03/18/2010 05:12 am ET Updated May 25, 2011

What About China's Exchange-Rate Protectionism?

This article originally appeared on my site Credit Writedowns

As I indicated earlier today, I generally see protectionism not as a second-best argument like Paul Krugman, but as something to avoid entirely.  Nevertheless, calls for more protectionism are being heard everywhere.  Gregory Clark, an Australian Professor who is a vice president at Akita International University in Japan, has made the case for protectionism against China in the English-language Japan Times. He says:

It's time to start getting tough on Beijing...

Where China is at fault is in a very different area. It complains bitterly about Western, U.S. mainly, tariff/subsidy protectionism. But China itself indulges in a much worse kind of protectionism -- exchange rate protectionism. If China's currency is undervalued by around 20 percent, as many estimate, that is equal to a 20 percent tariff on all goods entering China, and a 20 percent subsidy for all exports. Tariff/subsidy protectionism in the West never gets as wild as this.

True, China is not entirely to blame. It has simply been taking advantage of an extraordinary lacuna in orthodox Western economic thinking -- the idea that tariff protectionism is evil but exchange rate protectionism can be ignored. We saw a good example at the recent APEC summit conference in Singapore. APEC repeated its ritual calls for free trade. It had almost nothing to say about the 800-pound elephant at the conference table -- the controls that Beijing uses to keep its currency consistently undervalued.

Orthodox Western economists are like the man who cannot walk and chew gum at the same time. They are obsessed about the way tariff protectionism raises costs to consumers. But handled well, tariffs are simply a tax on consumers to assist producers whose new or continued existence is crucial to the growth of the economy. There can easily be a net gain for the entire nation, including consumers. There can also be a net gain for the world economy if the strategic use of tariffs helps create vibrant economies able eventually to help expand world trade. Japan was but one example.

Exchange rate protectionism, by contrast, protects all import-competing industries, across the board, whether they deserve protection or not. True, it too can have net beneficial effects; quite a few Asian economies owe their growth to keeping their currencies undervalued for long periods. But the suffering of consumers is greater. And those economies gain at the expense of others. The distortion to world trade is far greater than that caused by tariff/subsidy protectionism.

History is part of the reason for this strange weakness in economic thinking. The 1930s Great Depression saw harmful beggar-thy-neighbor tariff policies as nations competed to protect domestic industries and employment. So the textbooks on which the current generation of economists were raised concentrated almost entirely on the evils of tariff protectionism. Meanwhile, the Cold War and other ideological factors made them favor anything tagged with the word "free" -- free trade, free markets, free enterprise, and allegedly freely fluctuating exchange rates despite the ease with which those rates can be manipulated or controlled.

Before I send you off to the rest of the article, I should clear up one thing; it is patently false that APEC said nothing about China's own exchange-rate protectionism. I wrote about it at the time. Read the article here

In any event, you can see that not everyone is against protectionism. In fact, the argument that it is China which acted in a protectionist manner first makes sense. It has fixed its currency to a plummeting dollar and that makes the Yuan artificially weak to everyone else's detriment.  This is one reason the Europeans are starting to make protectionist noises too.

I see a protectionist response in retaliation as a likely outcome unless China changes its tune -- not that I favour that outcome. We will soon know if protectionism works.

The rest of the article is at this link here.