Paulson and China
By
Henry C.K. Liu

This article appeared in AToL on December 13, 2006


With some 27 anti-China trade bills pending in various stages of legislative process and prospects of passage in Congress as background, and a just released critical report on Chinese trade practices by the US Trade Representative, US Treasury Secretary Henry M. Paulson Jr., an expert on China with over 70 business trips there as a private banker, will go to China with six other Cabinet members and the chairman of the Federal Reserve, Ben Bernanke, to discuss US-China trade relations. The venue is the first meeting of a newly created semi-annual “strategic economic dialogue” to be held in Beijing on December 13-15. In addition to Paulson and Bernanke, the other top US officials making the trip are Commerce Secretary Carlos Gutierrez, US Trade Representative Susan Schwab, Labor Secretary Elaine Chao, Heath and Human Services Secretary Mike Leavitt, Energy Secretary Sam Bodman and Stephen Johnson, head of the Environmental Protection Agency.

A fact sheet issued by the Department of the Treasury on September 20, 2006 states:
President George W. Bush and President Hu Jintao have agreed to create a Strategic Economic Dialogue between the United States and China.   Reflecting the growing relationship between the US and Chinese economies, this dialogue will occur at the highest official levels and is the first of its kind.  Further, it will provide an overarching framework for ongoing productive bilateral economic dialogues and future economic relations.  It will examine long-term strategic issues, as well as provide coordination among the specialized continuing dialogues.  The Strategic Economic Dialogue will also be a forum for discussing ways the United States and China can work together to address economic challenges and opportunities as responsible stakeholders in the international economic system.

The essential goal of this dialogue is to ensure that the benefits of our growing economic relationship with China are fairly shared by citizens of both countries.

The Strategic Economic Dialogue will convene semi-annually in the United States and China, with the first meeting occurring before the end of 2006.  Each of the two Presidents will strongly support and take an active role in the strategic economic dialogue.

President Bush has designated Secretary of the Treasury Henry M. Paulson to lead the US side of the dialogue. National Economic Adviser Al Hubbard and other members of the President’s Cabinet will join Secretary Paulson.  Additional U.S. agencies will include Commerce, U.S. Trade Representative, State, Health and Human Services, the Environmental Protection Agency, Energy and others.  Deborah Lehr [who has resigned after only three weeks] will serve as Special Envoy to the Strategic Economic Dialogue to ensure it receives the attention and continuity necessary to produce meaningful results.

President Hu has designated Vice Premier Wu Yi to lead the Chinese side of the dialogue.  In that role, she has been given full decision-making authority across all aspects of the Chinese economy.  To demonstrate the importance of the Dialogue, the Chinese government has created its largest and the highest ranking inter-ministerial working group which Vice Premier Wu Yi will chair, supported by Foreign Minister Li Zhaoxing, Finance Minister Jin Renqing, and Deputy Secretary General of the State Council Xu Shaoshi, as well as the Ministries of Commerce, Agriculture, Health, and Information Industries, the various financial regulators, the National Development and Reform Commission, the People's Bank of China and others.

The Strategic Economic Dialogue will help to ensure leaders of the two countries can address critical economic challenges facing their economies, have a forum for discussing cross-cutting issues, and can make the most productive use of the existing bilateral commissions and dialogues. Likely themes of the discussions will include: building innovative societies, seizing the opportunities of global economic integration to assure sustained growth, and the economics of energy and conservation.  The United States will also support China in China's goal of building a consumer-driven economy rooted in open markets.  The intent of this dialogue is to discuss long-term strategic challenges, rather than seeking immediate solutions to the issues of the day.

The discussion of long-term structural issues in the Strategic Economic Dialogue will provide a stronger foundation for pursuing concrete results through existing bilateral economic dialogues and ensuring citizens of both countries benefit fairly from the growing bilateral economic relationship.  The new strategic dialogue will provide support and guidance for these existing bilateral economic forums, which will remain essential to managing specialized aspects of the interdependent US-China economic relationship. These high level discussions will enhance, not diminish these existing forums.  Bilateral issues will continue to receive full attention, including pressing China for floating exchange rates, greater intellectual property rights, and increasing market access.

Existing economic and related dialogues include:
The Joint Commission on Commerce and Trade (JCCT) between the US Department of Commerce, the U.S. Trade Representative, and the Chinese Vice Premier responsible for trade.
The Joint Economic Committee between the U.S. Department of the Treasury and the Chinese Ministry of Finance.
Joint Commission on Science and Technology between the U.S. Director of the Office of Science and Technology Policy and the Chinese Ministry of Science and Technology.
The Economic Development and Reform Dialogue between the U.S. Department of State and China's National Development and Reform Commission.
The Energy Policy Dialogue between the U.S. Department of Energy and China's National Development and Reform Commission.
The Global Issues Forum led by the U.S. Department of State and China's Ministry of Foreign Affairs.
The Healthcare Forum between the U.S. Department of Health and Human Services and the Chinese Ministry of Health.
The Asia-Pacific Partnership on Clean Development and Climate, which brings together China, the United States, Australia, India, Japan, and Korea. (End)

Intense pressure is on the new Secretary to produce tangible results of Chinese acquiescence to rising US trade complaints or face a wave of protectionist measures in the new Congress next year that could reverse long-standing US preference for free trade. Paulson conferred last week with US business leaders all of whom urged him to use the considerable power of his office to bring about accelerated changes in China’s trade policies and practices, particularly in opening and deregulating Chinese markets, abandoning the alleged manipulation of currency levels to spur exports, or at least to manipulate it upwards against the dollar to reduce its enormous and still rising trade surplus with the US. Also on the Secretary’s agenda is a mission to convince Chinese authorities of the need to suspend illegal subsidies to such industries as steel and auto parts, crack down on piracy of computer and entertainment software, pharmaceuticals, and other intellectual property issues to avoid US retaliatory measures.

To prepare for the high-level trip on December 13, Treasury aides have been conferring with their Chinese counterparts to lay the groundwork for an image of diplomatic progress if not immediate substantive resolutions. Both sides on the discussion table cautioned the public not to expect unrealistic breakthroughs on difficult key issues, in part because Chinese domestic politics is sensitive to US infringement on Chinese national sovereignty and US domestic politics is trigger happy with rash reactions to disappointment from unrealistic expectations on intractable trade issues with China.

There is much that is dysfunctional and unsustainable in US-China economic relations. The unhappy situation is the natural result of inequitable terms of trade that have evolved over two decades, beginning with China’s economic opening to the outside world in Deng Xiaoping’s reform policy introduced in 1978. Since the end of WWII, the US has conducted US foreign economic and trade policies on the basis that trade with the US is a favor the rich US economy grants to the poorer economies. The conditions that render such attitude operative have changed as the US, in an interdependent global economy, has become addicted to low price imports to fuel its loose monetary policy based on dollar hegemony. The US economy now is dependent on foreign trade as much as, if not more than, the exporting economies. Victims of addiction are usually not in any position to dictate the terms of supply.

A Trade Deficit is in the US National Interest

A case can be made, although few in the US are intellectually honest enough or politically courageous enough to make it, that a rising trade deficit is in the US national interest, just as a strong dollar is in the US national interest. Dollar hegemony, a term that describes the effect of the dollar, a fiat currency, assuming the unmerited role of the key reserve currency for international trade, enables the US to use its capital account surplus to fund its trade deficit. For this reason, a balanced trade with the rest of the world would dry up the capital account surplus and create serious structural problem for the US financial system that needs $3 billion of net capital inflow a day to keep afloat.

Many in the US fear a new threat to the sustainability of US hegemony emerging in the form of excessive dependence on foreign capital and growing foreign debt. Former Treasury Secretary Lawrence Summers of the Clinton Administration observed that “there is something odd about the world’s greatest power being the world’s greatest debtor.”

Actually, what is odd is US foreign debt being denominated in dollars, a fiat currency that the US and only the US can print at will. The US is the only nation in the world whose foreign debt is denominated in its own currency. In that sense, the US has no real foreign debt as all its debts are sovereign debts payable in currency it can issue at will. The term foreign debt usually means debt denominated in foreign currencies. Such debts require the backing of adequate foreign reserves because the debtor governments cannot print foreign currencies and are therefore subject to risks of default on foreign currency loans. Foreign debts for the US, as they are denominated in dollars, are only sovereign debts held by foreigners. If the foreigners holding US sovereign debt want to cash them in, the US can print as much dollar as it needs to satisfy them. Therefore the US does not face risks of default on its foreign debts. This is what makes US sovereign debts relatively safe investments, as sovereign debts are not exposed to default risk, only foreign exchange risk. The key behind the intrinsic value of the dollar is that dollars, and only dollars, are accepted by the US government for payment of taxes and all other governmental receipts. These characteristics, laid out as the State Theory of Money, make the dollar a political instrument exempt from rules that govern financial instruments.

A New Approach to China

Following his first major speech that signaled a new US economic approach to China, Paulson told the Financial Times on the eve of his first trip to China (September 22) as Treasury Secretary that his message to China was: “We want you to succeed.” Paulson said: “The United States has a huge stake in a prosperous, stable China – a China able and willing to play its part as a global economic leader.” He said the US and China shared areas of economic interest, highlighting energy and the environment as two specific areas where the two nations should work together.

No doubt Paulson is sincere when he says what he recommends for China is in China’s own interest within the context of neo-liberal ideology. Yet Paulson’s formula for China is that the US wants China to succeed only on US terms.  Paulson’s approach is based on the assumption that neo-liberal economic reforms in China are “necessary to sustain its growth” despite heated policy debate now raging in Chinese policy circles on the desirability of such modes of growth. Paulson wants China to open up Chinese capital markets for “healthy competition” within the domestic financial system, so China can have a currency that is “freely tradable,” despite a history of financial crises that befell economies with open financial amrkets and freely tradable currencies in recent decades.

Paulson warns Chinese officials they underestimate “at China’s own peril” the extent to which the currency issue is “viewed by their critics as a symbol of unfair competition” even though his own expert opinion differs from those held by such uninformed critics. Yet if such critical complaints are substantively groundless, any appeasement on them will only lead to further absurd demands to perpetuate their anti-China agenda, amounting to “if its not one thing, it would be another”. Free traders, of whom Paulson is one, should not tolerate political bias to interfere with free trade.

Paulson calls on China to press ahead with liberalization across a broad front, including financial sector reform, fiscal and regulatory policies to reduce excess savings, market-based macroeconomic management and enforcement of intellectual property rights. “We are taking a comprehensive approach,” he said. “We are collectively pulling it together.” Paulson said China had become a lightning rod for fears about globalization, but insisted it is “manageable”.

Paulson’s neo-liberal message is music to some in China, particularly his fans in Tsinghua University, the bastion of neo-liberal supply-side economics in China. These reformers would like to see US political pressure push the Chinese economy more towards capitalistic market economy, at a time when Rubinomics, a set of policies named after Robert Rubin, Treasury Secretary under President Clinton, is forced to be on the defensive by rising economic populism in the US and around the world. Chinese reformers are similarly put on the defensive by glaring defects of their export dominated economic policy, in the form of worsening income disparity, life-threatening environmental pollution, economic and developmental imbalances, erosion of national spirit and worst of all, systemic corruption. China is not about to drive its economy further down any road that leads to an economic equivalent of a dangerous cliff merely to appease US ideological displeasure.

Chinese Socialism

In an interview with US television journalist Mike Wallace on September 2, 1986, Deng Xiao-ping, the architect of China’s market reform and open-up policies, responding to a question on corruption and other obstacles to foreigners doing business in China, said:
“I am aware of these things. They do exist. As we are new to doing business with the West, it is inevitable that we shall make some mistakes. I do understand the complaints of foreign investors. No one would come here and invest unless he got a return on his investment. We are taking effective measures to change the present state of affairs. I believe that these problems can be solved gradually. But when they are solved, new problems will arise and they, too, should be solved. As leaders, we have to get a clear picture of the problems and work out measures to solve them. There is also the question of educating the cadres.”

Wallace: To get rich is glorious. That declaration by Chinese leaders to their people surprises many in the capitalist world. What does that have to do with communism?

Deng: We went through the “cultural revolution”. During the “cultural revolution” there was a view that poor communism was preferable to rich capitalism. After I resumed office in the central leadership in 1974 and 1975, I criticized that view. Because I did so, I was brought down again. Of course, there were other reasons too. I said to them that there was no such thing as poor communism. According to Marxism, communist society is based on material abundance. Only when there is material abundance can the principle of a communist society -- that is, “from each according to his ability, to each according to his needs” -- be applied. Socialism is the first stage of communism. Of course, it covers a very long historical period. The main task in the socialist stage is to develop the productive forces, keep increasing the material wealth of society, steadily improve the life of the people and create material conditions for the advent of a communist society.”

Deng went on: “There can be no communism with pauperism, or socialism with pauperism. So to get rich is no sin. However, what we mean by getting rich is different from what you mean. Wealth in a socialist society belongs to the people. To get rich in a socialist society means prosperity for the entire people. The principles of socialism are: first, development of production and second, common prosperity. We permit some people and some regions to become prosperous first, for the purpose of achieving common prosperity faster. That is why our policy will not lead to polarization, to a situation where the rich get richer while the poor get poorer. To be frank, we shall not permit the emergence of a new bourgeoisie.”

Deng’s view of a socialist market economy during the transition phase from socialism to communism is still the national purpose of the People’s Republic, despite the fact that Chinese economic policy has veered off course from Deng’s original vision for the decade after the Tiananmen incident in 1989. The current leadership is moving to put economic policy back on the socialist path and to rein in the excesses of market economy and address the imbalances of development approaches that emphasize quantitative over qualitative performance.

The 16th Central Committee of the Communist Party of China (CPC) concluded its fifth plenary session in Beijing on October 11 2005, which examined and approved proposals for formulating the 11th Five-Year Plan for National Economy and Social Development. Hu Jintao, general secretary of the CPC Central Committee, gave a working report on behalf of the Political Bureau of the CPC Central Committee. Premier Wen Jiabao made an explanation on the draft proposal.

Premier Wen Jaibao presented the government’s 2006 Working Report on March 5, 2005. The three sections of the report outlined the government’s workings in 2005, the direction in which the government would be going in the coming year, and a brief outline of China’s 11th Five Year Plan of 2006-2021. Agriculture with the “Three Rural Issues” policy (Agriculture, Rural development, Farmer livelihood) was emphasized throughout the speech, as was the renewed concept of “Govern for the People”. Wen strongly emphasized help for the poor and closing the wealth gap, and announced that century-old agriculture taxes on peasants would be repealed.

China's new Five-Year Plan, the roadmap for the country's development in the next five years, will bring revolutionary changes from the “Getting Rich First” phase to the “Common Prosperity” phase to bridge the growing income and wealth disparity to avoid polarization of society. That is a historic adjustment to the pattern of five-year plans since China changed its approach to economic and social development in the 1970s.

More than 2 decades after Deng’s reform and open-up policy, the per capita Gross Domestic Products (GDP) has risen to only $1,700 in 2005 and is expected to reach only $3,000 in 2020. Even with a purchasing power parity of 4:1, Chinese 2005 per capita GDP was $6,800, still substantially below the US 2005 per capita GDP of $35,000. China is still, and will continue to be, a poor developing country notwithstanding all the glister of high-rise apartment towers and office skyscrapers in Shanghai. 

In fact, the weakness of China's market-based economic development record in the past two decades, despite the high price paid in the near total collapse of its social infrastrcture, life-threatening environmental degradation, cancerous systemic corruption, intractable high unemployment and widening income disparity, is its snail-paced revitalization of the Chinese economy, not the phantom fast progress that has received much undeserved praise.  Compared to other stagnant developing economies operating under market neoliberalism, China appears to be a great success, but compared to the post-WWI achievements of NAZI Germany, which turned a war-devastated economy in total ruins into the strongest economy in Europe in just four short years, China's record is at best mediocre.

China's "rapid" economic growth has also engendered new socio-political problems that are in danger of outweighing its achievements. The lowest-income families, comprising the bottom 10% of all families, owns less than 2% of all the private assets in the economy, while the highest-income families, or the top 10% of all the families, own over 40%.  Chinese leaders have warned against extremes of poverty and wealth, rising unemployment and intensifying social conflict.

“Common prosperity is not an unreachable goal, but the basic principle and pursuit of socialism,” said President Hu Jin-tao.

The 11th Five Year Plan recognizes that the single-minded quest for economic growth does not necessarily lead to sustainable economic development, and rejects unbalanced quantitative growth as the goal of development, putting importance instead on improvements in the quality of life.  Chinese leaders have of late repeatedly criticized flawed concepts of economic growth, asserting that that the doctrine of “economic development as a focus” should not be misinterpreted as “speed at all cost.” In the 11th Five-Year Plan, economic growth will be measured by “Serving the people to improve their life quality” rather than GDP readings. Yet evidence suggests that speed is not the problem. The problem is the ineffectiveness of market fundamentalism and excessive reliance on export as development paths.

Foreign trade now accounts for over 70% of China's economy as compared with 24% in the US economy. Frequent trade frictions with China’s trade partners have imposed high costs on the Chinese economy. China has become a major consumer of energy resources in the world. International energy institutions predict that from 2002 to 2030 around 21% of the world's new demand for energy resources will come from China. In 2004, nearly 50% of the petroleum used in China was imported to feed the export sector. When it comes to energy consumption, China is merely the kitchen; the dinning room is in the US.

Chinese planners are working to change the country’s heavy reliance on foreign investment and resources to secure its national economy through energy and capital independence in the next five years. The new Five-year Plan will bolster social services to deal with the imbalances in strong economic growth and weak social development.

The problem of social security is particularly serious in the countryside, where the medical care system and welfare are been neglected and allowed to deteriorate in the past 2 decades.  During the period from 1993 to 2003, the number of people with no access to medical insurance in the country increased from 900 million to one billion, with the percentage rising from 67.8% to 80.7%. The number in the urban area rose from 96.53 million in 1993 to 300 million in 2003. And this is an economy that holds $1 trillion in foreign reserves. 

Structural demographic dynamics is a ticking time bomb with population planning conflicting with the need to preserve an operative ratio between retirees and workers who are expected to support the retirees with worker currency income. China's one-child-per-fiamily birth rate is falling behind the retirement rate of its workers with dire atuary consequences.

In the next five years, China will place more emphasis on science and technology, education and health care in policy and investment. All rural children are expected to enjoy nine-year of free education before 2010, which will reduce farmers' economic burden by 100 billion yuan ($12.37 billion) every year. The poor and the weak will get more protection and have improved access to social welfare.  In all these policy objectives of socio-economic development, neo-liberal market fundamentalism has very little to contribute.

China Trade Not Unfair to US

Objectively, the case that Chinese trade with the US is unfair or damaging to the US is very weak. The fact is that the terms of US-China trade favors the US more than it does China. The US trade deficit with its flip side capital account surplus does more for the US economy than for the Chinese economy.

Conventional wisdom mistakenly suggests that the US economy rests precariously on an unsustainable accumulation of debt, particularly foreign debt. Fueled by government profligacy and low private savings rates, the current account deficit and fiscal deficit, the US has become the world’s largest debtor nation. But the US is a debtor nation with a difference, for all its debts are denominated in its own currency which the US can print at will.

The current account deficit is created by the difference between what US residents spend on imports and what they earn from exports in a given year. This deficit now stands at almost 7% of GDP. Total net foreign liabilities are now approaching 25% of GDP, but that's less than half of that of Japan. And China is now the top trade surplus partner of the US as well as the top creditor to the US. While this means China has been shipping real wealth in the form of goods to the US in exchange for US dollars it cannot use at home, there is much talk among fear-mongering pundits and politicians of the danger of sudden unwillingness by investors abroad (read Chinese) to continue adding to their already large dollar assets. In this scenario, a panic will cause the dollar to sink, dollar interest rates to skyrocket, and the US economy to descend into crisis, dragging the rest of the world down with it.

But the prospect that this scenario will actually come to pass is nil. This is because economists fail to understand that the dollar after it was taken off gold backing is no longer a financial instrument subject to market laws of supply and demand. Under dollar hegemony, the dollar is really a political instrument. When viewed as a political instrument, everything that Larry Summers considered odd about the dollar falls in place logically.

As long as the US is the world’s dominant power and the US economy is the world’s dominant economy in terms of both size and focus, and the dollar remains the key reserve currency for world trade, all other currencies are merely derivatives of the dollar. Derivatives contracts have profit or loss with volatility, but such volatility does not threaten the dollar. The dollar will rise and fall within a range from its bench mark exchange rate, which is the rate the market has come to accept as normal at any given time. Volatility in exchange rates is caused by complex factors, mostly technical while the fundamentals of dollar hegemony anchor the dollar’s base rate. The base rate changes only slowly over the long run, rising according to the quantity theory of money as related to the size of the world economy. When the world’s debt and commodities are denominated in dollars that only the US can print, the US essentially owns all the financial wealth of the world. Foreign-held dollars are mere accounting technicalities of little real macro consequence. In fact, the more dollars a foreigner holds, the more he/she becomes American. When China holds more than a trillion dollars in foreign reserves, it is moving closer to become a US financial colony trapped in domestic poverty.

For those who spends dollars in their daily activities, such as US residents, or most US trans-national corporations, the exchange rate of the dollar is of little fundamental relevance. If import prices rise because of a fall in the dollar exchange rate, the Federal Reserve, the US central bank, will view it as inflation and raise dollar interest rates in response, thus pushing the exchange value of the dollar back up. The exporting economies will then devalue their currencies to reset the price of their exports in dollar terms, or to subsidize it by other means, such as lower wages from higher unemployment, or rebates of export taxes. This game goes on until fatigue set in to stabilize the bench mark exchange rate of the dollar.

As long as current US economic and monetary policies remain unchanged, the long-term trend of the exchange value of the dollar is down. But this is not necessary a bad thing for the US. If the down trend of the dollar is gradual and moderate, the resultant growth of the US economy will be able to withstand the dollar's oderly fall which in essence reflects only the declining share of the US economy in the global economy. Such a decline does not mean slow growth for the US economy. It can mean that the world's developing economies will grow at a faster rate than the US to reduce the now overweighted US economy when measured by the size of the US population in global terms. US GDP in 2006 was $13 trillion with a population of 300 million while China's was $2.5 trillion with a population of 1.3 billion.  By that measure, a case can be made that the dollar is overweighted and overvalued in a global perspective. This illustrates the main problem in understanding globalization. Global issues are seldom viewed from a global perspective, only from a US perspective.

US tax revenue is immune to fluctuations in changes in dollar exchange rates because it is denominated in dollars. US fiscal spending is also immune because it is also denominated in dollars. With a falling dollar, US imports prices will rise, forcing more purchases of domestic-produced goods by US consumers and more US exports. But even the current account is immune because it is settled in dollars. What will happen is that the face value of the deficit will not change, only the actual volume of good bought and sold will change. A fall in current account deficit only means less dollars leaving the US as debt with less dollars returning as capital. As long as US geopolitical hegemony keep all key commodities denominated in dollars, no one who participates in the global economy can escape the dollar, much less dump it.

The US economy is being held up by dollar asset appreciation which allows higher debt without changing debt/equity ratio. There is a torrent of dollar creation by the Fed but more by the growth of financial derivatives. This causes three phenomena:
1) More dollars to fund mergers and acquisitions which with increasingly lame anti-trust regulation, create more efficient monopolies in the short term thaty may threaten free markets in the long term;
2) more dollar equity available to company to enable them to carry more debt for expansion that makes even distressed companies to look temporarily healthy, but exposes them to the danger of default if revenue falls behind debt service ppayments, and
3) more dollars for investing outside the US to fund more low-cost export to the US that will exacerbate the current account deficit problem.

As long as interest rate, the cost of the use of money within a time period, is lower than the rate of return on capital, the economy will expand by taking on debt. Consequently, corporate earnings will look strong as long as US consumers are willing to take on more debt collateralized by the rising value of their assets to keep consuming. A fall in the exchange rate of the dollar will put an abrupt end to this joy ride.

China has a serious structural problem with its export-dominated economy.  It earns dollar income from its oversized export sector but has yuan expenses in its anemic domestic market. When the export sector dominated the Chinese economy, China is essentially shipping wealth to the US in exchange for a currency it cannot use at home. China has accumulated over $1 trillion in foreign reserves, equivalent to its annual GDP, yet it does not have enough yuan-denominated money to alleviate widespread poverty or to fund its social security obligation or to pay for environmental restoration. A falling dollar will make China poorer because its variable income from trade is in fallen dollars and its fixed expenses at home are in more expensive yuan. This condition will remain until China requires payment of its export in yuan and not in dollars, and frees itself from dollar hegemony.

All the factor inputs to the Chinese export sector are imported: capital, loans, energy, technology, design, machine tools, production lines, packaging, paper cartons, marketing, transportation and distribution systems. These are all dollar costs. To its export sector China contributes only two under-priced factor inputs: labor and environmental pollution. Profits to China from the Chinese export sector come entirely from low wages and hidden-cost pollution. In about 25 years, China has accumulated over $1 trillion in foreign exchange reserves equivalent to its current GDP. China’s GDP grew at average 10% annually while its foreign exchange reserves have been growing at up to 30% 2005 to 2006.  For the last few years China has been holding back its GDP by over $200 billion every year, sending the earnings to finance US trade deficits, earnings from slave wages and toxic pollution.

What China needs is to reduce its dollar income and shift that income to yuan by selling more of its products in the domestic market. But the entire neo-liberal globalized trade is built on all exporting economies thinking earning foreign exchange is a good thing.

In the US, the decline of labor and environmental inputs has been compensated by the increased use of variable inputs and capital. Debt enters into the US financial system from China and is re-exported as capital back to China.  As for oil consumption, domestic consumption is 90% supplied from domestic sources. Imported oil feeds mostly China’s export sector, making China the kitchen with the US the dining room.

There is no way for China to diversify its foreign currency from dollar assets. The most Ch can do is slow the growth of its dollar holdings from its new trade surplus by cutting down export. Allotting new Chinese trade surpluses to other non-dollar currencies is merely enlarging the volume of dollar derivatives, an exercise in circular circuitry.

What China Needs to Do

What China needs to do is to keep export to the US at the same level as imports from the US. This is easily done. Every 3 months, as soon as export to the US exceeds export levels, export is stopped until import from the US catches up. No trade surplus, no new dollar foreign exchange holdings. The surplus production is then sold in the domestic market to earn yuan revenue which then is re-circulated as higher wages to sustain domestic purchasing power. Sovereign credit is used to finance the time gap between rising wages and domestic consumption and between corporate sales and rising employment to sustain full employment.

This will put the trade surplus/exchange rate monkey from China’s back onto the US’s back.  Prices in the US will rise from a shortage of supply and dollar interest rates will rise to fight inflation and the team from Washington will beg China to stop this rational nonsense and tell Senators Charles Schumer (D-NY) and Graham Senators (R-SC) who are threatening legislation that would slap a 27.5% tariff on Chinese imports unless China allows the yuan to appreciate significantly (20%) to go fishing.

Trade is a game of market power. The US needs to recognize that the scale of market power is tilting towards China’s side and that the US cannot make hegemonic demands from a position of weakness. The solution to the US trade dilemma lies in a reordering of US trade policy, not on the exchange value of the Chinese currency.

US geopolitical hegemony rests on an economy that is continually extending its lead in the innovation and application of new technology. It does not rest on what another country does nor does not do. The fact of the matter is that regardless of crybaby complaint of Chinese unfair trade practices, US-China trade still benefits the US more than it does China. A halt in US-China trade will do more damage to the US than to China. The dollar’s role as the global monetary standard is not threatened, and the risk to US financial stability posed by large foreign liabilities are exaggerated. The US economy will adjust to a decline in the dollar and a rise in interest rates that will slow the growth of US consumption and retard its standard of living, but it will not fatally undermine the US economy. The dislocations and inequities in the US economy both at home and overseas are caused by dollar hegemony, not by any foreign government trade policy. There is a mismatch between the democratic process in US politics and the dislocation in the US economy created by US-led globalization which no amount of China bashing can resolve.

Dollar Hegemony and Net International Investment Position (NIIP)

US external liabilities are denominated in its own currency, which remains the key global monetary standard. The net international investment position (NIIP), the value of foreign assets owned by US residents minus the value of US assets owned by nonresidents peaked at almost 13% of GDP in 1980. Up until 1989, the US was a creditor nation. But chronic current account and fiscal deficits since then have given the United States the largest net liabilities in world history.

At the start of 2004, foreign claims on the US of $10.5 trillion exceeded US claims of $7.9 trillion abroad, with a negative NIIP of $2.6 trillion. In 2005, US NIIP was a negative $2.7 trillion or 21% of GDP, an increase of $333 billion over the previous year, or 21.6% of GDP.  The largest share of this debt is in the form of foreigners holding US sovereign debt.  Foreign holdings of US government securities reached $2.4 trillion in 2005, an increase of $215 billion compared to the previous year.  The purchases of US government securities by foreign investors financed two-thirds of the increase in the net US international liabilities during 2005. US interest payments on this massive debt held by foreigners and to foreign holders of US assets means that less money will be spent in the US.  Annual US interest payments on that debt rose to $114 billion, which exceeded President Bush’s proposed budget for education, training, employment, and social services in 2007 of $86 billion.  Normally, these debt payments are the Achilles heel of vulnerability as affected by any rise in interest rates.  But what do foreign interest earners do with their dollar interest revenue? They reinvest it in more dollar assets, providing funds for US investors to buy foreign assets. A reduction in the US deficit will upset this circle of cash flow and cause financial problems in the US that can quickly translate into political problems for the sitting administration.

As a rule, a current account deficit, the broadest measure of the balance of trade in goods and services, must be financed through the sale of US assets to foreign investors and lenders.  However, the $333 billion increase in the net U.S. liability position in 2005 to a negative $792 billion was considerably smaller than the current account deficit of $210 billion for the year, largely because of a substantial increase in the value of foreign assets held by US investors.  The market value of foreign stocks held by domestic investors alone increased $384 billion in 2005, much more than the $69 billion increase in the value of foreign holdings of US stocks. In other words, US assets are being swapped for foreign asset at a premium.

Foreign central banks sharply increased their holdings of US government securities in 2005, as they purchased dollar assets in order to keep the values of their currencies from rising against eh dollar.  China alone increased its holdings of foreign exchange reserves by at least almost $210 billion in 2005.  As a result, the real value of the US dollar gained 3.7% in 2005, despite growing trade deficits and the declining NIIP. A rise in the exchange value of the yuan against the dollar will mean less Chinese purchases of US sovereign debt. Does the US really think that is to its advantage?

NIIP is measured by two components: 1) direct investment, the value of domestic operations directly controlled by a foreign company; and 2) financial liabilities, the value of stocks, bonds, and bank deposits held overseas. At the start of 2004, foreign direct investment in the United States was $2.4 trillion, while U.S. direct investment abroad was about $2.7 trillion.  US-held foreign financial assets amounted to $5.1 trillion while foreign-held US financial assets amounted to $8.1 trillion, or 74% of GDP. The 2004 NIIP was a negative $3 trillion, about one third held by China alone. FDI to China in 2005 was only $72 billion, about 7% of its foreign reserves.

At the start of 2004, total US securities had a market value of $33.4 trillion, about 50% of the world total. Foreign investors held more than 38% of the $4 trillion in US Treasury bonds, but only 11% of the $6.1 trillion in agency bonds (such as those issued by Fannie Mae and Freddie Mac); 23% of the $6.5 trillion in corporate bonds; and 11% of the $15.5 trillion in equities outstanding. These foreign liabilities are the result of a string of current account deficits that have grown from 1.5% of GDP in the mid-1990s to 7% of GDP, about $805 billion, in 2005. Economists at the Organization for Economic Cooperation and Development (OECD) estimate that ongoing deficits of 3 percent of GDP would bring the US NIIP to negative 40% of GDP by 2010, and that it would eventually stabilize at around negative 63%. If the deficit remains at today's level, they foresee the NIIP growing to negative 50% of GDP by 2010 and eventually to negative 100%.

Yet future dollar depreciation and market adjustments in interest rates and asset prices will likely check the negative increase of the NIIP. Dollar depreciation against the euro and the yen in 2002, 2003 and 2004 kept the NIIP flat despite rising current account deficits. Under dollar hegemony, chronic US current account deficits reflect strong economic fundamentals rather than fatal structural flaws. The problem with US trade policy is not economic but political fallouts from unbalanced dislocations such as income disparity and sector-related job loss.

Three Ways to Look at the Trade Deficit

A trade-oriented approach views US current account deficits as a byproduct of robust economic growth, reinforced by an overvalued dollar and the US economy’s structural import bias. In this view, the U.S. has a stubborn current account deficit because it grows both faster and with more efficiency than its trading partners and spends a disproportionate share of its growing income on imported goods and services to further accelerate its economic development paid for with debt denominated in dollars that the US can print at will.

A related perspective blames low domestic saving for the danger of trade deficits, fearing that a sudden reluctance by foreigners to continue exporting their excess savings to the US would send the US economy into financial crisis. But US saving is stronger than government statistics show. Capital gains on equities, 401(k) plans, and home market values even after coming correction, which add up to 20% of GDP, are excluded from measurements of personal saving. The national account also excludes “intangible” investment: spending on knowledge-creating activities such as on-the-job training, new-product development and testing, design and development, and managerial time spent on workplace organization. Economists at the National Bureau of Economic Research estimate that intangible investment grew rapidly during the 1990s and is now at least as large as physical investment in plant and equipment: more than $1 trillion per year, or 10% of GDP. Consequently, the size and growth rate of the US economy have been seriously underestimated by the neglect of stealth saving.

A third approach to the current account deficit focuses on the growth and composition of global wealth. In this framework, international capital movements drive the current account balance, rather than vice versa. With the US expected to grow faster than Europe and Japan over the next several decades and wealth growing rapidly in Asia, especially in China and India, foreign wealth will continue to flock to US financial markets. This could generate a sequence of U.S.U.S. assets; NIIP ratios that appear dangerously high relative to US GDP would still be sustainable because of the rapid growth of global wealth.  The only obstacle is political restrictions put on foreign acquisition of US assets.  deficits as high as 5% of GDP, causing the NIIP to balloon. But such an increase would not mean an end to the foreign appetite for US assets; NIIP ratios that appear dangerously high relative to US GDP would still be sustainable because of the rapid growth of global wealth. The only obstacle is political restrictions put on foreign aquisition of US assets.

US financial markets have stayed strong even as the financing of the US deficit shifts from private investors to foreign central banks. From 2000 to 2003, the official institutional share of investment inflows rose from 4% to 30%. A large percentage of the $1.3 trillion in Asian government foreign exchange reserves is in US assets. Central banks now claim about 12% of total foreign-owned assets in the United States, including more than $1 trillion in Treasury and agency securities. Official inflows from Asia will likely continue for the foreseeable future, keeping US interest rates from rising too fast and choking off investment. Yet US phobia against government ownership versus private ownership will eventually make this trend a political problem.

Senator Schumer charges China with pursuing a “mercantilist” development strategy of undervalued exchange rates to support export-led growth at the expense of the US.  This is uninformed grandstanding because mercantilism has to do with gold-backed specie currency, not a fiat currency as the dollar. Under dollar hegemony, China must continue to finance US imports of its exports, since the US is its largest market and a major source of inward direct investment. Only a fundamental transformation in China’s development and growth strategy could undermine this unequal terms of trade, an unlikely prospect as long as Chinese policy makers remain under the toxic spell of snake-oil neo-liberalism. The biggest threat to U.S. hegemony stems not from the sentiments of foreign investors, but from protectionism and isolationism at home.

For China, US protectionism will force it to turn from export toward domestic development. Mao Zedong said that bad things could be turned into good things. Such a shift will liberate China from its slippery path into a comprador mode of development back on the track of economic self-determination.

A Strategic Economic Dialogue

Since assuming office on July 3, 2006, Secretary Paulson has put together a “strategic economic dialogue” that began in September. A key to the success of this potentially highly useful dialogue is to not to push China in the direction as a cheap labor colony of the US, but to allow China to develop as a powerful engine of growth for Asia and the global economy. To do that China must be wean from its current addition to labor-intensive export and redirect its energy toward domestic development not from foreign capital but with sovereign credit. Only a vibrant Chinese economy that trades with the US as an equal partner can set the US free from the ironic problem that dollar hegemony has created for its economy.

Representative Nancy Pelosi, the California Democrat who is to serve as Speaker of the House next year, who has earned a string of misguided anti-China medals during her political career, has already signaled a tougher line on China, raising the stakes for the Treasury secretary. “Many of us in the Congress will be watching closely for tangible results from Secretary Paulson’s trip,” Ms. Pelosi said through a spokesman, asserting that the administration’s policies on China have generally been ineffective across the board. The tangible results, if they come to pass, will be a hard landing for the US economy. The incoming Speaker needs to understand that US-China trade is a key factor behind this Goldilocks US economy.

In his first speech, Paulson said: “These challenges are made even more difficult by the fact that within China, as in the U.S., there are loud voices espousing anti-reform, protectionist sentiment. In China this resistance stems from a number of factors including that the benefits of this economic expansion have been spread unevenly among its citizens and that some influential people have never fully embraced the need to open up the Chinese economy to competition. This protectionist sentiment is evidenced by increasing levels of public discontent, demonstrations, and anti-reform articles written by prominent academics.”

The Wealth and Income Gap

The widening gap between the richest and poorest US residents has not the focus of attention by anyone in the Bush administration until Henry Paulson, the new Treasury Secretary who sees it as a long-term economic policy challenge. Paulson appears to attempt to reframe the policy debate on this fundamental issue as a solution to the trade problem. The trade problem is rooted in global income inequality which is a problem that the US cannot solve without first addressing its domestic income inequality.

The wealth gap is a fixture of the industrialization phase of US economic history but relative income equality has been the dynamo of the US consumer economy. Fordism put the US on the road to rising industrial wages to create the US middle class out of factory workers and allow the US economy to overtake its older European competitors. The two world wars gave US workers income growth that consistently outstripped inflation and allowed productivity growth to sustain spectacular growth of consumer demand, a key component in the success of the US economy.

Market capitalism naturally produces income disparity and polarization that lead to recurrent economic crises. To correct this structural flaw, the nation adopted an income policy. Income redistribution has been the tradition of the US tax regime since the New Deal. With the onset of 8 years of supply-side “Reaganomics”, followed by  another 8 years of neo-liberal “Rubinomics” under Clinton, whom orthodox liberals Democrats accuse as the best Republican president in history, inequality has been growing in US society to fuel a vibrant economy. While the Republicans adopted a new income policy to redistribute income upward with the watering down of the progressive income tax, the neo-liberal Clinton Democrats used outsourcing in a globalized market economy kept US wages from rising, and built a fiscal surplus by starving social spending. The nest result is to expand the globalized economy at the expense of the US domestic economy.

For the past two decades, two-party democracy has failed to provide alternative choices in economic policy for the US electorate. And outsourcing is not the only factor driving US wages down, even as average worker productivity within the US has surged, average hourly earnings have stagnated, while the nation’s economic elites have prospered with astronomical levels of incomes. New sectors such as the high-tech, information technology and financial services operate on the model of low salaries and high stock options. Even for investors, the trend has been to favor equity appreciation over dividend income. Neo-liberal economist seemed to have forgotten the basic rule in finance: Income is all. Economic growth without income is a fantasy.

Income disparity has now reached obscene levels. Capital One Financial CEO Richard Fairbank exercised 3.6 million options for gains of nearly $250 million, on which he pay tax on the lower capital gain rate rather the income tax rate. His personal take exceeded the annual corporate profits of more than half of the Fortune 1000 companies, including Goodyear Tire & Rubber, Reebok and Pier One. Median pay among chief executives running most of the nation's 100 largest companies soared 25% to $17.9 million in 2005, dwarfing the 3.1% average gain by typical US workers. And Congress is in the midst of a passionate debate over raising the minimum wage from the current $5.15 an hour to $7.25 an hour in 2009 in three steps, with opponents to the proposed bill claiming that such a raise would destroy the US economy. The idea of indexing the minimum wage to inflation is considered a legislative non-starter.

US corporate earnings are at an all-time high because wages have been stagnant. Corporations are overflowing with cash but they refuse to pass it on to their workers. Instead corporations adopt share buybacks scheme with the surplus cash to raise the market value of the stocks.

To his credit, Paulson is the first Treasury Secretary in recent history to focus on the inequality problem. In his first major speech as Treasury secretary, Paulson said: “Amid this country's strong economic expansion, many Americans simply aren't feeling the benefits. Their increases in wages are being eaten up by high energy prices and rising healthcare costs, among others.” Paulson gave notice that this issue will be a priority in his agenda to restructure the US economy.

A Federal Reserve survey shows that between 2001 and 2004, the median income of US workers with college degrees barely budged, rising from $72,300 to $73,000, after adjusting for inflation. Clinton Administration did almost nothing to advance the interests of organized labor or working people more generally. Union membership continued its long decline during the Clinton presidency, standing at 13.5 percent of the total workforce when he left office.  A paper co-authored by Rubin observed: “Prosperity has neither trickled down nor rippled outward. Between 1973 and 2003, real GDP per capita in the United States increased 73 percent, while real median hourly compensation rose only 13 percent.”

New Populism Against Rubinomics

A new wave of economic populism is surging along with Democratic victory at the polls. Yet these new populists seem to exclusively target foreign trade, not realizing that the imbalance trade is the result rather than the cause of the new age of economic inequality, the fountainhead of which originated in US domestic policy. If Paulson really wants to deal with the problem of persistent US trade deficits, the solution lies not in Beijing, but at home in the US.

The new populists argue that the trade agreements beginning with NAFTA and continuing through the various World Trade Organization negotiations have failed to protect workers’ rights to organize unions and thus raise wages in the low-wage countries. Instead, wages in high wage countries have continued to stagnate or drift downwards in real purchasing power. They also insist not only on an increase in the minimum wage but on tying it to the cost of living so that future inflation will not erode its real value, as it has in the past.

Just as the neo-conservatives have hijacked foreign policy in the Bush Administration, the neo-liberal Clinton wing of the Democratic Party hijacked the party’s economic policies. The Clinton neo-liberals imported the Republican ideology that the economy could achieve sustained growth only if markets were allowed to operate unregulated globally. Treating labor as a captured constituency, the Clinton administration vigorously supported free trade agreements like Nafta and agreed to China’s admission into the World Trade Organization (WTO) to expand the global economy at the expanse of the US domestic economy, with half-hearted promises of worker retraining and other safety-net measures that Clinton’s balanced budget could not fund. The adverse effects of Reubinomics were masked by a temporary burst of unsustainable economic prosperity caused by corporate and consumer debt.

The new populists want an alternative to Rubinomics, one that register growths by the income received by the middle class. They argue that the national income has increasingly flowed disproportionately into corporate profit and the rich. They call for a review of US-led globalization and for new terms of trade that do not put the cost of economic expansion entirely on the chronic poor, the newly poor and the powerless both domestically and globally. They call for government regulation in the terms of trade to distribute the benefits more equitably.

The free traders accused the new populists of being protectionists. Rubin admits that globalization has not brought job security or rising incomes to US workers and that as the global economy expands to benefit the US in general, it does so at the expense of shrinking the US middle class’ share of the economic pie. Yet Rubinomists stick to the worn-out Maragret Thatcher claim of TINA (There is no alternative), arguing that regulating trade and imposing market restrictions would be self-defeating. There is now enough historical data to question the false claim of benefits of financial globalization which has brought about monetary and financial crises around the world every few years. The emergence of unregulated capital, debt and currency markets has prevented government around the world to effectively use sovereign credit to finance domestic development and force all nations to distorting their economies toward over-reliance on exports for dollars and to compete by joining the race to the bottom on wages and environmental abuse.

And it is not clear that Rubinomics was really responsible for economic growth of the 1990s. Historical data suggest that the information revolution greatly improved productivity even in economies insulated from Rubinomics, such as China and India.

The free market does not know best. Left undirected, a free market will race ahead at unsafe speed towards accidents waiting to happen. A more balanced US economic policy away from maximization of profits might have let that productivity burst lift the global economy into a higher plane without distortions that are haunting it now.

In his 2003 book, In an Uncertain World, Rubin admits: “In retrospect, the effect of the Clinton economic plan on business and consumer confidence may have been even more important than the effect on interest rates.” Business investment during the Clinton boom years was not exceptional vigorous. It was the brain-power intensive information revolution that helped trigger big gains in productivity and growth despite a comparative low capital input compared to earlier capital-intensive cycles, such as the railroad age.

The 1997 Economic Report of the President released in February, five months before the 1997 Asian financial crisis, predicted that growth would average a meager 2.2% over the next four years. The actual growth rate turned out to be 3.9%, almost twice. A case can be made that the high growth rate was the result of the Fed’s monetary easing in response to the Asian financial crises which started on July 2, 1997 in Thailand and whirled around Asia via contagion like a tornado. When contagion hit Wall Street in October, the Fed did what no other central banks could do. It printed dollars to provide liquidity to the US banking system to not only contain the crisis, but also to allow US banks to buy up distressed Asia assets at fire sale prices. It was a clear example of how dollar hegemony works.

“Rubinomics” is a doctrine of aggressive trade liberalization paid for by squeezing domestic and foreign workers while balancing the fiscal budget at home by cutting social programs to avoid the need for raising taxes progressively. The Clinton Federal surplus came directly from the pockets of workers. Yet Rubin has said publicly that he understands that income inequality, both domestic and around the world, will produce a political backlash at the core that threatens the neo-liberal trading system, even the stability of capitalistic democracy. Rubin acknowledges the ill effect of globalization on US wages which takes on political significance when the squeeze shift from just the poor who seldom vote, to the politically active middle class. The favoritism of government policy towards the rich, particularly the tax structure, has become so embarrassingly obscene that even the super rich such as Warren Buffet complained about its unfairness.

Rubin has launched the Hamilton Project, a policy group of like-minded economists and financiers who are developing ameliorative measures to aid the threatened workforce and to create a broader political constituency that will defend the trading system against populist backlash. Yet how can one defend a system that creates wealth by making the majority poor? It is not possible to deify Mammon, the demon of the love of money.

The populist tidal wave may well build up to tsunami scale. As outsourcing move up the skill ladder, threatening the job security of not just assembly line workers, but highly educated, resourceful and active workers in high-tech, information technology, medicine and finance, the democratic process will turn against neo-liberal globalization. The backlash can turn ugly, mixing xenophobia with anti-Semitism.

The neo-conservative Weekly Standard observes correctly that wages have been stagnant because the increases in compensation have been eaten out by soaring health care costs. Yet both neoconservatives and conservatives oppose universal health care as socialistic.  The Weekly Standard proposes “outsourcing healthcare services to cheaper foreign countries where highly qualified medical professionals working with the latest equipments only charge less than a fraction of the fees in the US. Some corporations have already started doing this, and the results so far have been very positive.” The American Medical Association, the conservative trade lobby for doctors, will soon join the march against globalization.

Neo-conservatives Defend Globalization

Globalization is being defended by neo-conservatives who are strange bed-fellows of neo-liberals. The Weekly Standard wades in: “It is estimated that of the 28 Democrats who beat GOP House incumbents on Election Day, 22 are unabashed protectionists, with five being pragmatic protectionists. All six losing GOP senators were free traders. Even free trader Jim Jeffords of Vermont is being replaced by the reliably anti-globalization Bernie Sanders. There is a new scent in the air, and if you're not convinced, consider the life and times of Lou Dobbs. The CNN television host suffered for years from flat ratings as the young upstart Fox News regularly cleaned his clock. Then Dobbs began pounding the anti-globalization theme, night after night bemoaning the American jobs lost to foreign competition. His ratings suddenly shot up by more than a third.”

Free trade still has one reliable defender: the presidential veto which the Democrats do not have the vote to override for the next two years.

A False Debate

Yet the debate on globalization is between two extremes rather than seeking solutions. International trade is very desirable if it augments domestic development. Unfortunately, in the last two decade, international trade has turned itself into an inhibitor of domestic development. This is because the destructiveness of dollar hegemony which forces all economies to suppress domestic wages and development to compete for export to earn dollars which cannot be used at home. What is needed is a new international finance architecture that allows export payments to be denominated in the exporting country’s currency so that domestic development can be financed with sovereign credit without having to resort to importing foreign capital.  Concurrently, growth needs to be measured not in terms of how many workers are laid off from mergers and acquisition in the name of efficiency, but by how many new jobs are created by improving productivity with new technology. A corporate tax regime should be introduced to discourage obscene profits so that earnings can be channeled more equitably back into wages to stimulate consumer demand to reduce overcapacity in the economy.

These are the issues that Paulson and his team should be exploring with their Chinese counterparts in the “strategic economic dialogue” to develop a symbiotic trade relationship between the two major economies that will augment urgently needed domestic development. There is no sense kicking around dead horse issues like exchange rates and intellectually property rights.