The Threat to the Muddle-Through Period

If the Chinese allowed the renminbi to rise, would that make the USA better off? That’s the contention of a cabal of critics from Senators to Nobel laureates. Paul Krugman wants to see a 25% tariff on Chinese goods. Today we examine that idea, and look at the real problems that we face. If only it were so easy. The numbers just don't add up. The fault, dear Brutus...

The Threat to Muddle Through

I’ve pretty well laid out over the past decade that I think the US will Muddle Through what promises to be a period of below-trend growth and a long-term secular bear market. It won’t be pleasant or fun -- there will be a lot of pain -- but we’ll get through the coming crisis (note: I think the Big One is still in our future). That’s what we do in a more or less free-market world. But, as I wrote seven years ago and have written since, there’s one caveat that turns me from a Muddle Through-er into a real doom-and-gloom type, and that’s the threat of protectionism and trade wars. As in Smoot-Hawley, which made the Depression into something much worse than it should have been.

Yet that’s the prescription that Paul Krugman is advocating. In a commentary in Sunday's New York Times (Taking on China), he called for an across-the-board 25% tariff on Chinese goods:
 

In 1971 the United States dealt with a similar but much less severe problem of foreign undervaluation by imposing a temporary 10 percent surcharge on imports, which was removed a few months later after Germany, Japan and other nations raised the dollar value of their currencies. At this point, it's hard to see China changing its policies unless faced with the threat of similar action -- except that this time the surcharge would have to be much larger, say 25 percent.

Krugman doesn't think the Chinese can really retaliate by dumping their hoard of dollars. He points out:
 

It's true that if China dumped its US assets the value of the dollar would fall against other major currencies, such as the euro. But that would be a good thing for the United States, since it would make our goods more competitive and reduce our trade deficit. On the other hand, it would be a bad thing for China, which would suffer large losses on its dollar holdings. In short, right now America has China over a barrel, not the other way around.

I probably shouldn't take on a Nobel laureate who got his prize for his work on trade, but this truly scares me. People pay attention to this nonsense, including the five Senators led by Schumer of New York who want to start the process of targeting China.

First, the Chinese have got to be wondering what they have to do to make these guys happy. In 2005 they were demanding a 30% revaluation of the Chinese yuan. And over the next three years the yuan actually rose by 22% at a gradual and sustained pace. Then the credit crisis hit, and China again pegged their currency. From their standpoint, what else were they to do? Force their country into a recession to appease our politicians?