Busting China Is Bad for U.S. Economy

Unfortunately for the American consumer, U.S. senators are once again threatening to raise tariffs on Chinese imports.

http://www.abcnews.go.com/Politics/wireStory?id=2436836

This threat is intended to force China to de-link their currency to the U.S. dollar. The belief among the senators is that a market valued Chinese currency will produce a rising value to the Yuan measured against the dollar. This will have the effect of increasing the price of Chinese goods in the U.S. and reducing the price of U.S. goods in China. (At least that’s assumption).

Of course, what could happen is that the Chinese producer might maintain their current prices measured in dollars and just accept lower profits. Other more deleterious outcomes are possible and more likely. By increasing the price of Chinese goods in the U.S., the move would contribute to higher U.S. inflation. This would, of course, force the Federal Reserve to more aggressively raise short-term interest rates. The current funds rate of 4.25 percent is the highest since the spring of 2001 Cheap Chinese goods have been an important factor restraining U.S. inflation and keeping short-term interest rates low.

Also, the large trade imbalance with China has meant that the Chinese central bank has accumulated billions of U.S. dollars over the past several years ($19 billion per month recently). They have used these dollars to buy U.S. Treasuries, particularly long term instruments. This action raises the price of U.S. Treasuries and lowers the yield (or effective interest rate) on them. This has produced low long-term interest rates which has been an important factor bolstering the U.S. housing market.

While it is certainly correct that allowing the Chinese Yuan to float or erecting tariffs would likely lower the U.S. trade deficit with this very large trading partner, the Bush Administration and Secretary of the Treasury Paulson must be prepared to deal with some of the negative consequences. I do support a market determined Chinese currency if it is done over a lengthy time period. However, erecting tariffs is not an effective method of lowering the trade deficit.