A Chequer-Board of Nights and Days

One of the top agenda items for Treasury Secretary, Henry Paulson, is to work for the appreciation of the Chinese yuan in the hopes that this will cause Chinese exports to be less competitive on the world market. A little over three months ago, Secretary Paulson went to China seeking to persuade the Chinese to let the yuan rise against the dollar. Secretary Paulson was promised greater flexibility in the evaluation of China's currency but the Chinese did not give a timetable for when this would happen. This naturally prompted editorials--like this one--demanding that China "act its age" and allow the yuan to rise.

Here's hoping that China continues to be immature. And relatedly, here's hoping that Secretary Paulson fails.

The belief that the yuan needs to appreciate stems in large part from the protectionist concern regarding the current "imbalance of trade" between the United States and China. But as Tyler Cowen points out, the balance of trade would in fact be a lot worse were it not for the currently undervalued yuan. As Professor Cowen argues, the lower yuan allows Americans to buy more Chinese goods for significantly less than they would have to pay if the yuan were higher. While concerns about the trade balance have prompted commentators to complain that China is profiting off of the United States, Professor Cowen shows that in fact, "[m]ost of the growth in Chinese exports to the United States has come from switching manufacturing and assembly from other, more expensive, Asian countries. In 1985, China, Japan, Hong Kong, Taiwan and South Korea accounted for 52.3 percent of America's trade deficit. By 2005, this percentage had fallen to 40.9 percent, in part because of cost savings from buying Chinese." As such, it is more accurate to say that Americans have profited from the lower yuan, since in the absence of a lower yuan, Americans would have had to pay more for Asian exports to the United States. The trade imbalance--such as it is--may not have depreciated significantly in this alternative universe either and even if it did, the American consumer would still have been worse off from a pocketbook standpoint.

Indeed, there is a great deal of consensus weighing in against any effort to cause the Chinese to revalue their currency. This broadside against yuan appreciation courtesy of Larry Lindsey, the former Chairman of the Council of Economic Advisors under President Bush, deserves attention. Lindsey reinforces Professor Cowen's key points by highlighting the fact that in China, the state plays the most important role in determining prices and wages and the market's role is significantly lessened. As Lindsey points out, this arrangement benefits the state by allowing it to maintain control of the economy and protect that control from external market forces. But Americans still get to buy Chinese goods cheap and the Chinese themselves are forced to purchase excess dollars from the United States--accumulating nearly $1 trillion in reserves, by Lindsey's estimation. The Chinese don't have any use for these excess dollars, which get loaned back to the United States allowing Americans to benefit from lower mortgage rates as a result. A good deal for all and another reason, as Lindsey rightly argues, to want to leave the yuan at its current low rate of value.

So why, in the face of all of these policy concerns regarding yuan appreciation, is the Treasury Secretary so bound and determined to get the Chinese to allow their currency to be more inflated in value? Probably because the "trade deficit" remains a potent political issue and the sense that "American goods are losing out to Chinese goods" remains strong among the electorate and the punditocracy. But as Professor Don Boudreaux argues--and I have sought to make this point many times in the past--the trade deficit is itself a flawed method of measurement:

Consider that if Americans export lumber, sheetrock, and architectural blueprints to China so that people build a factory there, we're gleeful. "Wonderful!" we proclaim. "Exports are up and our trade deficit is down!"

But if those very same building materials are assembled by Americans into a factory situated and operated in, say, Utah and then bought by Chinese investors, we complain -- led today by the likes of Senators Charles Schumer and Lindsey Graham -- that "Something's wrong! Our trade deficit is higher!"

Truth is, though, that nothing economically important separates the first scenario from the second. In each case the world's stock of productive capital grows as Americans produce things for sale to foreigners. Those cases appear different from each other only because of the conventions of international commercial accounting, which records investments separately from imports and exports.

This accounting convention creates the false impression that an excess of imports over exports -- called a "trade deficit" -- is an ominous imbalance requiring corrective action. In fact, America's trade deficit is evidence, not of any imbalance, but of the happy fact that our economy is so strong and stable that foreigners invest here eagerly.

The combination of healthy foreign investment in the United States and the ability of Americans to buy goods cheaply is a tough combination to beat. But alas, it seems that we are willing, by our own public policy actions, to beat it. And why? Because we remain fixated on the idea of the trade deficit as measuring something tangible and important when in fact, it does no such thing.

I certainly hope that Treasury Secretary Paulson enjoys a great many policy successes in his tenure. But on the issue of yuan revaluation, I wish him only the worst possible luck and hope that his efforts flounder completely. Better yet, let us hope that Secretary Paulson will take on those urging yuan revaluation and beat them back so that an effort at causing the Chinese currency to appreciate is not even tried.