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Tactical Issue Linkages

April 18, 2005

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Dan Drezner has an interesting post up, laying out the components of a "serious" approach to encouraging (or pressuring) China to change its exchange rate peg. He nicely lays out the options, though, as I will explain later, I think his list is incomplete.

But first, let me stipulate the following: It is not so clear to me that the Bush Administration’s EXTREMELY coordinated effort to turn up the rhetoical heat on China was directed at Beijing, rather than say Peoria, or Dayton, Ohio or somewhere in South Carolina. The President, the Treasury Secretary, the outgoing and ingoing Under Secretary of the Treasury for international affairs and the top international economist at the CEA all delivered the same message on Friday. That does not happen by accident.

And it was clearly a policy shift: until now, the Bush Administration has argued that overt pressure on China to change its exchange rate regime would be counterproductive. Now the Administration argues that not speaking out left China with the sense that there was no urgent need to change ...

So what changed? Did the Administration conclude that global imbalances are a real threat to the expansion, not just a sign of a global savings glut? (After all, China’s burgeoning current account surplus could be seen as evidence that Ben Bernanke is right, and there really is plenty of savings out there to finance US deficits). That loud shouting works better than quiet diplomacy?

I doubt it.

More likely, the Administration is worried that the Schumer-Graham bill imposing an across the board tariff on China if China does not revalue its currency was attracting a great deal of bipartisan support, which is sort of rare these days. Schumer and Graham were getting far more bipartisan support than exists, say, for the President’s proposal to issue tons of government bonds to privatize (partially) Social Security. I suspect that Rove (and others) are smart enough to know that whacking China plays better among lower-income, culturally conservative voters in places like West Virginia, Ohio and South Carolina than privatizing social security. Schumer-Graham risks making the Bush Administration look out of touch, at a time when their overall approval ratings are not so high.

But now that the heat has been turned up, the Administration does need to deliver something. Has Drezner done the Treasury’s staff work and highlighted all the options -- threaten protectionism, put carrots like Chinese membership into the G-7 on the table, or work to get the IMF to play bad cop and declare China a currency manipulator -- for prompting China to move? I say no.

His first option, threaten protectionism, could actually be broken into two options. The administration can (credibly) warn that if China does not move, then it will lose control of the Congress and be unable to prevent Congress from imposing protectionist legislation. That is the polite way to bring up the protectionist threat -- the implication is that the Administration won’t feel politically able to veto Congressional legislation (or Congress will over ride its veto), unless China gives the Administration something. See Robert Putnam, Two-Level Games. The option Drezner actually lays out is more nuclear. A Presidential call for tariffs on China would be a very big step indeed (see Richard Nixon, import levy, end of Bretton Woods 1) -- though the IIE’s Fred Bergsten thinks that is what the US needs to do. A somewhat less nuclear option would to indicate that the size of China’s global current account surpluses leaves the Administration with no choice but to declare China guilty of currency manipulation under the 1988 Trade Act. That sets a process in motion that would likely lead to the imposition of tariffs ... but leaves a certain amount of time for negotiations as well.

More importantly, I think Dan left other two important options entirely off the table.

Both involve carrots other than G-7 membership. G-7 membership, incidentally, raises a couple of dicey issues: most importantly, China ain’t exactly a democracy, so it is hard to square including China while excluding say India with the administration’s emphasis on "freedom." That why I suspect that you will need another G group, even tho the proliferation of G-X groups is imminently mockable.

What are the other options:

1) Offer to support - really support - efforts to increase Asian voting weight in the IMF. There is no doubt that Asia is underrepresented in the IMF relative to its share of the world economy. China would win here in two ways: first, its relative position in the IMF would improve; and two, it would deliver a goody for the rest of Asia that Japan has not been able to deliver (Korea is particularly underrepresented in the IMF). That would reinforce Chinese claims to regional leadership. The US would not necessarily have to give up its veto in the IMF to make room for Asia. The US is actually underrepresented (relative to its economic weight) in the IMF while Europe and the Middle East are over-represented. But a deal would be a lot easier if the US dropped its opposition to an IMF quota increase, and thus allowed a general expansion of the IMF. It is easier to reallocate an expanding pie than to divy up the existing pie differently.

2) A new "Plaza" accord, where the US agreed to cut its fiscal deficit in return for a Chinese revaluation. Yep, that implies macroeconomic policy coordination -- the initial raison d’etre for the G-7, but something that has gone out of style recently.

No doubt, successful coordination raises all sorts of difficulties.

Not the least is the probability that China probably won’t be willing to accept more US rhetoric claiming that it intends to cut the deficit in 1/2 by 2009 at face value. After all, the Administration does not seem very intent on delivering Congressional support for its proposed budget cuts.

Talk is cheap. China may want to see some rather precise commitments from the US, not vague promises that strong growth and spending restraint will bring the deficit down. Similarly, the US will want more from China than a commitment that it eventually intends to allow greater exchange rate flexibility.

Yet even as China will want a clear signal that the US is serious, the US has to worry that, politically speaking, any hint that the US is raising taxes/ cutting spending because that it what China wants will make the politics of fiscal consolidation even harder.

Despite its political difficulties, the economic logic behind such a deal is pretty clear. China has not just been complaining about US fiscal deficits because it wants to deflect attention away from its peg. China holds a fair number of Treasuries. A big increase in the supply of Treasuries in future risks lowering the price of existing Treasuries: old-fashioned supply and demand. Moreover, cutting the current account deficit requires cutting the gap between what the US saves and what it invests, and China probably figures that if the entire change has to come from rising private savings (falling private consumption) and falling private investment, then the need rise in the renminbi will be "brutal." The renminbi has to rise significantly in any case, and China will take losses (paper losses some say, though that is a bit too simplistic) on its existing dollar holdings when the renminbi appreciates -- but it presumably would prefer smaller paper losses to larger paper losses.

And on the US side, steps to cut the fiscal deficit will tend to reduce US domestic demand growth. That is necessary to bring the trade deficit down. But it would be good for the world, not just the US, is other countries picked up the slack and started contributing more to global demand growth as the US starts contributing less. A revaluation in China -- combined with other policy steps in emerging Asia to spur private consumption -- would help pick up some of the slack.

It goes back to Keynes’ idea of adjustment by both the surplus country (China) and the deficit country (the US), rather than adjustment by just the surplus country or just the deficit county. Adjustment by the surplus country alone -- a Chinese revaluation without any change in US policy to reduce its need to borrow savings from the world -- risks leading to large rises in US interest rates, as China would have less savings to lend to the US, while the US need for savings would remain unchanged. Adjustment by the deficit country alone -- a US fiscal retrenchment without any offsetting changes in the rest of the world -- risks leading to a contraction in global demand and slower global growth. That would slow US export growth: the trade deficit would fall, but because of falling imports, not rising exports ...

Symmetric adjustment will not be easy, not the least because adjustment, no matter how necessary or orderly, is still adjustment. America is over-investing in new housing stock, China looks to be over-investing in new export capacity. Too many Americans now work in real estate, in some form or another; too many Chinese will soon work in China’s export sector (and too few supply China’s underdeveloped domestic market). Changing those patterns will hurt some people.

Don’t get me wrong, there is a reason why policy makers are reluctant to act. Even if they believe the current situation is unsustainable, initiating any move toward a more sustainable equilibrium is risky ... but so is not moving.

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