The escalating calls for China to rebalance its currency are based on deeply flawed assumptions and will only make Americans pay more for their favorite products -- like iPhones.
Pick something up from your desk or countertop, anything at all. Chances are that it was made in China. We just tried that experiment -- and our clock and stapler came from Chinese factories, along with $296 billion of other goods imported into the United States last year.
Those imports are the driving force behind calls for a stronger Chinese yuan and the renewed threat of a congressional bill to add a 27.5 percent tax on Chinese products -- calls that China has pushed back against, with Premier Wen Jiabao reiterating the country's determination to keep the yuan "basically stable." And both are based on the assumption that if the yuan is more expensive relative to the dollar, U.S. domestic production will rise and the U.S. trade imbalance will fall. But neither assumption is correct.
For one, U.S. domestic production is actually rising -- even if employment in manufacturing is not. The percentage of jobs in the sector has dwindled from 20 percent of the total in 1979 to 10 percent today, not due to China so much as U.S. innovation. Over time, manufacturing has become more automated and efficient, and factories now produce more goods with fewer workers (many of whom have transitioned into the service industries). The United States today produces nearly a quarter of all global goods, up from about a fifth a decade ago -- even with fewer employees. The problems of the American factory worker are real, but cannot be solved with trade embargoes against Beijing.
China's dramatic manufacturing growth over the same period makes it look like Guangzhou has stolen jobs from Detroit. But the growth of China's manufacturing sector, and its accompanying jobs, came at the expense of other countries in Asia, not across the Pacific. Televisions and audio equipment that once came from Japan, for instance, are now made in China. By 2007, Japan produced 6 percent less of the world's goods than it did in 1995 while China produced 7 percent more, rising to an 11 percent share of the global total. Goods once made in Thailand, Malaysia, and Singapore are increasingly made or assembled in Chinese factories. What is striking about all those items on your desk is not how many are made in China, but how few are made in other Asian countries, even ones with low-cost workers and friendly trade policies.
Making Chinese products more expensive in the United States will do nothing to shift production to U.S. factories. Let's say that a certain kind of cell phone costs $100 if made in China and $200 if made in the United States. Using tariffs to increase the price of the Chinese version to $130 does little to make the domestically produced version more attractive, and nothing to encourage local hiring. Furthermore, increasing the value of the yuan does not increase U.S. exports by making them cheaper abroad. If the yuan rises in value, it does not spur Germans to start driving Fords.
Plus, a strong yuan in many cases means higher costs for U.S. goods, too. A large proportion of goods imported from China are not end-state products, but components ready for assembly. A U.S. auto manufacturer that uses Chinese car seats, for instance, pays more for the seats under a strengthened yuan and then either cuts into its profits or charges higher prices on the finished vehicle. Domestic clothing companies loudly protested a proposed tax on imported cotton fabrics for precisely that reason. If the prices of Chinese components (like fabric) and simple goods (like buttons) rise, the prices of finished products made primarily in the United States rise in turn. All that does is increase costs for American consumers.
A rise in the yuan, though, would nudge production toward other developing countries, giving the United States an artificial indicator of success: the trade deficit specific to China would fall. But the overall trade imbalance would likely actually worsen. To buy the same $100 phone, an American would send $130 to Beijing or perhaps $120 to Singapore. In either case, more dollars would go abroad for the same goods.
In the case of an iPhone, the real cost in the store is closer to $300 -- but very little of that money goes to China, whose workers assemble the device. That final step adds just $4 of value to the phone, whose components come from other countries. Singapore builds the core processor, and the United States provides the touch screen -- and keeps most of the profit. If the proposed 27.5 percent tax applies only to the $4 assembly, the overall cost will rise just one dollar, hardly affecting consumer choices. But if it were applied to the whole phone, pushing the price closer to $400, any drop in demand would cause greater losses to American firms than to Chinese ones.
The trade deficit will not improve even with goods made entirely in China if the tariff (or increased value of the yuan) exceeds the impact on consumer demand. When Chinese goods leap in price 30 percent, Americans cut back their purchases. Imagine that before the price increase, every day 10 Americans bought a shirt for $10. At the increased $13 price, though, two of them (20 percent) decide to skip the purchase. The other eight now pay a total of $104 -- more than all 10 did before. The rising prices make the trade deficit worse because it takes more money to buy fewer items.
Still, it remains the rule that policy recommendations about exports focus nearly exclusively on currencies -- ignoring the economic realities. For instance, about 90 percent of U.S. production is consumed domestically, so any move that increases the cost of production is borne primarily by Americans. Moreover, policy recommendations about exchange rates neglect the fact that foreign exchanges are high volume and highly volatile, hardly providing a solid foundation for Washington initiatives.
There is a better way to improve the U.S. trade deficit and help American workers and consumers. To do so, Washington needs to help provide opportunities for U.S. exporters.
A better economic grounding can be found in the exchange of actual goods and services. Because U.S. manufacturing output has grown but domestic demand has wavered, foreign markets offer a natural opportunity. China often protests that it would like to import more from the United States, but there are excessive U.S. export controls -- such as on security-related goods, like closed-circuit cameras. The White House estimates than more $40 billion in additional goods could be sold annually without any threat to national defense.
There is also truth to Washington's claim that Beijing could do more to open its markets to U.S. goods and that so doing would benefit both Chinese consumers and U.S. producers. For instance, the United States has world-class companies in fields such as express delivery, financial services, consumer safety, and medical products -- services and products in demand in China. But China restricts the activities of foreign firms and has currency controls that make it difficult for mainland companies to buy U.S. services. Removing such impediments would heighten trade as much as $60 billion a year, Oxford Economics estimated in 2006.
Further gains could be made through increased Chinese enforcement of intellectual property protections and patents, improving the demand for genuine American products. Unlike import tariffs, which China has met with retaliatory measures, market access and product protections are areas where China has shown a willingness to negotiate for mutual benefit.
That benefit might prove substantial, if pursued on a wiser course than through currency intervention. The currency market is enormous and volatile, and it is a poor place to pin hopes for stable improvement. The United States and its skilled workers will see more success by focusing on improving ways to get their goods and services to the billions of people who want them.