Bernanke to China: Stop Hurting Us or You'll Hurt Us

Even though the Chinese economy is growing at a 10% pace while the United States economy is growing at 2%, Federal Reserve Chairman Ben Bernanke could not resist telling the Chinese government how to run its economy.  His remarks appeared in his November 17 2010 speech in Frankfurt, Germany.  He lectured China:

[C]ountries that maintain undervalued currencies may themselves face important costs at the national level, including a reduced ability to use independent monetary policies to stabilize their economies and the risks associated with excessive or volatile capital inflows. ... Perhaps most important, the ultimate purpose of economic growth is to deliver higher living standards at home; thus, eventually, the benefits of shifting productive resources to satisfying domestic needs must outweigh the development benefits of continued reliance on export-led growth. 

The trouble is that it is the United States, not China, which is having difficulty stabilizing its economy, and the "ultimate purpose of economic growth" may not be higher living standards at home."  Nations have other goals like dominating their neighbors, as Japan, the USSR, and the Nazis had before WWII.  Even the U.S. had dominating the Americas as an objective during the late nineteenth and early twentieth centuries.

China is running huge trade surpluses (about 5% of GDP) because it is concentrating on growing its national power.  And she has the help of hundreds if not thousands of multinational corporations.  Her trade surplus is largely made up of the products produced by multinationals in China, including high-tech products like computers, televisions, cell phones, and automobile parts.  The list of companies looks likes the Who's Who of the industrial world!  And make no mistake: their factories -- really co-factories -- are Chinese.  The Chinese have learned from Stalin's mistakes and understand, as Lenin did, that the capitalists in their greed will provide the rope to hang themselves with!  Recently, Andrew Grove, a founder of Intel, warned his fellow high-tech companies like Apple, HP, Dell, and many others that their outsourcing in China foretells a coming disaster for the U.S.  Grove noted that most of these companies have ten times as many employees producing in China as they do in the United States.

Although Bernanke thinks that China is sacrificing higher living standards through its present policies, he is incorrect.  While hundreds of millions in the provinces have not participated in China's economic growth, millions of Chinese workers have reaped substantial benefits.  China has a significant middle class.  It is the United States that is seeing its living standards decline and its distribution of income worsen as a result of the loss of factory jobs, all because Bernanke and America's other economic leaders don't understand the negative effects of our chronic and escalating trade deficits.

Modern Mercantilism

If Bernanke wishes to further his understanding of China's mercantilist development strategy, he needs go no farther than Heng-Fu Zou's 1997 Dynamic Analysis of the Viner Model of Mercantilism, originally published in the Journal of International Money and Finance.  Zou is a Harvard-educated Chinese economist who served as Senior Economist at the World Bank from 1989 through 2008.  Zou has appointments at both China's Zhongshan University and Peking University (China's premier national university).  He is also co-chairman and Dean of the China Economics and Management Academy at Central University in Beijing and has won multiple outstanding scholar awards from China's Ministry of Education and the National Natural Science Foundation of China.  China's current policies may be based upon his work.

Modern mercantilism appears to be based upon the twin goals explained by the late University of Chicago economist Jacob Viner: (1) maximizing a country's power through accumulation of foreign assets while (2) maximizing long-term standard of living by suppressing the current standard of living.

In order to accomplish these goals, the mercantilist government places tariffs (and other barriers) upon foreign products while at the same time buying foreign assets (mainly interest-bearing bonds today -- gold and other commodities in the past).  In other words, modern mercantilist governments maximize their power and their people's standard of living over time through the combination of import barriers and foreign loans.

Zou demonstrated mathematically that Viner's twin goals are compatible.  First, he found that the more that a mercantilist country is willing to sacrifice present standard of living by accumulating foreign assets, the more power the mercantilist government gains and the higher the standard of living its people attain in the long run.  Second, Zou found that the higher the tariff that the mercantilist country places upon foreign imports, the more power the mercantilist government gains and the higher its people's eventual standard of living.

Although Zou did not address the effect of mercantilism upon its victims, the trade-deficit countries, those effects can be predicted as going in exactly the opposite direction from the the mercantilist country.  In the short run, the mercantilist country gets a lower standard of living, while the victim countries get a higher standard of living.  In the longer run, the mercantilist country gets a higher standard of living and increased political power, while the victim countries get a lower standard of living and reduced political power.

We experienced our higher standard of living during the house price bubble from 1998-2006 as Americans lived beyond their incomes, spending consumer loans that were indirectly provided by China and the other mercantilists.  Since 2006, we have been experiencing the lower standard of living and loss of power that comes to countries whose governments tolerate mercantilism.

Mercantilist Depredations Continue

It has been two years now since the Great Recession hit in October 2008.  As Bernanke noted in his speech, pointing to the data graphed below, "[a]s you can see, generally speaking, output in the advanced economies has not returned to the levels prevailing before the crisis, and real GDP in these economies remains far below the levels implied by pre-crisis trends."

According to Bernanke, one of the reasons why the United States and the other advanced economies are not recovering is that many emerging countries are purchasing foreign assets in order to manipulate the exchange rate of their currencies.  He doesn't mention that unequal WTO rules let emerging market economies, but not advanced economies, place high tariffs on any sector of their economy that they deem "strategic." In other words, most emerging market countries are currently practicing mercantilism.

If the emerging market economies weren't purchasing foreign assets, their currencies would appreciate in value and their trade surpluses would be reduced.  As a result, the advanced economies would experience increased exports and increased production for domestic markets.  As Bernanke pointed out:

This currency appreciation would ... tend to reduce net exports and current account surpluses in the emerging markets, thus helping cool these rapidly growing economies while adding to demand in the advanced economies.  Moreover, currency appreciation would help shift a greater proportion of domestic output toward satisfying domestic needs in emerging markets.  The net result would be more balanced and sustainable global economic growth.

The graph below shows purchases over the last year of the primary type of foreign asset that governments purchase: international reserves.  It shows that the governments of all of the emerging-market countries listed, with the exceptions of Turkey, India, and Chile, have devoted more than 3% of their GDP to the purchase of foreign assets over the past year.

These mercantilists are violating Article IV of the International Monetary Fund Articles of Agreement, which requires that countries "avoid manipulating exchange rates or the international monetary system in order to prevent effective balance of payments adjustment or to gain an unfair competitive advantage over other members."

Even though four countries exceed China in the proportion of their GDP devoted to foreign asset purchases over the past year, China is still by far the dominant purchaser.  In his speech, Bernanke pointed out that China's accumulation of $2.6 trillion in international reserves is about the same amount as all of the other emerging market countries combined.  (Many of the emerging market governments are now copying China's successful mercantilist strategy.)

Warning to China from Bernanke?

Although Bernanke did not recommend that the United States take action to balance trade, he did include an ambiguous statement which one commentator construed as a warning to China that the United States may soon take action.  Bernanke said:

[A]s I have described, currency undervaluation inhibits necessary macroeconomic adjustments and creates challenges for policymakers in both advanced and emerging market economies. Globally, both growth and trade are unbalanced, as reflected in the two-speed recovery and in persistent current account surpluses and deficits. Neither situation is sustainable. Because a strong expansion in the emerging market economies will ultimately depend on a recovery in the more advanced economies, this pattern of two-speed growth might very well be resolved in favor of slow growth for everyone if the recovery in the advanced economies falls short. Likewise, large and persistent imbalances in current accounts represent a growing financial and economic risk.

As warnings go, this is a peculiarly weak one.  Telling a mercantilist that he should change course or he will make his competitors in the international trading system weaker is like telling a Pittsburgh Steelers linebacker that he is hitting players on the opposing team too hard.  If Bernanke thinks that his advice will change China's policies, he has completely failed to understand that power is one of mercantilism's twin goals.  The Chinese government would like nothing better than to bury us. 

The Solution

America's long-term problems are caused by imbalanced trade, imbalanced budgets, and economic stagnation.  And our economic leaders can't think of any way to jump-start our economy except through spending increases and tax cuts that would make the budget deficits worse.  And those spending increases and tax cuts don't work because of our growing trade deficits.

The solution is simple: balance trade and balance budgets!  Trade can be balanced simply by adopting the WTO-legal scaled tariff.  Its tariff rate goes up when our trade deficit with a mercantilist country goes up, down when our trade deficit goes down, and disappears when our trade deficit with that country disappears.  It would force China and the other mercantilists to buy our products in order to export to us.

Balancing budgets reduces aggregate demand for American products, but balancing trade increases it.  Balancing trade increases American interest rates, but balancing budgets reduces them.  The two policies, taken together, cancel the negative effects of either taken alone.  Investment in new, highly efficient American factories would stimulate the economy almost immediately.  And the long-term benefits to American power and living standards would be enormous.

If we don't act against mercantilism, the future is predictable: America will decline as an economic and political power.  Eventually, China will replace the United States as the dominant power on the world stage, and totalitarianism will likely replace democracy as the world's dominant political philosophy.  All because our leaders wouldn't balance budgets and trade.

The authors maintain a blog at, and co-authored the 2008 book Trading Away Our Future: How to Fix Our Government-Driven Trade Deficits and Faulty Tax System Before it's Too Late, published by Ideal Taxes Association.