China's Currency Manipulation

We've all been hearing lately about how China has been manipulating its currency.

China, of course, viewing the US as both a key trading partner but also a rival threatening its own economic, political and military interests, did not just change its tune on Iran because it was the "right thing to do" for an emerging superpower. Some experts believe the key motivation behind the move is the US' willingness to go slow on accusations and trade sanctions based on continued RMB manipulation, which make China's exports cheaper than they should be under a truly floating currency. In other words, if the US punts on a tough line economic policy with China, the communist giant will support our foreign policy agenda to isolate a severe military threat not only in the middle east, but worldwide.

How does China manipulate its currency? What is the effect of that manipulation, and is there anything the U.S. can do to control their manipulation? The mechanism of China's currency manipulation lies in its trade policy. When China sells goods in the U.S. they get paid in U.S. Dollars. After all, that's our currency. Now, in normal free trade, the Chinese would turn around and buy some of our goods with their new wealth. China is different. First, the Chinese government uses coercive taxation and regulations to discourage spending and encourage savings. As a result, Chinese citizens have a savings rate of about 40%. Our savings rate is near zero.

Instead, the Chinese use their new wealth to buy our securities like U.S. Treasury bonds, mortgage bonds, and real estate. This reduces, artificially, the supply of dollars and thus strengthens, artificially, the dollar. By doing so, their goods are cheaper here and ours are more expensive there. This, in turn, artificially gives the Chinese a larger trade surplus against the U.S. This keeps more jobs in China.

The United States allows this willingly. First of all, our government has an insatiable appetite for debt. The U.S. can't stop spending and its being financed, in large part, by the Chinese. A side effect is that all this debt financing gives the Chinese a stronger trading position. Second, the U.S. imposes no penalties or pain on foreigners buying our securities. The Swiss once faced a similar problem and their manufacturing suffered. So, the Swiss imposed heavy taxes on foreigners buying their debt and that financing went down significantly.

The U.S. faces a more complicated problem. The U.S. needs as much foreign debt purchases as we can afford because without it interest rates will shoot up. Another idea is to increase U.S. citizens' savings rate. This seems to be an idea that's easier said than done. So, I asked Ian Fletcher, author of the book Free Trade Doesn't Work, what we can do. Following through on his trade policy proposal, Fletcher says that tariffs would increase savings rates.

Think of savings production minus consumption. So, adding tariffs would decrease consumption. That would increase savings. By doing so, our governments' insatiable appetite for debt could be financed in larger part by our own citizens. China would be in a smaller position to manipulate its currency. Our trade deficit would decrease.