Steering U.S.-China economic relations toward a new normal

By Steven Pearlstein
Wednesday, June 30, 2010

Let's take a moment to note that stock prices fell sharply Tuesday in part because of a downward revision of leading economic indicators -- in China.

I suspect that Richard Nixon and Henry Kissinger had no idea what they were getting us into 40 years ago when they first broached the subject of normalizing relations between the world's most populous nation and its richest. Nor could Bill Clinton and his team have foreseen how imbalanced an economic relationship they were ushering in with the deal that effectively opened U.S. markets to Chinese exports. If we had known then what we know now, we would have surely insisted on tougher terms.

Getting this economic relationship back into balance is the single biggest challenge to the global economy, not just because of its direct effects on China and the United States, but the indirect effects it has on the rest of the world. The alternative is a return to living beyond our means, a further erosion of our industrial and technological base and a continued loss of ownership of business and financial assets.

The essential problem is that China was allowed to gain full membership in the global market system without having in place the fundamentals of a market economy. Its business sector continues to be dominated by state-owned companies financed by state-controlled banks within the context of what remains a largely state-planned economy. Its government strictly controls the flow of capital in and out of the country, while its currency is manipulated to maximize export-driven growth and development. And while exports are subsidized, directly and indirectly, there exists a web of formal regulations and informal prejudices that make it difficult, if not impossible, for many foreign companies to sell profitably into its domestic markets. Those outsiders who manage to break through invariably find that they have few protections from a system that is larded with corruption and largely unconstrained by the rule of law.

None of this is said in anger or meant as a criticism of the Chinese -- as I've written before, they've done a masterful job at creating a modern industrial powerhouse and lifting millions of people out of poverty in the span of a single generation. The Chinese deserve our respect and admiration, and there is lots of mutual gain that can come from maintaining and expanding the economic ties between our two countries.

This relationship, however, is one that must be actively managed by the two governments. It should be obvious by now that their government is rather effective at managing their end of things. It should be equally obvious that we cannot continue to rely on free markets to manage our end.

Up to now, a succession of administrations has argued against directly challenging China over its mercantilist policies, figuring it would be more effective in the long run to let the economic relationship grow deeper and give the Chinese the time and respect their culture demands to make the inevitable transition to democratic capitalism.

What we have discovered, however, is that the Chinese don't view the transition as inevitable and that, in any case, they really aren't much interested in relationships. If anything, they've proven to be relentlessly transactional. And their view of business and economics remains so thoroughly mercantilist that they not only can't imagine any other way, but assume that everyone else thinks the way they do. To try to convince them otherwise is folly.

So if the urgent need is to rebalance the global economy by rebalancing the U.S.-China economic relationship, we are probably going to have to begin this process on our own. And that means establishing some sort of tariff regime that will increase the cost of imports not just from China, but other countries that keep their currencies artificially low, restrict the flow of capital or maintain significant barriers to imports of goods and services. The proceeds of those tariffs should be used to encourage exports in some fashion.

I'm not going to get into the technicalities of various proposals out there to do this and whether they comply with World Trade Organization rules. That's why God created trade lawyers. The important thing is to begin putting a new tariff regime in place, starting slowly so as not to unduly disrupt supply chains, but forcefully enough so that the Chinese understand we mean business.

For if there is anything we should have learned by now, it is that China is not going to open its markets and unpeg its currency until it is clear that the costs of not doing so will be even higher.

I agree with trade skeptic Clyde Prestowitz that the recent announcement by China's central bank that it would begin to let the value of its currency float upward looks now to be more of a "head fake" designed to divert criticism at last weekend's G-20 meeting than a serious change in policy.

And even Fred Bergsten, the pro-trade economist at the Peterson Institute, acknowledges that a policy that allows the yuan to rise a few percentage points against the dollar each year is barely enough to keep up with the difference in growth rates between the two countries. It will take a series of much more significant upward adjustments to compensate for a currency misalignment that Bergsten and his colleagues now estimate at as much as 40 percent.

The larger point, however, is that it's not just currency manipulation we need to be concerned with but a range of policies that have created and protected China's powerful export machine -- a machine that still relies on the United States to consume more than it produces and continue its addiction to cheap foreign credit.

The time for diplomatic patience and gentle prodding has passed. Using the tools we have available, we need to do what we need to do to rebalance, restructure and revitalize our economy. And we need to do it now.

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