A Revalued People's Currency? Be Careful What You Wish For

06/05/2010 05:12 am ET | Updated May 25, 2011

Treasury Secretary Timothy Geithner, on a recent trip to India, reiterated his hope that China would revalue its currency. In an interview on Indian television, Geithner claimed that he trusted the Chinese to do what was in their best economic interest.

In recent weeks, Obama Administration officials have professed an almost dogmatic belief in the power and necessity of a Chinese currency revaluation. They claim that by artificially depreciating the Yuan, the Chinese make US exports artificially more expensive, thereby depressing export-oriented industries in the United States, exacerbating global trade imbalances, and causing the Chinese to stockpile dollar reserves (for a good synopsis of the US-China monetary relationship, see here).

Aspects of this argument make economic sense. But as with any action taken in the global economy, a Chinese currency revaluation would entail both benefits, outlined above, and real costs. A renminbi appreciation is by no means a panacea to the US' economic woes. In fact, there are several reasons to believe that an appreciation of the renminbi might not have the desired economic effects on the US economy.

First, commentators are right to assume that all other things being equal, an appreciation of the renminbi relative to the dollar would increase US exports and decrease US imports. Still, economist and China expert Pieter Bottelier contends that a 25% increase in the value of the renminbi would add up to $75B to the US import bill in the near term. This is because short-term import demand is somewhat price inelastic. In other words, it takes time for consumers to adjust their consumption habits in response to rising import prices. Consumers are already battling high unemployment and stagnant real wages. Adding rising import prices to the mix would hurt an already cash-strapped American consumer. Meanwhile, a China revaluation would add to the US current account deficit, exacerbating the very problem that revaluation evangelists are trying to solve.

Secondly, the causes of persistent trade surpluses in Asia and large trade deficits in many advanced industrialized countries, known broadly as "global imbalances," are far more diverse than simply an undervalued Chinese currency. Since 1980, both US private and public savings declined, causing the US to become a net borrower worldwide, thus running a current account deficit. Public savings is a function of fiscal largess, and low private savings has as much to do with skewed incentives that favor consumption as much as it has to do with the Chinese currency policy. On China's behalf, can we really blame consumers who only fifty years ago saw such failed policy experiments like the Great Leap Forward for saving aggressively? Global imbalances depend far more on internal country dynamics within the US and China than on the Chinese's nominal exchange rate.

Finally, and perhaps most importantly, by demonizing China into abandoning their currency policy and allowing the renminbi to float, the US risks upsetting a delicate economic balance between both countries. China is the United States' largest foreign creditor, and the United States is dependent on the Chinese for financing everything from Obamacare to low mortgage rates. A drastic reduction of Chinese dollar holdings precipitated by a currency row would reap disastrous effects on the US macroeconomy, raising interest rates and choking off our nascent economic recovery from the global financial crisis.

The upshot of these potential costs is that the Obama and Secretary Geithner should tread lightly. By drumming up populist political pressure against a worthy economic partner, Obama risks alienating America's most vital economic relationship. Instead of resenting the Chinese from doing what is in their own best economic interests, perhaps the United States should adopt its own set of reforms closer to home, including policies that would encourage more private saving and eventually confronting America's deficits. By doing so, the US could show the Chinese that it is a good faith partner in confronting the challenge of global imbalances. Instead of chastising the Other, perhaps some more introspection is in order.