The Magazine

Worry About OPEC, Not China

If a stronger dollar is what you want.

Dec 25, 2006, Vol. 12, No. 15 • By IRWIN M. STELZER
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Mission impossible. That's the best way to describe Secretary of the Treasury Hank Paulson's just-concluded trip to Beijing, ostensibly to persuade the Chinese to do something to whittle down their huge trade surplus with the United States. Paulson and his colleagues--the delegation included the commerce, labor, health and human services, and energy secretaries in addition to the U.S. trade representative, the administrator of the Environmental Protection Agency, and the chairman of the Federal Reserve Board--don't have much of substance to show for their 13,000-mile round trip. Indeed, if their aim really was to pursue that oft-stated goal of U.S. policy, a "strong dollar," the delegation that the Wall Street Journal derisively labeled "the biggest economic expedition since Marco Polo's" should have been rerouted to Riyadh.

While the Chinese have been accumulating dollars at the rate of about $200 billion per year, high oil prices have driven oil exporters' trade surplus with America to $500 billion annually. These oil producers, members or fellow travelers of the oil cartel that is keeping prices above competitive levels, are feeling put upon because the dollars they are getting for their oil now buy fewer pounds to spend in Harrods, and fewer euros to spend on the necessities of life in the south of France. Worse still, the dollars they have already accumulated are declining in value.

To protect against further declines, the oil producers are diversifying out of dollars and into other currencies, most prominently euros and Japanese yen. The central banks of the members of the OPEC cartel cut their dollar-holdings from 75 percent of total reserves in 2001, to 67 percent at the end of the first quarter of this year, and again to 65 percent at the end of the second quarter. That increased the downward pressure on the dollar, pressure that was alleviated a bit at week's end by two developments: It became clear that the American economy is sufficiently strong to make it unlikely that the Fed will soon cut interest rates, and it was announced that the trade deficit for October fell by over $5 billion.

The problem created for U.S. policy by the oil producers' dollar-holding is that many of these countries are outright hostile to America--Venezuela, Russia, Iran--and others might wreak havoc with the dollar should the Palestinian-Israeli crisis flare up, putting pressure on Arab regimes to inflict pain on the United States. The fact that any dollar-dumping would also harm the Arab states is irrelevant: The Middle East is not a region in which economically rational behavior consistently trumps self-inflicted wounding.

The problem with China is of a different sort. To the consternation of many politicians, its policy of pegging the yuan to the dollar undervalues the Chinese currency. This gives Chinese exporters a de facto subsidy, and makes made-in-the-USA goods, as well as those produced in Europe and Britain, more expensive in China. China has allowed the yuan to rise in value by almost 6 percent since mid-2005, but with no discernible effect on its huge trade surplus.

Paulson's mission is impossible for two reasons. First, the Chinese regime's overwhelming priority is to stay in power. That means providing jobs for the 300 million farmers expected to move to the cities in the next 20 years, which in turn means the government will under no circumstances allow the yuan to rise to a level that cuts sharply into exports.

Second, even if Paulson could persuade the Chinese to allow their currency to appreciate to a point where made-in-China merchandise became more expensive in America, the effect on the trade deficit would be trivial. American consumers would simply shift to goods manufactured in other countries in which labor costs are far lower than they are in the United States.

Still, Paulson's trip probably was worthwhile, although the exaggerated importance it took on as a consequence of the Bush administration's decision to bloat the delegation with cabinet members and to enhance its prestige by persuading Fed chairman Ben Bernanke to join the junket probably created expectations for success that were unattainable. My guess is that some bright blade in the White House thought it would appease the president's congressional critics if Bush sent a large delegation to prove he feels the pain of those who have lost jobs because of imports. Still, the 61-strong team of cabinet members-plus-aides was outnumbered by the 86 Chinese accompanying their lead negotiator, the tough, well-regarded vice premier, Wu Yi.

Paulson is clever enough to distinguish the practically attainable from a political wish list, which is why he put the word out that his trip was designed to open a two-year "Strategic Economic Dialogue" with China, not to produce a floating yuan. The Chinese are well aware that their mercantilist policy of accumulating foreign currency creates problems for them, and that their standard of living would be better if domestic demand grew so as to reduce their need to export. Wu Yi--after a diatribe about past grievances, starting with the opium wars (a traditional Chinese opening gambit beautifully described by Margaret MacMillan in her new book Nixon and Mao: The Week That Changed the World)--said that the regime is in the long run seeking a "rough balance" between imports and exports. But the Chinese authorities can't figure out how to get from here to there--how to achieve that goal without creating huge unemployment during the transition from an export-led to a more balanced economy.

Paulson hopes to change the conversation from a shouting match over the undervalued yuan to a "dialogue" ranging over joint interests in increasing world oil output, reducing the environmental degradation incident to China's inadequately green policies, improving labor standards in Chinese factories, protecting intellectual property rights, and opening markets to U.S. imports. Apparently unaware that previous "road maps" drawn up by the administration have not led anywhere, Commerce secretary Carlos Gutierrez called for still another "road map," this one to direct China to a more market-oriented economic model. If that's the destination China's rulers have in mind, Paulson is the man to help them find the way. Of course, they knew that before he and his entourage came calling last week on a mission designed more to quiet protectionist Democrats than to have a real impact on America's trade deficit.

Irwin M. Stelzer is a contributing editor to THE WEEKLY STANDARD, director of economic policy studies at the Hudson Institute, and a columnist for the Sunday Times (London).