According to conventional reason, The U.S. is concerned with Chinese policies that favor domestic firms and limits competition from foreign companies. The chief anti-competitive practice is the dollar-pegged exchange rate of the Renminbi. The ‘artificially’ low value of the Chinese currency is (in the words Fed Chairman Bernanke) a “subsidy” for Chinese exporters and the chief cause of the near $800 billion U.S. current account deficit. The  current account deficit is responsible for a growing and worrying ‘global imbalance:’ China recycles its trade surplus through buying U.S. treasury bonds. Without this recycling, the U.S. would not need to continue consuming nearly 7% more that it produces.

What did Paulsen want from China?

If only the market were allowed to work its magic on exchange rates—so says conventional wisdom—Chinese exports would become more expensive in dollar terms, and U.S. manufacturing more profitable, the trade deficit would close and demand for U.S. workers would surge, reversing the outsourcing trend that is becoming a political liability for the free trade consensus in the U.S. Paulsen therefore went to China to lobby the Chinese to float the Renminbi.

It is hard to believe however that this is the view that motivates Paulson. Few economists take this conventional wisdom seriously. For most it is “protectionist” nonsense, not the kind of nonsense a former Wall-Street executive is likely to entertain. Economists generally agree that the “China is cheating on trade” line is standing things on their head: the U.S. is in fact the beneficiary of the current trade imbalance. Effectively, China is working hard to produce useful stuff which it then ships over to the U.S. in return for paper (or rather electronic) dollars that it cannot use, but must instead loan back to the U.S. Moreover, since U.S. debt is denominated in dollars, China is trapped. The more dollars it holds the less they are worth, whereas the U.S. can always print as many dollars as it owes. China accepts this bad bargain because its economic and political stability depends on exports, but also because it accumulates in the process hard assets and valuable know-how.

The question on which opinions diverge most vehemently is the sustainability of the U.S. current account deficit. The “Cassandras”[1] warn of the day China and other countries are unwilling or unable to continue to buy treasuries. In 2006, the U.S. for the first time paid more to service its foreign debt than it received from its foreign investment. If current trends persist, the U.S. will be shipping abroad 2% of its GDP within a decade.[2] Sooner or later, the “Cassandras” argue, a more or less painful global readjustment would have to take place, lowering U.S. living standards through a combination of higher interest rates, a dollar decline, and a recession.

The “Panglosses,” on the other Hand, argue that the deficit is sustainable forever, or at least for a very long time. The Panglossian argument comes in a number of flavors. Louis-Vincent Gave[3] argues that the trade deficit reflects the enduring division of labor between the intellectually rich West and the labor rich South. Hausmann and Sturzenegger argue that an invisible factor of U.S. productivity, “dark matter”,[4] evens out the trade imbalance. “Dark matter” supposedly represents the superior knowledge that give U.S. companies a higher rate on return. The most mainstream position is represented by Levey and Brown[5] who argue that the superior economic dynamism of the U.S. allows for faster growth and a higher level of sustainable debt. According to this view, the U.S. attracts capital simply because it is so much better than other countries in creating it. Fed Chairman Bernanke popularized a variant of this theory when he referred to “the global saving glut” that pushes money into treasuries.

These Panglossian explanations share the neoclassical economist bias against taking political power into considerations. Henry C K Liu of Asia Times  shows how much of the deficit absorbing fast growth in U.S. assets is an artifact of the ‘dollar hegemony’.[6] The more the U.S. consumes, the more it forces its trading partners to finance it by buying dollar denominated assets. However, the income these assets produce cannot be used either. It has to be plowed back into yet more dollar assets. The result is capital gains in nominal terms. The debt is made sustainable by nominal capital gains that are an artifact of the fact the U.S. controls the printing press of the dollar. However, the printing press is but one aspect of U.S. hegemony. If one looks at the U.S. trade relation with China from a perspective of unequal exchange, ‘dark matter’ (and Gave’s brave new division of labor) is nothing other than power. The U.S. owns and controls capital—physical capital, technological and organizational know-how, and access to the consumer and financial markets. Higher profits are the result of market power (see my previous article on Veblen and Goodwill).

The U.S. earning a higher rate of return on its invested capital is the reflection of its hegemonic position in the global economy. The directions of flows reflects the relation of power. To see that, compare the current situation today to the relation between the British empire and the Far East and African colonies a century ago. Then as now the colonies shipped valuable agricultural and manufactured products back to the metropolis. What did Britain ship to India, China ands Africa in return for these goods? Except for Opium, Britain sent to the colonies mostly “civilization,” an insubstantial and highly overrated quantity that most people in the colonies experienced as back breaking labor and rank oppression.

The current globalization, being based on a façade of exchange between equally free agents, substitute dollars for civilization. But dollars are just as overrated. The trade terms, which effectively dictate that Chinese work hard while Americans party hard, are therefore unremarkable as far as they reflect a normal relation between (metropolitan) capital and (colonial) labor, a relation sustained by structures of ownership, military might and control of the global currency.

Yet understanding the current trade relations in terms of power means that the sustainability of the deficit depends on the sustainability of the U.S. hegemonic global position. On this, the Panglosses seem to be in denial. Conversely, the actions of the U.S. government can only make sense if one seeks their logic in the concern for maintaining hegemony. And here is the rub: the rhetoric of the free market in which all transactions involve exchanges of things of equal value masks the unequal relations of exchange between the U.S. and China. Nonetheless, this very rhetoric gives China a countervailing power former colonies did not have. The dollar, unlike British ‘civilization,’ is backed “by the full faith and credit of the United States.”

Thus, although the U.S. derives benefits from the fact that the dollar represents non-tradable market power from which only the U.S. can benefit, the U.S. cannot allow this aspect to fully overtake its tradable value. The contradiction of globalization under dollar hegemony is that the U.S. derives a premium from the debasement of the dollar even as the maintenance of its hegemony requires preserving the face value of the dollar. The relation between hegemony and currency debasement under dollar hegemony becomes essentially a dividend payout ratio issue, with the dividend being the trade deficit. The main question is one of management: can the U.S. replenish its hegemonic power faster than it must debase its currency in order to benefit from it?

 The main question is one of management: can the U.S. replenish its hegemonic power faster than it must debase its currency in order to benefit from it?

China is not a naïve market participant. Simple trade theory stipulates that trading parties maximize their benefits when each specializes in their respective area of comparative advantage. China’s only historic advantage is cheap labor. A market based approach of rational profit maximization would have led China to be the world’s factory floor and remain that forever. But China is not after short term profit maximization. The political leadership consciously manipulates the trade relation, sacrificing profits in order to entice the transfer of capital and know-how to China. There is nothing remarkable about that. It is called “industrial policy” and every nation used to have one as a matter of course. Control of capital and know-how, however, are the famous “dark matter” (i.e. power) whose ownership is fundamental to U.S. profitability.

 The U.S. therefore preaches that all nations forego industrial policies and let the market rule.

The acquisition of foreign reserves is part of the Chinese industrial policies.

• It produces fast growth in the capital base
• while simultaneously giving China financial leverage over the U.S.

The second result is simply a matter of size. Since the Asian financial crisis of 1997, all countries have adopted a defensive policy of maintaining dollar reserves. Reserves protect small countries from speculators, but at the cost of financing U.S. consumption and asset binges. China, however, is so big that its reserves become a factor in the value of the dollar by impacting the U.S. long bond rates.

 Chinese authorities have thus acquired power over the value of the dollar itself, the pillar of U.S. hegemony.

Capitalist profits, as Veblen argued, are the result of differential market power. The most important forms of market power results from the way the government structures the market through

• laws,
• regulations,
• licenses,
• monetary and fiscal policies and so forth.

Corporate profits depend on the ability to leverage governmental action on behalf of corporations. This is true nationally, as different coalitions seek to mobilize government to their advantage (e.g. the oil industry, the Military-Industrial Complex, agribusiness, etc.), and as all corporations act in concert to lobby against the interests of workers, consumers and small shareholders (labor laws, consumer protection, business regulation, unionization, and, last but not least, monetary policy). Internationally, governments are most often fronts for the most powerful national business coalitions against competing foreign capital coalition (think Airbus vs. Boeing).

The U.S. government represents a variety of competing industries with stakes in the Chinese Economy. One obvious point of contention, for example, is “intellectual property,” a class of assets whose character as a pure creation of government is more than usually obvious. “Intellectual property” is the legal right to monopolize the  sale of goods whose competitive equilibrium market price, based on marginal cost of production, is zero. Intellectual property is thus a revenue stream the U.S. effectively ‘grants’ its corporations. In contrast, Chinese businesses are emulators and need intellectual property to be as cheap as possible. This is a conflict of interests in which any talk of “free markets” is nonsense, since it is a conflict purely about the scope of monopoly rents. The U.S. has successfully bullied many smaller countries into enforcing intellectual property rights that benefit U.S. corporations but harms both their industries and their consumers. The U.S. however finds it difficult to bully China. This is the direct result of the aforementioned countervailing market power that China draws from being such an important creditor to the U.S.

The most important U.S. industry with a stake in China is the Financial industry (Wall Street). After decades of fast credit expansion, Wall Street is highly leveraged and depends on new markets to survive. There is little doubt that the underdeveloped and potentially huge Chinese markets are where Wall-Street’s future will be decided. China, however, is determined to keep foreign capital under tight leash, severely limiting potential Wall Street profits. The most important friction point is the “Rhenish” quality of Chinese capitalism: banks, not capital markets, provide most of the funding for new and existing businesses. Conversely, capital operations such as IPOs, M&As, LBOs and debt collateralization, Wall-Street bread and caviar, are very limited. This is particularly important to the Chinese government for political reasons—by the simple control of banks the communist government has a tight hold over the rising class of the Chinese super-rich.

China is so enticing, however, that Western companies are rushing into China despite the limits imposed on profits. Nevertheless, the independence of the Chinese government relative to Western business interests represent a severe risk factor. Government determines profits, and profits determines asset valuations. Investing in a country where the investors class does not control the regulatory and legal landscape is therefore highly risky, and risk reduces value. The interests of Wall Street in China are therefore straightforward:

• first, to replace Chinese banks with capital markets, developing derivatives, M&A, IPOs, debt collateralization, consumer credit, and all other specialties;
• second, to shape the legal and political landscape of China according to the U.S. template in which the government obeys the big business interests.

Wall Street, however, must rely on U.S. muscle to force trading parties to reshape their economic system to the benefit of Wall-Street. It is therefore not surprising that one finds on Paulsen’s Chinese agenda such items as “opening capital markets” and shilling for U.S. “financial service products.” Yet, as we’ve seen above, the trade deficit itself limits the ability of the U.S. government to muscle China effectively on these issues. More fundamentally, the power China gains from its status as creditor allow China to build itself a capital base that would sooner or later compete with the U.S., nullifying the “dark matter” effect that props up U.S. corporate profit. The stakes cannot be higher—the final ownership of the Chinese asset base itself. This, and not the concerns many Americans have about the outsourcing of jobs, is why the trade deficit is suddenly becoming all the rage in a Congress dominated by business lobbyists.

Conversely, one must sees the American fixation with floating the Renminbi in the light of the history of U.S. control of the world monetary system rather than the trade balance. Many economists challenge the very premise that the Renminbi is undervalued. Others fear an exchange rate readjustment would damage the U.S. economy, raising inflation and interest rates and potentially tipping the U.S. into a severe recession. Besides, floating exchange rates do not prevent the Japanese and European central banks from intervening in currency markets. The major effect of a floating currency is loss of central bank control over either interest rates or exchange rates. Under a floating currency regime, the U.S. is the only country that can have an autonomous monetary policy, thanks to the status of the dollar as a reserve currency. A floating renminbi might go up or down. Nobody knows for sure. But the ability of the Chinese government to exercise control over the Chinese economy would be severely reduced, resulting quite probably in increased economic volatility and quite likely a crisis. Conversely, U.S. leverage over China will increase and the U.S. government would be better able to pressure China on behalf of U.S. businesses. Trade balance might or might not be restored, but U.S. global power would be undoubtedly replenished.  And, who knows, Wall Street might come to own China.

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[1]  Sester, Roubini, Roach, etc.

[2]  http://www.globalpolicy.org/socecon/crisis/tradedeficit/2006/0925usdebt.htm

[3] Our Brave World Charles Gave   

[4]  http://www.ksg.harvard.edu/ksgnews/Features/opeds/120805_hausmann.htm

[5] Foreign Affairs  

[6]  http://www.atimes.com/atimes/China_Business/HL14Cb04.html  

 http://www.atimes.com/atimes/China_Business/IB15Cb03.html

Other sources 

Foreign Affairs 

http://www.atimes.com/atimes/China_Business/HL14Cb08.html

http://www.msnbc.msn.com/id/16111863