Beijing Has Budged on the Yuan. It Doesn't Really Help.

Both China and the United States need to remember that good economic policy starts at home.

The White House has been pressing Beijing to revalue China's currency, the yuan, for quite a while. Last week, it got a little of what it had asked for. Beijing announced a new currency-management system, and as part of that reform increased the yuan's value by a little more than 2 percent against the dollar. The White House greeted this change as a step in the right direction. But a few months from now, is America going to like the results? Maybe not.

The yuan was certainly overvalued before last week's change—and because the revaluation was tiny, it still is. Estimates vary, of course, but most analysts reckon that the currency would need to rise by 25 percent (some put the figure as high as 40 percent) to control inflows of foreign capital, brake the Chinese economy's over-rapid growth, and stabilize global financial markets. As the Bush administration sees it, a big appreciation—much bigger than 2 percent, for sure—was needed to make Chinese exports to the United States more expensive and American exports to China cheaper. A large rise would have helped to balance America's trade, buoy its manufacturers, and lessen the country's need to keep borrowing so heavily from abroad.

All of which seems to make sense. If China has at least made a start in pushing its currency up, what's the problem? There are two. The first is that China's economic relations with the United States are distracting Congress, the White House, and America at large from what the United States itself needs to do to protect its living standards: China is not the main reason why American consumers and businesses face big economic risks over the next year or two. The other problem is that China may be unable to manage the process it has embarked on quite as well as it thinks. Its timidity in choosing such a small appreciation of the currency could backfire, to everybody's cost.

To listen to some of America's politicians, the country's awesome trade deficit and the foreign borrowing needed to finance it are all a Chinese plot. China is pursuing a mercantilist trade policy, deliberately underpricing its exports (by means of the undervalued yuan, and in other ways) to hammer American manufacturing down. If China could be persuaded, or forced, to trade fairly, America's trade deficit would come under control and its manufacturing base would revive. All would be well. So goes the argument.

Well, China's regime is mercantilist—that much is true. Its economic policies are designed to promote exports, come what may, even at the expense of domestic living standards. (The counterpart of underpriced exports is overpriced imports, hence lower real incomes for Chinese consumers.) But it is worth noting that in the short term, at least, this policy can hardly be said to hurt the United States. In fact, at first blush, it makes America better off.

When a country subsidizes its exports through an overvalued exchange rate, other countries are well advised to take advantage and snap up the goods while they can. Odd as it may be for the Chinese, who are still very poor, to be transferring great slabs of their income to Americans, who are very rich, there is little reason in the first analysis for Americans to object.

And the deal is even better than this, of course, because America's trade deficit, which results only partly from trade with China, is being financed on amazingly advantageous terms. China's decision to keep its currency cheap has obliged it to lend vast amounts of dollars back to the United States, which Beijing has done by adding American government debt to its burgeoning foreign reserves. That debt pays about 4 percent a year. In other words, America has been buying underpriced goods from China, using credit extended by China at bargain-basement interest rates. This is the fabulous deal (fabulous for America, that is) that has Congress in a rage over Chinese perfidy.

It is true that the deal carries a downside for America. The pressure on American manufacturing is one drawback—but jobs in that part of the economy are under stress in any event, mainly because of labor-saving innovation. Greater demand for American exports in the rest of the world would help a bit, so a well-managed yuan revaluation would be welcome, but this would not stop the long-term decline of American manufacturing jobs. And even a big revaluation of the yuan might not spur American exports to China by all that much: Demand in China for imports would rise, all right, but much of that expansion in demand would be met by other countries.

The main risk for the United States in all of this is not "unfair" pressure on its manufacturers, but the possibility that the foreign lending needed to finance its overspending will at some point stop. If it did, the dollar might collapse, causing a spike in inflation and forcing the Federal Reserve to push up interest rates hard. American consumers are more deeply in hock right now than ever before, carrying a burden of mortgage and credit card debt that will be crushing if the cost of money rises by much. If interest rates shoot up, a recession will likely follow. Alan Greenspan, the Fed's chairman, has often warned that this is a thinkable scenario. A lot of economists regard it as not just thinkable but probable.

In a way, China is beside the point. The view that its growth comes at America's expense is simply wrong—it's more accurate to say that America is consuming beyond its means at China's (and others') expense. And that would not rank very high on America's list of economic problems, so long as the situation could continue indefinitely. Unfortunately, it can't. This pleasant state of affairs must come to an end—and if that happens too abruptly, it may drive the economy into recession. This is the homegrown risk that American policy needs to address.

The current American expansion is dangerously fragile not because of China's exchange rate policy but mainly because the United States is saving too little, and thus is borrowing too much from abroad. Much the best remedy for that is to curb the government's own borrowing—a task that Congress and the administration find much less congenial than bashing China. Policies to encourage private saving would also help. These could include tighter restrictions on tax relief for debt interest, more-generous tax incentives for saving, and maybe a broader shift from taxes on income to taxes on consumption.

Boosting public and private saving would improve the long-term performance of the economy at the same time it would lessen the short-term financial risks. Leaning on China to strengthen its currency is a far less reliable strategy. It distracts attention from the larger underlying issue. It tells protectionists inside and outside the government that they have something to play for. (If they should ever succeed in raising trade barriers, that would directly harm American economic interests.) It cannot even be relied on for the immediate palliative effects the administration has in mind.

In some respects, China's timid revaluation could actually make matters worse. Now that Beijing has backed down from its insistence that it would not loosen its currency peg, America's protectionists will press on. Threats of trade retaliation (and the chance that they may one day be carried out) could increase. The reform directs attention away from the economic issues that really count for the United States. It helps politicians to keep ignoring them.

The direct economic effects might also be perverse. Beijing's reluctant new flexibility on the currency may only strengthen the financial markets' conviction that the yuan has much further to rise. That belief has already been driving foreign investment into China, overstimulating the domestic economy, worsening the strains on the country's fragile banking system, and adding to the rate at which the country has been accumulating dollar reserves. This speculation may now accelerate. On the most-favorable assumptions, the currency change is too small to reduce the danger of a financial crunch in China very much. If China and the United States are unlucky, it may set in motion forces that make a crash more likely.

The right thing for both countries is clear, even if it is politically hard. Strictly in its own interests—not because America wants it—China should keep trying to rebalance its economy. It needs to consume more, invest less, stabilize expectations in the global capital markets, and for all those reasons let the yuan rise another 20 percent. Equally in its own interests, the United States needs to recognize and deal with its own savings shortfall by cutting the budget deficit and encouraging private saving. For America, this matters far more than what China does, and in the end will be necessary regardless. Both governments need to remember that good economic policy starts at home.