jonathan Catalan in Mises Daily (mises.org/daily/4256). In short, by holding the value of its currency down, the Chinese government is reducing the number of dollars received by its exporters for each item that they sell. This in turn, raises prices and reduces the purchasing power of the Chinese currency for all Chinese residents. Americans, on the other hand, benefit from being able to buy Chinese goods at a lower dollar price than otherwise.

Mercantilism and Keynesianism have much in common and represent a faulty understanding of how an economy works. The large US trade deficit is not the cause of high unemployment in the US. Trade deficits mean that instead of buying US goods with the dollars they obtain from trade, foreign citizens or their governments are purchasing US financial assets. The Chinese government uses the dollars it accumulates from trade surpluses to buy US government securities. This increases the supply of savings in the US, which, by reducing interest rates, should lead to more investment. Krugman argues from the paradox of thrift, that in a time of mass unemployment, if anyone (including the Chinese government) tries to save more, demand and investment fall because there is excess capacity in the economy.

Reduced trade with China would result in lower standards of living for Americans and would not lead to a net increase in jobs in the US. If the Chinese government responded to the threat of trade sanctions by raising the value of its currency, would that hasten the economic recovery? Not necessarily, because in order to raise the value of the yuan, the Chinese government must sell US government securities, which would lead to higher interest rates in the US and less capital investment. The reduction in investment would offset the increase in exports. The Federal Reserve could keep interest rates from rising and investment from falling by increasing the money supply. This, however, would lead to more price inflation.

It would be a good thing for the Chinese people, if the Chinese government allowed their currency to appreciate. It might even result in a small short term reduction in unemployment in the US as the Chinese buy cheaper American goods and Americans buy fewer Chinese goods. It would also make it harder for the US government to fund its deficits and would not cure the fundamental problem that is hindering economic recovery in the US- uncertainty about the rules and tax policy that will determine the profitability of investment projects. A return to full employment and prosperity requires a stable market economy where entrepreneurs have the confidence to invest in anticipation of future profits. This is more likely if instead of taking over health care and a greater share of the economy, government reduces its role, ending bailouts and unsustainable government spending.