This week the U.S. Senate passed the Currency Exchange Rate Oversight Reform Act, which is a bold sounding name for a bill intended to require the the U.S. to greatly increase tariffs on goods imported from China in retaliation for China keeping its currency pegged at what many believe to be an artificially low value over what it would be if allowed to float freely on foreign exchange markets.
Even if passed into law by the House and signed by the President, my bet is, it's not going to work -- at least not in the way it is intended.
To begin with, it's at least a little ironic that the U.S., through the Fed's extended policy of maintaining near "0" interest rates coupled with its large scale purchases in the bond market (what it calls quantitative easing), has been keeping the dollar at an artificially low valuation in an effort to spur our domestic economy. What's more, this de facto devaluation of the dollar caused by U.S. monetary policy has a very real negative impact on the economies of other countries by causing the prices of goods denominated in dollars -- mainly internationally traded commodities such as oil -- to remain higher than they would be otherwise. In fact, the high price of commodities caused in part by the weak dollar also hurts our own economy, arguably offsetting any domestic benefit the weak dollar policy has in the first place.
In addition to this general negative impact, the monetary policy of lower than low interest rates and the resulting weak dollar has a very direct negative impact on the value of investments held by large U.S. government bond holders -- i.e. China which funds a disproportionate share of our national debt.
So imagine that China's reaction to the U.S. engaging in protracted intervention into our own monetary markets in order to keep the dollar artificially weak, thereby damaging China through high commodity prices and an inadequate return on its sizable investment in U.S. government debt instruments, decided to pass legislation imposing retaliatory tariffs on American goods going onto China. I think our senators and representatives would be outraged! A foreign country with the temerity to pass unilateral legislation seeking to dictate to us how we should exercise sovereign control over our own currency! We'd be screaming how it violates WTO standards and other international agreements.
And yet China exercises control over its currency in an effort to better manage its own domestic economy and we're passing laws to punish them. Of course the limits of sovereign power being what they are, it is not all that surprising that the next day China actually took action to lower the value of its currency -- sort of a "yeah -- and how are ya gonna make me" response to the Senate's action.
The worst part of the scenario is how it is likely to end. Placing high tariffs on Chinese goods will have the immediate impact of raising the prices of the many goods imported from China on which we are all so dependent, both consumer goods and inputs for U.S. manufacturing. These higher prices will decrease the real disposable incomes of Americans while increasing the costs of our own manufactured goods, driving our own economy further into a recessionary spiral.
Of course it won't end there. China will impose retaliatory tariffs on American goods headed to China, further dampening, rather than increasing, the access of American companies to the world's fastest growing market.
Challenging China apparently sounds good on the campaign trail -- one of the few bipartisan messages in this dismal political season. But unless cooler heads in Washington prevail (fortunately at least John Boehner seems to get it), this could all end very badly for global trade and the American economy -- a real lose / lose scenario of unintended consequences. Would someone in Washington please Google "Smoot-Hawley" and see how that worked out?