Market Analysis

Debating the Yuan

The Senate began its annual exercise debating US-China trade policy Monday.

In a development that truly makes us wish a government shutdown had happened, Monday, the Senate began discussing resolution 1619—the Currency Reform and Oversight Bill. In what’s become basically an annual event, congressional politicians are debating our trade relationship with China and proposing legislation to supposedly “fix” it.

These protectionist politicians assume China’s yuan is dramatically undervalued and the resulting “unfair” trade hurting America. Their solution? Slap a tariff of roughly 25% on Chinese goods until their currency has appreciated sufficiently.

I have no real reason to doubt China’s currency is undervalued. But if I worked for any US politician (perish the thought), I’d hand him or her a copy of Peddling Protectionism by Douglas Irwin and point out this proposed solution is loosely equivalent to drinking Clorox to drown your sorrows.

History’s quite clear: The idea tariffs and protectionism actually “protect” is pure poppycock. Anyone bothering to read material on the subject would likely know tariffs have a long history of degrading economic conditions for both the “protected” nation and the targeted. And then, generally, the target turns around and erects tariffs in response. A classic example of this is the Tariff Act of 1930, or Smoot-Hawley.

Smoot-Hawley, first introduced in 1928, was originally intended to enact tariffs to protect US farmers whose land values had declined for some time. Further, a major migration to cities was afoot and farm employment’s share of the US workforce in decline—to the point where it’s now a tiny slice. Farmers, or more specifically, politicians supposedly representing farmers, blamed foreign imports (basically an omnipresent scapegoat—see Solyndra). That, despite the fact a minute proportion of US agricultural imports actually overlapped with American-grown products at that time. And agricultural exports far exceeded imports. The real culprit was technology-driven productivity gains, though the public didn’t appreciate it.

So Senator Reed Smoot and Representative Willis Hawley set forth on their mission to “protect” farmers. But once the wacky scoundrels in Congress got their hands on it, the bill morphed (a not uncommon occurrence). No longer was it solely to protect American farmers, but now it extended to manufacturers, too. In fact, the bill went literally product by product, erecting barriers against imports on hundreds of goods entirely unrelated to agriculture. I mean, hey, if you’re a congressman or senator from Massachusetts, there’s little political return in voting for agriculture protection—but the bill provided an opportunity to stretch “protection” to industrial firms in politicians’ home states. That political opportunity didn’t go to waste.

Once the US’s trade partners—most notably, Canada—got wind of the tariffs, they responded in kind. Further, many types of trade restrictions appeared in Europe. (Though one can quibble as to whether all were directly related to Smoot-Hawley, it’s highly likely many were.) All this led not to resurgent agricultural employment or land values—rather, when combined with monetary policy errors and other factors, Smoot-Hawley played a key role in global trade’s collapse during the Depression, likely both prolonging and deepening the downturn. And the Depression benefited few—even those “protected” industries. International trade was a rather small slice of the US economy in the 1920s (exports totaled about 5% of US GDP in 1929). It’s far larger today, both in absolute terms and relative to overall US GDP (exports totaled 13.3% of GDP in Q2 2011)—meaning protecting our economy from protectionism (and protectionists) is of even greater importance today.

But politicians’ misunderstanding of our trade relationship with China is deeper than this. They presume an undervalued yuan is universally bad and that it’s responsible for American manufacturing’s decline (among other things). Balderdash. American manufacturing isn’t in decline. Like agriculture in the 1920s, industrial firms today simply do more with fewer workers—the definition of productivity. And last I checked, we want a more productive economy, not a less productive one. That some in the public and many politicians don’t see this is just repetition of the same error that motivated Smoot-Hawley.

Moreover, if we assume China’s yuan is undervalued, then that also means American consumers and businesses are buying Chinese goods for less than they’d otherwise pay. Considering Chinese equipment and parts are used in many final products produced in America, that means the tariff or higher-valued currency would likely be passed on to consumers. Including for products not purely “made in China.” Higher costs for American consumers and businesses are unlikely to stimulate greater economic activity.

Also, currency valuation is an important inflation-fighting tool for China—one of three levers they can pull to tame it. A rising currency dampens inflation—falling does the opposite. Only problem today is they’re already pulling the other two levers, slowing growth and inflation. If the currency sharply and suddenly rose, the probability of a Chinese hard landing would increase. Tanking China’s economy does no one any good—it would depress their ability to buy our goods (trade is a two-way street) and other nations’ goods as well.

Finally, under World Trade Organization guidelines, countries cannot craft legislation singling out a country for trade restrictions like tariffs. So where do we stop? Much of Asia is currently engaged in currency market interventions, as are Switzerland and Japan. That’s an awfully big slice of the world!

This legislation is far from a good economic idea, in our view. But at the same time, it’s also not terribly likely to go anywhere. After all, very similar bills have come up multiple times in recent years with a more united Congress and simply died. (For reference, there are multiple versions of the current bill sitting stalled in just the current Congress.) That we have greater gridlock today seems to indicate the probability this passes now is low. And that’s good. At the same time, it’s clearly a factor to watch.

Protectionism—even if you assume China’s currency is undervalued—does no one any good. Politicians would serve our country far better by debating names for government buildings and when to go on recess.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.