The US and China opened their twice yearly Strategic Economic Dialogue with currency issues on the front burner:

BEIJING (AP) – The deepening world economic crisis and a possible spat over currency levels hung in the air as the United States and China sat down Thursday to discuss the future of their economic relations.

U.S. officials say Treasury Secretary Henry Paulson will press Beijing to let its yuan rise against the dollar to ease trade tensions at the two-day Strategic Economic Dialogue. American companies contend that China keeps the yuan undervalued, giving its exporters an unfair advantage and adding to its swollen trade surplus.

The Chinese sent a clear message earlier this week when they let the Yuan fall the daily limit against the dollar Monday and Tuesday. This is dangerous ground we are treading. US politicians have threatened tariffs before if China didn’t allow the Yuan to rise. They are apparently still convinced, despite the evidence, that we can devalue our way to prosperity.  That hasn’t been a brilliant strategy to date but we seem intent on doubling down and finding that magic exchange rate that will solve our trade deficit “problem”.

Our trade deficit, if it is a problem at all, is our problem not China’s. It is in our power to solve the trade deficit or at least reduce it dramatically with no help whatsoever from our currency manipulating Chinese creditors. All we have to do is consume less and save more. The root of the trade deficit is not the exchange rate – it’s the savings rate. The Chinese have allowed their currency to appreciate by 20% against the dollar in the last year with no discernible affect on our balance of trade. That approach is obviously not working or at least not doing enough to dramatically alter the balance. The exchange rate does affect trade, but it is only one factor. If Americans continue to increase their savings and reduce their consumption the trade deficit will shrink.

Take a look back to the early 90s recession and you can see that when savings rebounded after the 1987 stock market crash, the trade deficit stablized and then shrunk into the recession:


As I said the currency has an effect too although evidence of it being positive is hard to find. From 1985 to 1988 the dollar fell by almost half and yet the trade deficit continued to rise:

From 1988 into 1989 the dollar generally rose and the trade deficit narrowed. From 1989 until the end of the recession the dollar fell and the trade deficit continued to narrow. What does that tell us? Not much. It’s tempting to say there is a lagged effect but that doesn’t hold up when you extend out to the 1990s:

The dollar was generally falling in the first half of the 90s and the trade deficit rose. The dollar rose significantly from 1995 to 1998 and the trade deficit rose more. The savings rate though was falling the entire time:

The exchange rate seems to be correlated sometimes and non correlated at others. It is obvioius that something else is driving the trade balance. The changing savings rate would seem to be a better explanation.

We have no leverage with the Chinese anyway. China holds about $800 billion of our debt and we can’t afford to tick off our biggest creditor just as we are about to spend a lot of money we don’t have. If we don’t get it from China, where exactly are we going to get the money for this economic recovery, infrastructure pork, green investment spendathon? It seems to me that China holds all the cards right now and Paulson is likely to have little success in convincing them to sacrifice their export business just so some politicians can brag about how they forced the bad Chinese to fix their currency to solve our problem.

The last thing we need right now is a trade spat with China. Imposing tariffs against Chinese goods would merely punish US consumers by rasing the price of imorted goods at a time when we have enough problems paying our bills. Yes, it will hurt China too, but don’t we want to export things to them? If we reduce imports from them how will they get the dollars to buy our exports and our new bonds?

The new Obama administration needs to rethink our approach to trade with China and how to reduce the imbalance between our countries. The right approach is for both countries to concentrate on solving their own problems and pursuing their own best interests. And it isn’t in either country’s best interest to devalue their money.