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Geithner thinks our trade problems with China are solving themselves
Howard Richman, 3/4/2011

In testimony before the Senate Foreign Relations Committee on March 2, U.S. Treasury Secretary Timothy Geithner explained why he thinks that market forces will balance U.S. China trade without the Obama administration having to do anything more than talk. Here are some selections:

China understands they can no longer depend on demand from United States consumption being such a substantial contributor to growth. So, they have no alternative but to shift their growth strategy to a growth strategy that relies more on domestic demand.

"They are moving in that direction but it can't happen unless they let their exchange rate move too. If they don't let their exchange rate move, it will work against that imperative in rebalancing. It is not just China, it requires a bunch of other countries that traditionally run large surpluses to make those same changes."...

"It is essential for China that they move. If they do not move they will face the risk of much more rapid inflation, much more risk of financial crises. That is why they are beginning to adjust now. They have not moved that far yet ... in real terms against the dollar the currency is now moving at an annual rate of 10 percent a year.

"(The yuan) is still undervalued substantially, they have not moved very much yet. (But) we want this to be sustained over time, and we are going to continue to use every tool of persuasion we have directly and multilaterally to encourage them to move more quickly.

"It is inevitable it is going to happen. It is either going to happen through more rapid inflation, in which case in real terms it is moving in our direction, or it will happen because the exchange rate appreciates more rapidly. But the real annual rate against the dollar is north of 10 percent a year. If that were sustained that is a huge shift over time."

I agree with Geithner that the U.S.-China trade balance will improve in the short-term. Federal Reserve Chairman Bernanke gets the credit. His massive buying of U.S. long-term Treasury Bonds (QE2) has made long-term U.S. Treasury Bonds such a bad investment (due to anticipated future inflation) that many investors are sending their savings out of the United States, including to China.

This has been causing a huge problem for the People's Bank of China. In order to manipulate currency values, it not only has to buy enough foreign financial assets to overcome China's trade surplus, but now it also has to buy enough to balance this Bernanke-caused inflow of private financial capital. These increased purchases of foreign financial assets contribute to China's growing inflation. (Basically, the People's Bank of China is printing the yuan that it uses to buy the dollars that it uses to buy these assets.)

But QE2 can't go on forever. It will soon cause considerable inflation in the United States, probably starting this year. Bernanke will be forced to end the program. He will be forced to cut back by growing U.S. inflation.

Geithner's mistake is a basic misunderstanding of economics.  He is living in a dreamworld in which market forces eventually end mercantilism. This is indeed what classical economists throught, beginning with David Hume. Geithner hasn't yet figured out that the modern version of mercantilism, in which the mercantilist countries lend the earnings of trade back to the trade deficit countries, is largely impervious to market forces. In contrast, Bernanke's strategy for fighting mercantilism will soon be prevented by the market force of growing inflation.

Unlike Geithner, I don't expect that China will give up its mercantilist strategy. The twin goals of mercantilism are economic growth and political power. By buying our financial assets (the key step in currency manipulations), China grows its own economic and political power while shrinking ours. Why should it give up that successful strategy when it is causing Chinese power to grow and the power of their western adversaries to shrink? China will indeed slow down its mercantilism, but the slow down will be temporary, because the Bernanke-caused speed bump is just temporary.