- The Washington Times - Thursday, May 24, 2007

For those who were hoping that China would agree to significantly increase the value of its currency (the yuan), the second round of Treasury Secretary Hank Paulson’s biannual Strategic Economic Dialogue with China ended in disappointment Wednesday. Congress and many U.S. manufacturers are convinced that last year’s $233 billion trade deficit with China was directly related to Chinese currency manipulation, which, they argue, keeps the value of the yuan as much as 40 percent below the exchange rate that would apply if the currency were permitted to float freely. In many sectors, particularly the U.S. auto industry, Japan, which ran an $88 billion trade surplus with the U.S. in 2006, is also believed to be a currency manipulator.

Mr. Paulson reported that he and Vice Premier Wu Yi “agree• that it is vital to the prosperity of both our nations that China rebalance its economic growth, encourage consumption and spread development more broadly among its people.” Conspicuously absent was any agreement that the American economy could use some rebalancing as well. That’s unfortunate. After all, the biggest reason that America ran a $765 billion trade deficit (5.8 percent of GDP) last year was due to the fact that our savings were inadequate to finance our business investment. Running a trade deficit enables America to import the financial capital necessary to fill the gap between business investment and domestic saving.

Personal saving turned negative in 2005 and deteriorated further in 2006. Fiscal policy has been an even bigger source of dissaving. For the 2002-06 fiscal period, cumulative budget deficits exceeded $1.5 trillion. Over the same period, foreign holdings of federal debt more than doubled, rising from $1 trillion to $2.1 trillion.

Over the last four years, China’s holdings of long-term U.S. Treasury and federal agency debt increased by 300 percent, rising from $154 billion to $620 billion. Japan’s holdings of the same debt categories more than doubled, increasing from $348 billion to $719 billion. When China and Japan purchase Treasury and agency debt, they raise the demand for dollars, which keeps the values of their currencies lower than they otherwise would be. These debt purchases by foreigners have a dampening effect on long-term U.S. interest rates. If China and Japan were to quit buying U.S. debt, while U.S. government and personal saving rates remained negative, then interest rates would rise; the dollar would be in danger of a free fall, which might require additional increases in interest rates; and the prices of imports would increase, fueling inflationary pressures.

Obviously, we need to rebalance our economy.

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