It appears the honeymoon with China is over-will we skip marital bliss and head straight for divorce and, if so, how ugly will it get?

It appears the honeymoon is over-will we skip marital bliss and head straight for divorce and, if so, how ugly will it get? On July 21, 2005, China announced that it would revalue its currency, the yuan, by 2% and allow it to float more freely (though not completely freely) in order to permit the market to play a greater role in its valuation. A visit to the U.S. by Chinese President Hu Jintao was planned, and the currency regime adjustment was widely seen as an attempt by the Chinese to set a cooperative tone for the meeting. It worked. Rhetoric on all sides softened considerably. A bill sponsored by a democrat (Charles Schumer of N.Y.) and a republican (Lindsey Graham of S.C.) to levy a 27.5% tariff on all imports from China was shelved.

Then Hurricane Katrina hit. The visit by President Hu was cancelled due to President Bush's hectic, hurricane-related schedule. More importantly, the U.S. economy appeared to take an immediate hit, and predictions of longer-term impact did nothing to quell the notion that the U.S. economy does not have the strength to maintain its one-sided trade relationship with China.

No Quick Fix

Many months have passed since the Chinese currency regime change, and people are beginning to notice that the yuan has barely moved since being allowed to move more freely. With Katrina having depleted what little patience existed in the first place, we are already beginning to hear renewed calls for protectionist action, including the reintroduction of bills like the one sponsored by Sens. Schumer and Graham.

What to make of it all? American protectionists point to China's enviable economic growth rate (averaging 8% annual growth over the last two decades), burgeoning foreign exchange reserves (US$700 billion and counting), huge trade surplus with the U.S. (US$162 billion trade, the largest bilateral deficit among all U.S. trade partners) and the loss of American manufacturing jobs (estimated at 3 MM since the bubble burst in 2001) to support the position that China is an economic power that is unfairly taking advantage of America.

China, on the other hand, points to its low per capita GNP ($1200 vs. $30,000+ in the U.S.); its own enormous unemployment problem (real unemployment is estimated to be well over 10% as a result of workers displaced from the collapse of communist, state-owned enterprises); its trade deficit with Japan, South Korea, ASEAN and other nations; and its rapidly growing imports to support the position that it is still a highly impoverished country that is competing as freely as it can given the frailty of its young economy.

Many observers (including this one) doubt that China will move its currency enough in the short term to satisfy those who want to see drastic action. Against this we have the growing resolve of those who insist drastic action is necessary. This is beginning to look like an immovable object against an unstoppable force. Did somebody whisper "trade war?"

What Next?

I'm not an economic historian, but as best I can recall the last time the U.S. instituted such dramatic, across-the-board tariff increases was the Smoot-Hawley Trade Act, which is credited, among other things, with contributing to the 1929 stock market collapse and the Great Depression. Oops.

Maybe it won't come to that. Perhaps a confrontation can be avoided. Or maybe a trade war is actually a good idea-we can level the playing field once and for all. Whatever the future holds, it is likely we will be hearing much more on this subject in the months ahead. While space constraints do not allow me to thoroughly represent both points of view, I would, for the sake of discussion, like to use the remainder of this column to make a few points to those who think we ought to "get tough" with the Chinese.

Don't hold your breath waiting for those jobs to come back. China isn't the only option out there. With the ideological death of communism, a much larger portion of the world now sees capitalism and participation in the global trade system as the only route to freedom and prosperity. China has 1.3 billion people, which is roughly the same number of people as India and Central/Eastern Europe combined. Those regions are gaining momentum and are already on the radar screens of major companies whose investment patterns help drive trade flows. The drive for lower costs will continue regardless of whether we "punish" China or not.

Sell your Boeing stock (and perhaps the market as a whole). China will not sit passively if America takes action. Beijing will reciprocate, and Boeing's loss will be Airbus's gain. But that's not the half of it. In most major engineering/technology-related sectors, from electronics to pumps and valves, 70% of the exports from China come from foreign-invested companies. Those companies will take a serious hit to their profits. That might seem like a good way to punish corporate America for sending American jobs overseas, but when overall investment in both the U.S. and abroad slows due to declining profits, this move might feel like we have cut off our nose to spite our face.

Open your wallets. When we instituted quotas on steel, the impact was felt directly in the price of cars (among other things). In the end, the cost of our imports is reflected in our cost of living. Trade wars have a price, and that price is paid by the people.

Let's solve the real problem. The global economy is out of whack. The U.S. likes to spend money and will borrow whatever it takes (at the individual, corporate and government levels) to keep on spending. The rest of the world likes to protect jobs, which it does by loaning the U.S. the money to keep buying its products. The problem is that the U.S. is up to its ears in debt and the rest of the world isn't really doing a great job of creating jobs (note double-digit unemployment in Europe and a 10-year recession in Japan). It turns out that neither over-stimulation nor mercantilism is a good way to manage an economy. In this environment, low-cost country sourcing can serve as a temporary replacement for actual increases in productivity, but that will only go so far. The real answers are fiscal-monetary restraint in the U.S. coupled with deregulation and market-driven reform in the rest of the world. Any other solution, including tariffs on Chinese products, will do little more than punish the wrong party, shift (without curing) the imbalance and further delay meaningful adjustments. Let's hope it doesn't come to that.

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