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How to Manage China's Challenge to the Global Economy [Rush Transcript; Federal News Service]

Speaker: C. Fred Bergsten, Director, Peterson Institute For International Economics
Presider: Sebastian Mallaby, Director, Maurice R. Greenberg Center for Geoeconomic Studies
June 19, 2008
Council on Foreign Relations

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New York, New York

SEBASTIAN MALLABY: Thank you, operator. So, I'm Sebastian Mallaby. I direct the Center for Geoeconomic Studies at the Council on Foreign Relations. And our speaker is Dr. Fred Bergsten, the director of the Peterson Institute for International Economics and he is going to be discussing the ideas in his new article in Foreign Affairs, "A Partnership of Equals: How Washington Should Respond to China's Economic Challenge." And Fred, you have a provocative and somewhat, I think, hard to pigeonhole view of the Chinese economic challenge. You're not saying that it's the either the case that China is consistently destructive towards the international system nor that it's consistently the opposite. In fact, you see a change in the behavior since WTO accession. Can you expand a bit how you see China's challenge changing?

C. FRED BERGSTEN: China's challenge really has two major dimensions. The first and most obvious dimension is simply its size. It's become the world's second biggest economy, second biggest trading nation, by far the biggest surplus country, biggest holder of foreign exchange reserves. It's clearly an economic superpower. And anytime that a new economic superpower emerges on the scene, it inherently challenges the current economic system. Sometimes in the past, that's led to disaster, like Germany in the late 19th century, sometimes it's worked out benignly. But the emergence of a new superpower just per se challenges the existing order and raises new questions about how it can function and how that new superpower can participate in it.

The second dimension is the one that I really focus on in the article. The fact that China, in addition to its sheer size and importance, does now seem to be challenging some of the fundamental tenets of the existing economic system that we've had for the last 50 or 60 years. I do not suggest it's doing this as part of concentrated grand strategy to disrupt the system. I do suggest that on each issue area -- exchange rates, trade, energy, foreign aid -- the Chinese are adopting national policies that really do counter the norms, the guidelines, the rules, the institutional arrangements of the current economic order.

And that when you stand back and look at those different pieces together, which is what I try to do in the article and the new book from which it's taken, that you have a second, and in a way more profound, challenge to the existing international economic order. You've got not only a new emerging economic superpower, but one which seems to be unwilling, uncomfortable to play by the rules of the current game, thereby it is challenging the rules of that game, which raises the question: do we need to modify the nature of the order in order to integrate China into it in a way that will assure a peaceful transition, one that will not destabilize the economic system, one that will be sustainable for the longer run.

A very important aspect of the issue is that the international economic system itself has not been performing so well of late. The traditional institutions -- the IMF, the WTO, the G-7 -- have not been functioning effectively for the last decade or I would say even more. So, there's pretty clearly a need for systemic reform and modification anyway. In that sense, the challenge from China might turn out to be a good thing, but it depends on how it's channeled, it depends on how it's accommodated.

My proposal is for the United States to essentially reach out to China, offer it co-leadership in managing, and in some areas probably, modifying the existing international economic order. I call it a G-2. We've got G-7s, G-10s, G-5s. I call it a G-2 where you'd have the two current economic superpowers who could operate effectively as unitary actors. The European Union is also an economic superpower, but nobody speaks for it. Somebody does in trade. It works effectively there, but no where else. So, it's hard to work with the EU in this way.

The U.S. and China, I think, as the other two economic superpowers, should form an informal but explicit steering group to try to jointly manage the evolution of the global economic system in a way that would be effective, sustainable and provide a foundation for the global economy going forward. We've got some nascent steps in that direction. Here in Washington the last two days we had the latest meeting of the so-called Strategic Economic Dialogue between the U.S. and China. That I think is a useful stepping stone. It's been a good thing. But it simply has not operated on the kind of conceptual foundation that I'm talking about. It has not, therefore, achieved any substantive outcomes, it's all been process. That was the case with this meeting, as well.

And so I think we need to take a leap of both imagination and policy. That would really of course require the new U.S. administration starting next year -- and I hope this will be one of the focal points of its foreign policy as well as its international economic policy. China is right at the of the challenge list, there's no doubt about it. I think this would be the most constructive way to try to approach that set of issues.

MALLABY: So, the G-2 is your prescription, but let's just go back for a second to your diagnosis. You're suggesting -- and I think you say this in the article, right? -- that there is a potential parallel with Russia's post-communist trajectory, where Russia for a while appeared to be integrating into the international system and wanting to adopt sort of that playbook, and then under Putin moved back in a different direction and became more of a challenger to that system than a --

BERGSTEN: Right, right. Russia in a way is even more dramatic. Well, it's more dramatic in one sense. Ten years ago, Russia was broke. It defaulted. It was a supplicant to the IMF. It was dependent on the U.S. and other countries to cancel its outstanding debts and reschedule them or accept repudiation. Russia was flat on its back. And at that time, not coincidentally, the energy price was at about $10 a barrel.

Ha! Now with the energy price at $130 a barrel and Russia having benefited from that for the last six to eight years, Russia has become a very successful economy. In dollar terms, the Russian economy has increased six times in size over the last eight years, an even more stunning increase in wealth than China has experienced. As a result, yes, Russia is now -- I won't say it's thumbing its nose at the world system, but certainly feeling its oats, try to restore its role as a superpower, certainly leveraging its energy clout in its relationships with Europe and the rest of the world.

China is different in the sense that China has now recorded 40 consecutive years of not just successful, but dramatic economic growth. China's economy is 14 times as big as it was when it began its reforms back in 1978. It's been the most successful development story in human history. So, it's move from a poverty-stricken country to a country that's still poor -- it's per capita income is only 10 percent or less than ours -- but, as I say, it's a global economic superpower. And through the course of that has changed from simply accommodating to the global system it inherited to challenging that system and, yes, now raising, I think, fundamental questions about whether the current system is still sustainable.

MALLABY: So, in concrete terms, an example of that would be the shift from being eager to join the World Trade Organization back in 2000 versus what you see them now doing in terms of creating a regional nation trading bloc that would be a threat potentially to the global system, is that right?

BERGSTEN: That's perhaps the most dramatic example. China is clearly promoting the development of an Asian economic bloc. That's part of its overall foreign policy for regional solidarity and also part of its challenge to the economic system.

In the case of the World Trade Organization itself, there's also an interesting contrast. China did capitulate to an ever escalating series of demands from the U.S. and others to join the WTO less than 10 years ago, and, in fact, it did that very consciously to use the WTO rules to promote internal economic reform and overcome some of the resistance to that reform.

Now, the WTO is involved in its biggest exercise since that time, the Doha Development Agenda -- the big Doha round of trade negotiations. China has totally absented itself from that effort. Despite being the world's second largest trader, the biggest surplus country, heavily dependent on the world trading system, China has just copped out of any active participation in the Doha round. That's as if the U.S. had never started up Doha in the first place. That's as if the European Union, the other economic superpower, had never participated in negotiations. China's non-participation has not attracted as much attention as other people's because it's simply stayed on the sidelines, but it's an equally critical element in producing the stalemate in the Doha round that I would say likely failure of the round, reflecting, among other things, this very radical change in China's view toward the global institutions, the success of the current global system.

MALLABY: And that radical change in terms trade is paralleled, as you argue, in terms of China's view of its current currency policy and also its energy policy. Could you just elaborate on those two?

BERGSTEN: Yeah, I think China's most frontal attack on the current economic order has been in the currency area. China is the only major trading country not to adopt a flexible exchange rate. The Europeans have fixed among themselves, but as a group they have a flexible exchange rate toward the world. All the other major economic actors have floating exchange rates. They manage them, of course, to an important extent, but they're at least floating exchange rates. Until three years ago, China had a very fixed exchange rate against the dollar, and even since it allegedly reformed its exchange rate policy three years ago, it has still intervened massively in the currency market to keep its currency from strengthening. This is all aimed at maintaining a substantially undervalued exchange rate for the Chinese currency thereby buttressing its already formidable global economic competitiveness, as a result of which China is running massive trade surpluses.

China is running by far the biggest trade and current account surplus in the world, more than twice as large as Japan's or what Japan ever ran back when people worried about it. China's surplus is more than 10 percent of its whole GDP. That's an unprecedented number for any major trading country. The U.S. deficit even at its peak has been no more than six percent of GDP and China's is well over 10 (percent), and it's a poor country at that.

So, China has clearly flouted the basic IMF proscription against maintaining an undervalued exchange rate for competitive reasons. They've flouted the proscription against frequent, large-scale, one-way intervention in the currency markets to maintain an undervalued exchange rate. And that's been a root of a great deal of the protectionist reaction against China in the U.S. Congress, the initiatives in the Congress to put on new import barriers against China if they keep their exchange rate policy as it is.

That, from a systemic standpoint, has really been a frontal assault. Beyond that, we've seen from any surplus countries in the whole post-war period of the last 50 or 60 years -- even when Japan or Germany or others ran surpluses they were never this big, they always, in a reasonably short period of time, gave way to cooperation with the international system to let their currency go up and adjust their big surpluses. China has let the currency go up a very small amount over the last three years. It's still weaker in average terms than it was six years ago when the dollar started coming down. And it's, again, a very dramatic example of systemic challenge from China.

MALLABY: Fred, I want to ask one last question before I open it up to other people on the call to ask their questions, and this gets to your prescription that you, too -- what you're describing really is that China is, in your view, on the trade side, on the currency side, on energy policy, even on development aid is challenging the global system. And some people when they see China, you know, mounting a threat, the prescription is to say, you know, don't engage, engagement won't work, they obviously don't want to be engaged, their interests are different from ours, we shouldn't kid ourselves in thinking that engagement works. But you on the other hand lay out this rather pessimistic diagnosis of what China is up to, and your prescription is not just engagement, but for the more and more energetic engagement. Can you just comment on why you don't go for the hard-line option?

BERGSTEN: Right. I think the hard-line option is just not sustainable in three major senses. First of all, I think the Chinese now have enough clout, enough global economic power on their own just to resist it. If we tried to take a hard-line, I think it would not alter their behavior in the way we want, and in fact there's even evidence that it would push them in the other direction, that if we tried to push them into a corner, tried to take a hard-line against them, it would actually stiffen their backs and they would react in the opposite direction and make things worse. So, that's the Chinese angle.

From our own angle, I just don't think a hard-line would actually fly on any sustainable basis within the United States. There are too many Americans who benefit from engagement with China. The Wal-Mart consumer loves all those cheap Chinese products. Many of our companies are now deeply engaged in China, their global supply chains include an important part in China. They don't want to confront Beijing in any way for fear of retaliation and undermining their international economic activities.

So, whether it's American consumers or American companies or, I might say, American export workers because China is by far the most rapidly growing U.S. export market -- it is now our third largest export market. It is growing far faster than any others. We have a big trade deficit with China, but our exports are growing rapidly and it produces a lot of good jobs here. So, there are just two many Americans who benefit. Likewise in the foreign policy regime and foreign policy area, we need China on a lot of issues: on North Korea, on Iran in the Security Council. There's a whole panoply of issues where we need cooperation and help from China, and to try to take a hard-line and confront rather than cooperate, I think, just wouldn't work.

The third area is with our other allies, whether it's European allies or Asian allies, Japan, Korea. They, to put it mildly, are not going to join us in some anti-China cabal. They're too dependent on China. They don't want to rile the Chinese. They don't want to risk retaliation from China. So, we wouldn't have any friends. It would be very lonely if we tried to confront China in an aggressive and negative way.

So, for those three rather fundamental reasons, I just don't think the hard-line would work. Now, let me go to the positive side of it. It's admittedly a big leap to suggest that we could overcome the China challenge by offering to partner with them in a co-leadership mindset to help steer the world economy. And I think it would take time to get there. It would have to be developed probably through pragmatic cooperation on individual issues. Start -- I suggest two or three issues we could start on right now and evolve this broader concept over time.

But I do think at the end of the day the Chinese would go for it. The reason is that they too have become so integrated into the world economy that they have a massive stake in its successful functioning. The United States, which many Americans are not aware of, is really very integrated in the world economy now. If you add up exports and imports, it's more than 30 percent of our total economy. For China, that number is more than 60 percent. They are more than twice as integrated in the world economy as we or the European Union. They are three times as integrated in the world economy as Japan.

If you look at their financial side, they have this huge hoard of foreign exchange reserves. It's in dollar times, though they're diversifying modestly now, but it's a huge share of their national wealth. They have a massive stake in the stability of global finance, the international monetary system, as well as they have a huge stake in the continued openness and expansion of world trade and investment for their real economy. So, they by choice -- by deliberate choice have become highly globalized. They therefore have a very large stake in the effective functioning of the world economy, it's continuing openness, it's continued hospitality to investment, trade flows and the like.

In their meetings here in Washington -- the last couple of days at the Strategic Economic Dialogue, one of the main Chinese concerns was that the United States remain open to foreign investment. The Chinese want to invest in the United States. When their state oil company was rejected here three years ago when it wanted to buy up a minor American oil company, they were shocked and they were very, very unhappy about it. They viewed it as a normal part of trying to meet their energy needs and take advantage of open global capital markets, which we always espouse, but when they wanted to buy an American oil company, the Congress erupted emotionally and they were deterred.

So, it's not that they don't want to participate actively in the world economy, it's that they increasingly want a set of rules where they have something to say about the creation and implementation of those rules. And that's why I think a G-2 of the type I mentioned is the way for the United States to try to go.

MALLABY: So, they want to be present at the creation?

BERGSTEN: Exactly.

MALLABY: Operator, let -- (inaudible). Operator?

OPERATOR: Yes, sir. At this time we will open the floor for questions. If you would like to ask a question, please press the "star" key followed by the "one" key on your touch-tone phone now. Questions will be taken in the order that they are received and please introduce yourself before asking your questions.

Our first question comes from Daniel Neumann.

QUESTIONER: Good morning. This is Dan Neumann with Inside U.S. Trade.

Dr. Bergsten, I was wondering if you could explain a bit more the differences, in your mind, between the SED and your proposed G-2 system. And I'm wondering if part of the problem, in your mind, with the SED is that Secretary Paulson seems to be aiming at seemingly non-controversial matters like cooperation on environmental protection rather than on some of the more difficult issues like currency policy. And I was hoping you could also just describe briefly the first three issues you suggest that could be tackled by the G-2 and any reason why China might be more willing to create results in a G-2 than at the SED, which hasn't produced many.

Thank you.

BERGSTEN: I think Secretary Paulson did start out the SED with more ambitious agendas in mind. He was driven to it partly by the big controversy over the exchange rate and its trade effects that I mentioned in my remarks, but he quickly found he was not likely to succeed much in that way and continuing to try to do so would have negative repercussions back here at home. So, he quickly changed the agenda first to openness of capital markets in general with related exchange rates, a much broader issue, and now to energy and the environment.

Again, I don't criticize that because I think those issues are important and should be on the U.S.-China agenda. But the fact is that, despite Secretary Paulson's leadership and relationship with the Chinese and all his vigorous efforts, the SED is very much operating within the construct of the current economic system, which at least de facto is led by the United States -- it was originally constructed by the United States with some input from the Europeans and few others -- and the Chinese just don't feel comfortable with that system. They view it as an effort to co-opt them rather than to really cooperate with them. And that I think may be a subtle difference, but I think is really a very fundamental difference. And I think until we go to the Chinese with that very different mindset and point of departure, it's going to be very hard to get effective cooperation.

Now, one very practical, and you might say headline, change that I propose is to dramatize and implement the proposed G-2 with annual summit meetings between the heads of state of the two governments. That would carry it to a whole new level in political terms, it would actually dramatize it more to the world politically and put it much more in the forefront. I think it would be a way for the United States to indicate its genuine desire to work cooperatively with the Chinese.

And in substantive terms, it would permit the two countries through their heads of government to pull together the whole range of issues that are on their agenda, and trade off one against the other and make decisions that cut across specific topics: trade and currency, energy and finance. There are lots of trade-offs that are necessary. Secretary Paulson has a lot of authority in the Bush administration, but not really the ability to cut across those issues and not really to put them in the overall security and foreign policy context that only a head of government can do. So, I think those would be very big differences and they would characterize the approach I have in mind as compared with the current approach.

On the specific issues of -- the two that I really would single out. And, again, both have been discussed in the SED, but without any significant result. One is global warming. Whoever is elected president in November is going to come into the White House in January with a very aggressive program to create a new global regime on climate change. That simply cannot happen without China. In fact, the U.S. probably won't be able to put in place a serious national program unless China and some other developing countries -- but led by China -- participate in the new regime.

We saw the recent congressional debate on a climate change bill that many U.S. politicians will continue to hide behind Chinese non-participation to oppose any U.S. action on the somewhat reasonable grounds that if China and other developing countries don't participate, whatever we might do on climate change would be frittered away by their activities. And a lot of the polluting activities would simply move from here to there, so you wouldn't gain much anyway. So, you've got to have China there.

This is, I think, a fortuitous opportunity of creating a new international regime from the ground up, and we ought to do it with China as a partner. This is to me an ideal opportunity to start implementing a G-2 in an area where you are not operating with an inherited or existing regime, but rather one that is to be created. And that's why I would use it as an example to start with China.

The other big one I would look to relates to sovereign wealth funds. This is, of course, the big new issue for international finance. We're trying to make the world safe for sovereign wealth funds, both make sure that they operate in a responsible and purely economic way, and avoid protectionist reactions here and in other countries to their investment so that they will behave in that manner. Again, this is creating a new regime. The idea is to put in place some international codes of good conduct, rules of the road that the sovereign wealth funds themselves would adopt, but also that the recipients, the countries that receive their investment, would adopt as well and which would hopefully, between the two of them, create a global architecture for the activities of sovereign wealth funds that would be a win-win proposition both to the investors and for the countries in which the investments took place.

So, again, you're starting up a new regime. China as the biggest holder of foreign exchange reserves will certainly be one of the biggest sovereign wealth funds, if not the biggest, in the new future. The U.S. is still the biggest recipient of investments from entities of that type. So, again, the U.S. and China could partner to put in place this new regime and, by the way, start moving toward implementing a G-2 concept.

MALLABY: Great. Okay, another question.

OPERATOR: Our next question comes from Scott Malcolmson with the New York Times Magazine.

QUESTIONER: Hi. Yeah, I'm just hoping you could expand slightly. I'm fascinated by the climate change proposal, which you ended your Foreign Affairs article with. I was just wondering, those sorts of negotiations have taken place mostly under U.N. auspices and you haven't mentioned the United Nations in your discussion yet. Do you just see that as something, I'm gathering, as something that's best just left aside?

BERGSTEN: No, I didn't mention it much because the existing global economic system is really affected very little by the U.N. I mean, technically, the IMF, the World Trade Organization, the World Bank, technically they are all part of the U.N. system, but they operate autonomously, they cooperate among each other to some extent, but they do not really interact with the basic U.N. system very much at all. So, and the same with the energy regime, it's with the OECD, or it's, in the case of the OPEC cartel, obviously outside the U.N.

So it's just that the existing economic system really transpires with very little regard to the U.N. system as we usually think about it. You're quite right, however, that in the case of climate change, there will have to be a fusion. The Kyoto negotiations originally and now the current effort to put in place a post-Kyoto framework does take place within the United Nations system. It will have to have a big international trade component to link together the different national climate change policies that are put in place. That may link back to the WTO, and I think eventually will have to, but it may be negotiated in the U.N. context, which would be a big departure for international trade negotiations since World War II -- maybe a good thing or a bad thing depending on your view. But the U.N. does come into it in a big way here.

China likes the U.N. institutionally, of course, because of its role in the Security Council, its ability to veto any major decision taken by the Security Council. The U.S. has tended to prefer the non-U.N. institutions, even though we too have a veto in the Security Council, because we've had a bigger weighted vote in things like the IMF and the World Bank.

So there's a big institutional question there, but my G-2 that I'm proposing would need to cut across all these institutions. I certainly would want it to increasingly take on a leadership role in the existing organizations -- the IMF, the WTO, et cetera -- but in these cases where new institutional arrangements are being created -- sovereign wealth funds, but notably here climate change in the U.N. -- the G-2 leadership would need to be implemented, in that case, in a U.N. context.

The idea, remember, is that we're talking here about a leadership steering committee. I explicitly say that the U.S. and China should do a G-2 but not talk about it. They shouldn't rub other countries' noses in the fact that they are now going to become the leadership condominium. You don't want to politicize that any more than necessary because of the obvious discomfort that other major countries would have in the U.S. and China doing that. So you want to do it, but not trumpet it too much.

You would, of course, implement that leadership to a very large extent through existing international institutions. Some of it would be implemented through the other Gs -- the G-7, the G-10, the G-20, which has existed now for the last 10 years on international finance -- but also, and particularly when you get to formal multilateral organizations, in the global institutions -- the IMF, WTO and in the global -- in the climate change case the U.N. process.

So envisage the G-2 as kind of cutting across the entire institutional spectrum that now exists or might be put in place in the future as kind of your steering committee behind-the-scenes kind of direct the show. That's, in my experience, necessary in everything from a global economic institution like the IMF down to your neighborhood gardening club. You got to have somebody who takes the lead, usually the people that have the most responsibility, the most clout, hopefully take a responsible lead in organizing things, and that would be the model here.

MALLABY: Okay. Next question.

OPERATOR: Our next question comes from Karim Warren (sp) from AFP.

QUESTIONER: (Off mike) -- Warren from AFP. Mr. Bergsten, just two quick questions.

One is you propose a summit, for example, with China as a key platform or a key pillar of your G-2 strategy. But what about Japan? And you know, Japan has been always touted as -- I mean, it's the world's second-richest nation and a great democracy in Asia which U.S. has always used as an example for the others.

And the second point is, how about democracy, human rights, which has been pushed by the U.S.? I mean, U.S. always talk about how American consumers and American businesses would benefit from a good relationship with China, but with NGOs and politicians pushing for greater human rights, greater transparency, would your G-2 formula work with such opposition from, for example, people in Congress who seem to be pushing for a relationship with China but with a lot of transparency and human rights, et cetera?

BERGSTEN: Those are both good questions, and they both raise obvious issues that would have to be dealt with in pursuing this strategy.

Japan has, of course, now for over 30 years been a member of most of the inner clubs -- the original G-5, then G-7 and G-8. It is, as you say, the world's second-largest economy.

I do address the Japan question in my article and say that, while it's a major economy and would have to be involved in the implementation of many of these issues in the way that I mentioned a moment ago, it's simply not in the same league now as the U.S. and China. It's true that it's national economy is still larger when you calculate at market exchange rates, though when you calculate at purchasing power -- purchasing power or parity exchange rates, China is already much larger than Japan. And even in market rate terms, it will pass Japan in a few years given its growth rate and Japan's very low growth rate.

Remember, too, that Japan's population is declining, it's just coming off a lost decade of economic stagnation. Its currency has never played a big international role despite its earlier period of trade prominence because it was never willing to open its capital markets enough.

So Japan's important, as the European Union is of course important, and as India will be important over the coming decades. But I think none of them are really capable of adopting this kind of co-leadership role with the United States now that China is.

Again, one would have to be very careful in the way one described this publicly. One would have to be very careful to continue to work closely with Japan in all the existing institutions to avoid negative repercussions from the special U.S.-China relationship. But I think you -- one simply has to go ahead with U.S.-China because they're the only ones with the clout to carry this off.

China, incidentally, has already far surpassed Japan as an Asian regional power. The countries of Asia now look to China much more than they look to Japan for economic leadership. They're certainly much more concerned with their position -- their relations with China than they are with Japan. Not that they're uninterested in their relationship with Japan; it's still important. But China has clearly passed up Japan in the region, and therefore I would say in the world, in addition to all the things I mentioned.

The second question you raise about human rights, democracy, a whole set of questions, I think it cuts a couple of ways in this discussion. I only mentioned it briefly in my article, but I address it in more detail in the new book that the article's taken from. It's called "China's Rise: Challenges and Opportunities," and it will cut across the economic, national security, domestic political, foreign policy issues. It will integrate the whole range of issues in the U.S.-China relationship and very explicitly address those that you raised.

What I suggest is twofold.

A, China's challenge is more than economic; it also goes to the topics you mentioned: human rights, democracy and the like. In a way, China's biggest overarching challenge is to become a dominant player, leader of the global economy, whilst maintaining an authoritarian political system. They're trying to pull off something that no country has ever done. No economic superpower in the past has ever been an authoritarian society in political terms. All the successful economic superpowers in the past have been democracies or at least pretty close to democracies. So this is new in that sense, and adds to the nature and complexity of the China challenge and the difficulty of responding to it.

You're quite right; there are congressmen and others in the United States who would put a higher priority on the issues you mentioned than they would on the economic topics I'm emphasizing. What I'm suggesting is that for pragmatic reasons -- reasons of our own economic interest, a stake in an open and sustainable and effectively functioning world economy -- we separate those issues and work with a Chinese leadership that is admittedly of a political stripe not totally of our liking.

Now, we do that every day now when we work with China on a whole range of issues. The SED the last two years, we were sitting down -- our government representatives at high level were sitting down with high-level Chinese officials from an authoritarian government. That did not indicate the U.S. approves of the system of government in China. It did say that we have to work with these folks because their clout, their economic significance, is of great importance to us and we have to work with that.

I'm suggesting taking that to another level, including the summit level, that would add to the discomfort some might have in it. But I think, again, we have to pragmatically address the economic issues on their merit, try to deal with that side of the relationship.

I do think, over time, that if we did that effectively on the economic issues, it would inevitably spill over to the political side. It would strengthen the overall relationship. It would give us greater legitimacy and standing with the Chinese on other topics where they might not be so happy to hear our message, and would probably also give us a better understanding of their system, which after all has liberalized the human rights of Chinese residents, Chinese citizens, just in enormous ways, beyond anybody's imagination from 20 or 30 years ago.

So I think doing this on the economic side makes sense on its merits, and therefore should be pursued. But I would argue that it would also have some helpful spillover effects in the more political issue areas that you mentioned, and that would be a helpful thing as well.

MALLABY: Okay, good. Next question.

OPERATOR: As a reminder, if you would like to ask a question, please press the star key followed by the one key on your touch-tone phone now.

Our next question comes from Kim Landers from the Australian Broad(casting).

QUESTIONER: Hello, sir. Kim Landers from Australian Broadcasting.

I wanted to ask you for your reaction to China's announcement today that it is going to raise petrol and diesel prices. How do you think that this will play into what you've been talking about?

BERGSTEN: Well, I think that's a very good decision. China has, of course, been the biggest single driver in the growth in world energy demand over the last five years. It's not the only reason why prices are so high, but it's been a key reason. And in turn, that Chinese demand has been fueled, importantly, by their price controls. They've been holding down the prices of some petroleum products in China. That, of course, sustains a higher level of demand than market prices would suggest, and has added pressure to the world market given the importance of the Chinese economy and the size of its population and total demand.

So this is a good thing. It's certainly something that the U.S. has been urging them to do, including I'm sure through the Strategic Economic Dialogue the last couple of days. So I regard that as a very healthy step, a cooperative step incidentally in terms of the global system, by taking a bit of pressure off demand, therefore a bit of pressure off price, and an indication that in some areas that China continues to cooperate.

MALLABY: Great. One more question, or maybe we've got time for -- yeah, maybe one or two. Anybody left?

OPERATOR: Our next question comes from Garrett Mitchell from The Mitchell Report.

QUESTIONER: Thanks. Dr. Bergsten, I'm going to go back to an earlier question to try to cast a different light on it.

Earlier this week, the Chicago Council on Global Affairs issued a report on soft power in Asia. And among the findings -- and this was a survey that dealt with publics in the U.S., China, Japan, South Korea, Indonesia and Vietnam -- one of the interesting observations was that while in all of those countries it was clear that there was belief in China's rise, that it's inevitable, strong majorities in the U.S., Japan and South Korea said that they are either somewhat or very uncomfortable with the idea of China one day becoming the leader of Asia.

Now, earlier you were asked a question specifically about Japan and whether G-2 creates a problem with Japan. I thought it would be interesting to introduce this Chicago council information to suggest that the potential negative reactions to this within itself would go beyond Japan, number one.

Number two, while I know you say in your article that you -- potentially that the notion would be to sort of keep the G-2 low key, I'm not sure that's achievable in the 21st century.

And the third observation that I would make or question that I would ask you is whether, not unlike the proposal for a league of democracies, whether unintentionally -- and even if it was sort of low key and it didn't have a secretariat -- whether the creation of something called G-2 sort of draws yet another line in the sand at a time when that's not necessarily in the interest of the global political order or even the global economic order.

And I'll just close by saying that as I listen to this -- and I'm -- I've read the article, it's very thoughtful, the proposal is interesting -- I also am wondering whether this is sort of some version of a return to a kind of artificial bipolarity.

BERGSTEN: On your first question, it is certainly true that all the Asian neighbors of China are somewhat wary of its intentions. I mentioned before that China has surpassed Japan in terms of leadership in Asia, and that other Asian countries are very careful not to rile it, therefore go along with most of its initiatives. But that's accompanied by a certain wariness, I think you're quite right.

Therefore, most of those other Asian countries, whether it's Japan or Korea or Indonesia or Singapore or Thailand, they all have pursued what is frequently called a hedging strategy, meaning that they want to maintain a pretty close relationship with the United States as the one country in the world that's a potential counterweight to China, including in their own region, and therefore might balance the influence that China might bring to bear.

Now, some people, like my old boss Henry Kissinger, actually call for a kind of balance-of-power strategy in the region, that the United States should not ally with anybody -- China or Japan or anybody else -- but should have relations with each, like the U.K. supposedly did with the continental Europeans in the Napoleonic period and then the Concert of Europe system in the bulk of the 19th century, to play the outside balancer role and be able to maintain an equilibrium within the region. And that's one strategy, and you actually -- mine might move in that direction, although, I mean, I think probably that's not what Kissinger has in mind.

But the basic point is that the Asians do want the United States to maintain a very active role in Asia to provide a hedge against a new hegemony and dominance in the region from China. To me, that suggests that the kind of high-level, intense, cooperative U.S.-China relation that would derive from my G-2 would be very welcome in the rest of Asia. On the one hand, it's true they would see the U.S. as being particularly close to China. On the other hand, it would mean that the U.S. was deeply involved in Asia; that the U.S. was in an influential position with China, which presumably would enable the United States to help rein in China from having any imperial or aggressive or expansionary attitudes toward the region. So on balance, I would think this would be something that the other Asians would welcome.

You know, it's not a perfect analogy by any means, but one reason that the other Europeans love NATO even when the U.S. and Germany had kind of a special close relationship within it, was that it enabled the United States to help make sure that Germany would never again adopt an aggressive, expansionary, militaristic approach. And as I say, it's not a perfect analogy by any means, but an intimate U.S.-China relationship, even if it was geared primarily or even wholly to economic topics at the start, would I think have that broader implication and be bound to limit the wariness or the anxiety that the other Asians, and perhaps countries elsewhere in the world, had about a possible powerful China in the future.

I mean, China -- it's hard to understate -- it's hard to overstate the trajectory China's on, not only to pass Japan as the second-largest economy -- whatever exchange rates you use -- fairly soon, but to become a bigger economy than the United States in the next 25, 30 years, if it stays on anything like its current growth path, which I actually think it might. So with that economic strength, it can of course develop a very powerful military. There's already some indications it's doing that in some areas. It could do it much more extensively, and that would inherently lead to anxieties and wariness elsewhere around the world.

So one reason I'm proposing this particularly intimate U.S.-China linkup is to anticipate and maybe head off some of the risks to world stability and the fears that might otherwise be generated if China were more on its own.

Much more quickly on your diplomatic point, I agree, it's hard in the current world to keep things quiet and low key. My suggestion, though, is simply not to formalize these things, not to talk about a G-2. Set up annual summits, have a broad agenda, but try to provide constructive leadership. And if that happens, then I think it will be welcomed around the world.

Just imagine the climate change issue. Right now, the worldwide fear is that nothing will happen on climate change because China will block it, and India and other developing countries will hide behind China, and they as a group will block it, won't participate actively; as a result, the United States will not participate and the whole thing will flop. I mean, that's a pretty widespread fear not without justification.

If, by contrast, the U.S. and China could get together, work out a post-Kyoto regime, even one that was less ambitious than having global carbon targets of the Kyoto type -- something that was less sweeping, maybe more sectorially oriented, maybe more pragmatically oriented, less dramatic, but nevertheless global in nature and more effective than the confrontation of the last 10 years over Kyoto targets -- maybe that would be wound -- would be widely welcomed, and push things to a much more advanced state than they are now.

So the proof will be in the pudding. If it worked and it had the kind of favorable effect on global economic performance that is the objective of the exercise, then my guess is others would swallow their diplomatic teak and say, "Well, yeah, it's good thing. There always has to be a steering committee." If it flopped, well, okay, then you sort of give it up and go back to the traditional approach.

But I think -- as I said, I think it's the most likely strategy -- remedy the economic yield and give us a chance to deal with some of the big, new issues like climate change, like sovereign wealth funds, maybe a few others.

MALLABY: Okay, thank you. I think if any of you on the call have not read Dr. Bergsten's article, I do recommend it. It is in the new issue, which is the July/August issue of Foreign Affairs, and it's called, again, "A Partnership of Equals: How Washington Should Respond to China's Economic Challenge."

Thank you very much, Fred, and thank you to all of you who joined the call.

BERGSTEN: Thank you, Sebastian. Good to talk to all you. And if anybody else has further follow-ups, drop me a note or an e-mail, and I'd be happy to come back to you.

QUESTIONER: Thank you.

BERGSTEN: Okay.

MALLABY: Bye.

BERGSTEN: Bye-bye.

OPERATOR: Thank you, ladies and gentlemen, for your participation in today's teleconference.

BERGSTEN: Sebastian?

OPERATOR: You may now disconnect.

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