Snowed Under

As the Labor Department reported employment falling last week -- in the midst of what the White House is calling a strong economic recovery -- Secretary of the Treasury John Snow traveled to Japan and China, where he and his request for more flexible exchange rates were buried beneath the treacly politeness Asia employs when handling irritating Western barbarians.

One factor behind the loss of U.S. jobs, particularly manufacturing jobs, is the enormous and seemingly ever-growing U.S trade deficit -- or to be precise, current account deficit. Having reached $244 billion for the first six months of the year, America's trade deficit is on track to top a record 5 percent of gross domestic product, and Japan and China together account for a whopping 35 percent of it all by themselves, with China last year having passed Japan to become the country with the largest trade surplus with the United States.

A significant factor behind these surpluses is the exchange-rate policy of each country. Since the bursting of its asset bubble in 1992, Japan's economy has struggled with an enormous overhang of bad debt and fundamental structural problems that have kept it mired in a deflationary near-recession for more than 10 years. Given its $70 billion-plus trade surplus with the United States, economic theory says there should be a tendency for the yen to rise in value against the dollar. And, indeed, that pressure exists. Yet the yen hasn't been rising relative to the dollar for a very good reason: The Japanese government has spent Y9 trillion (equivalent to $77 billion -- more than U.S. spending to date on Iraq) so far this year in order to prop up the value of the dollar and keep the yen cheap. This has enabled Japan to benefit from renewed growth in U.S. demand by raising its America-bound exports, thereby generating new growth and jobs in its domestic economy. Of course, this policy may undercut U.S. producers and serve as a barrier to their exports, but at the same time, it supplies American consumers and intermediary producers with very inexpensive products -- holding down inflation and encouraging continuation of the great American consumption boom.

China's currency was set at a fixed rate of 8.5 yuan to the dollar in the mid-1990s as a way of providing stability to China's primitive financial markets and reassuring prospective foreign investors. In the wake of the 1997 Asian financial crisis, some feared that China would devalue its currency in order to remain competitive with other Asian exporters whose currencies had fallen dramatically against the dollar. At the time, the United States urged China to keep the yuan pegged to the dollar and eventually gave it warm thanks for doing so. Over the years, however, China's productivity has grown rapidly, and most economists agree that the yuan is now 20 percent to 40 percent undervalued relative to the dollar. Just as with the Japanese yen, this yuan undervaluation accelerates Chinese exports while inhibiting dollar-denominated exports. But while it exacerbates the U.S. trade deficit, it also holds down U.S. inflation and provides American consumers with a bounty of inexpensive goods.

Many factors -- including the rise of the Internet and other productivity-enhancing technologies, plus wage and salary differentials between the United States and developing countries such as China and India -- have caused the loss of U.S. manufacturing jobs. These structural factors are more important than the exchange rates but are less easily addressed. Thus, in the face of rising complaints from labor unions and organizations like the National Association of Manufacturers (and with the presidential election just one year away), the White House sent Snow to Asia to make noise about undervalued exchange rates.

That he wasn't serious was evident from his first stop in Tokyo. After emphasizing how important flexible exchange rates are to ensuring that U.S. firms are not disadvantaged, Snow listened while Japanese officials explained that, despite a 50 percent surge in Japan's exports to China, they could not desist from intervening in the currency markets to maintain a weak yen as long as the Chinese yuan is undervalued. Snow then went on to commend Japanese Prime Minister Junichiro Koizumi on his policies, vision and leadership.

The story was similar in China except that Snow didn't get to see that country's prime minister; instead, he was shuffled off to meet with lower-ranking officials, who agreed with him that exchange rate flexibility is a good idea -- in the long run, but not now. As one Chinese official told me, "We think we are managing the United States pretty well right now."

If Washington were really concerned about the issue, it could actually take strong action. Under the rules of the World Trade Organization, it is illegal for a country to manage its currency in such a way as to effectively subsidize its exports. So a next step could be for the United States to file a formal complaint with the WTO.

But don't hold your breath. In fact, the United States is very ambivalent about the situation for several reasons. For one, Chinese exports are not displacing American manufactured products nearly as much as they are displacing imports to the U.S. market from Mexico and other developing countries. The United States no longer makes much of what China produces, but Mexico and Indonesia do, and they are getting hit hard by China's U.S.-bound exports. (In this regard, Washington should be more concerned about Japan than China because Japanese exports are more directly competitive with products still produced in America by Americans.) Furthermore, much if not most of the production heading from China to the U.S. market is coming from the factories of American companies in China -- and those companies like the currency the way it is.

More important than either of these considerations, however, is the fact that the United States is highly dependent on a steady inflow of dollars from both China and Japan to buy the U.S. bonds and other assets that fund the U.S. budget deficit and current account deficit. Think about it this way: In order to keep the U.S. dollar strong and interest rates low, Snow has to find about $2 billion every day. Imagine Snow waking up each morning and having to figure out where that money will come from -- but then remembering that it will come from Japan and China. As long as the United States runs federal budget deficits and has low domestic savings rates, it will have a current account deficit and will be dependent on capital inflow from abroad, mostly from China and Japan. And that's not to mention the fact that we also want those countries to help us with North Korea and Iraq. Which is why no American treasury secretary or president is going to mean it when he talks about getting tough with either China or Japan.

And yet two serious problems remain: The Mexicos of the world cannot compete with China and are likely only to become further impoverished unless we find some way to soften the blow of undervalued Asian currency to their economies. Beyond that, economists are unanimous in agreeing that the U.S. current account deficit cannot expand indefinitely. At some point China and Japan will run out of U.S. assets to buy or become very cautious about buying more -- while demanding a higher and higher return. At that point, the whole house of cards could come tumbling down. Maybe then Japan and China will agree to flexible exchange rates. But by that point it will probably be too late.

Clyde Prestowitz is the author of Rogue Nation: American Unilateralism and the Failure of Good Intentions. He is also president of the Economic Strategy Institute, a nonprofit research organization in Washington, D.C.

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