For more than a year now, Washington and Beijing have been locked in an escalating trade conflict. Media coverage typically dismisses the conflict as a "trade war" similar to dozens of others with Japan, Europe, and many countries, and urges policymakers to "make nice" and move on for the sake of the stock market. Both the stakes and the scale of this trade war, however, are fundamentally different than the trade squabbles that have come before. The current clash is nothing less than a battle of economic systems. The United States with its market-oriented trading system is attempting to establish some sort of trade parity with China's largely state-controlled system. The stakes for the United States, China, and the rest of the world could hardly be higher, and a "political solution" that puts off real change is simply not acceptable.
Numbers tell a great deal of the story. China is and is likely to remain--barring a massive unforeseen change--the United States' largest trading partner. It is far and away the largest source of U.S. imports, but only third on the list of markets for U.S. exports. And that is a large part of the problem. The United States steadily imports from China three and one-half times what it exports to China. The U.S. bilateral trade deficit with China is by far the largest in U.S. history and in human history. China has also grown, largely based on foreign trade and investment, into the second-largest economy in the world and may pass the United States within a decade for the top spot.
THE MACROECONOMIC PERSPECTIVE
The conventional wisdom has been that the trade deficit with China should be dismissed as merely the result of market forces penalizing the United States for spendthrift behavior. And there is an undeniable economic relationship between consumption, including government fiscal deficits, and imports. But why would an imbalance driven by bad fundamental economics be so pronounced with China and so much lower with market-oriented trading partners with which the United States also has a major trading relationship?
First, this trade deficit could be driven as much or more by Chinese efforts to restrict consumption in order to build up its industries, rather than by U.S. fiscal deficits. In other words, it might just as easily be said that China does not consume and import enough as that the United States consumes and imports too much. Particularly for an economy at its stage of development with so many of its citizens still in poverty, China should consume and import more. The accounting identity that links imbalances in the U.S. capital account with an offsetting imbalance in the current account (or dissaving and imports) is just an equation--it does not assign blame or indicate appropriate policy.
Further, a primary mechanism by which trade flows are supposed to balance over the long term is through the adjustment of currency exchange rates. A trade surplus should lead to a country's currency, which is used to purchase imports from the country, becoming more valuable (stronger) relative to other currencies. The stronger currency should increase the price of that country's exports and decrease the price of its imports, which pushes down the trade surplus. In theory, this currency adjustment should limit China's trade surplus with the United States.
Unfortunately, this mechanism relies on currencies that adjust in response to market conditions. The Chinese currency--the RMB or yuan--is pegged to the dollar by the Chinese government. It only adjusts in response to decisions made by the Chinese government, not the market. The Chinese RMB has been persistently undervalued for decades as part of a Chinese export promotion strategy and has been identified as such by the U.S. Treasury without meaningful remedy. In recent months, the RMB has deteriorated markedly, losing more than 10 percent of its value relative to the dollar. As a result, the U.S. trade deficit with China could actually rise in response to RMB depreciation.
THE MICROECONOMIC PERSPECTIVE
At the level of individual industries, China also does not play by free market rules. China's grand plan to dominate ten high-value manufacturing industries, including semiconductors, robotics, and aerospace, known as "China 2025," has drawn considerable criticism in recent...