Paulson's Agenda

Henry Paulson, the newly sworn in U.S. Treasury Secretary, debuted with a speech expressing a desire for China to move more quickly in changing its currency policy as part of his agenda to help the Bush administration reverse our nation's record twin deficits with minimum economic disruption. This desire stems in part to quell protectionist attitudes that have manifested in Schumer-Graham legislation that would impose 27.5% tariff on all Chinese goods. Many on Capital Hill are hopeful that Mr. Paulson can provide the leadership to make meaningful inroads on these difficult issues. He is a bright and talented man indeed, but I would caution against ebullience that he alone is capable of changing the precarious economic predicament before us. As former Fed Reserve Board Member Robert Ferguson has said, the causes for our large current account deficit are many so to assume a mere currency adjustment would reverse the trend is simplistic and wishful thinking. Rather, the changes that are required to ensure our economic strength in the global economy and to maintain our global competitiveness needs to begin at home, not by what Chinese bureaucrats decide to do.

Some Americans conveniently blame the Chinese for our record current account deficit. The argument goes that because the exchange rate between the U.S. dollar and the Chinese yuan is largely fixed as opposed to a floating exchange rate, the Chinese currency has been set artificially low, rendering Chinese exports to the United States too cheap and U.S. exports to China too expensive. By pressuring the Chinese to move to a floating exchange rate, the trade imbalance is expected to correct through market forces, thereby reducing our need to have China finance our spending, as well as stem the loss of manufacturing jobs to China from the United States. While most economic experts estimate that the yuan may be undervalued by roughly 30%, the Chinese labor force is on average about 25 times cheaper than comparably skilled labor in the United States. At a recent investor conference for example, Minco Silver Corporation (ticker MSV on the Toronto Stock Exchange) stated that the average North American miner earns roughly $80k per year while they paid the Chinese miners only $2400 per year which is considered a generous compensation package by Chinese standards. Thus, if the dollar were to fall roughly 30%, which happened when the Bretton Woods era came to an end in the early 70's, it would still have virtually no impact on the huge cost advantage of using the Chinese labor force. Unlike the sharp dollar depreciations of the past, export growth would not necessarily become more robust because the depreciation will not close the wage gap that exists between our labor market and the three billion people now entering the labor force from China and India alone. And not only are these workers cheap, they are extremely well-educated as Ted Fishman points out in his bestseller China, Inc. and in the book Guanxi by Buderi and Huang. By pressuring for a flexible exchange rate prematurely, the Americans will be the ones primarily hurt by the falling dollar. Today, estimates of 90% of all goods in the United States are made in China. That would mean that almost 90% of all we buy will be 30% more expensive. This scenario would hardly be in the interests of average Americans, even if it was achieved in an orderly and gradual manner. And worse, there is no guarantee that this outcome will generate more American jobs or reduce our current account deficit if the Chinese are not inclined to buy our products.

There is no quick fix to our economic conundrum. Cheap labor is here to stay for a long time, and it won't be corrected by tariffs or currency adjustments. While the U.S. should definitely hold the Chinese accountable for WTO violations, we should focus on developing a long-term solution to correct the current account deficit and to preserve the American lifestyle as we know it, and the answer lies in exporting higher value goods that China cannot yet produce. The United States still has a competitive edge in higher education and in creativity because China does not have strong enforcement of intellectual property protection. Rather than pressure the Chinese to move to a flexible exchange rate regime, Paulson should focus his efforts on convincing Congress to pass legislation that would create more tax incentives for Americans to invest more R&D dollars in science and technology and create disincentives in areas of our economy that do not produce competitive, exportable goods and services. Although I am at risk of oversimplifying the issue and am the first to admit that correcting the global imbalance and reversing the current account deficit is complex, I still believe that the core of our problem is the dearth of national will to drive innovation, and as we saw in the 90's, innovation rules. Right now, we do not have enough talented Americans becoming inventors, scientists, or global entrepreneurs because the incentives to go into areas like reality television are higher. If Americans, and thus politicians, are serious about this talk of encouraging more resources devoted to math and science, then the political agenda and rhetoric needs to change from finger pointing at the Chinese to more thoughtful discussion and action about how to implement domestic educational and research incentives that will give us enduring competitive advantage.