The China Challenge

Congressmen in Washington DC have considered 'punishing' China for having such a large trade deficit with the United States - either through trade tariffs, or forcing them to revalue their currency. Politicians say this because they don't know any better, and/or they're trying to score political brownie points with their consituents.

It sounds good at first glance, but it's a terrible idea for these reasons:

1) China is the 2nd largest holder of US Treasury notes (debt) at around $600 billion. Japan is #1, holding approximately $1 Trillion. If the Chinese get tired of lending us money, all they have to do is not make future purchases - or worse yet, sell even a small portion of their Treasury holdings. Interest rates on these 10-year Treasuries would spike very quickly, and so would most mortgage rates. It has the potential to hammer the residential real estate market - literally overnight. Cheap mortgage money and speculation are the big reasons for the real estate mania/bubble/craze. It's darn sure not fundamentals.

2) The big reason for the trade deficit is structural - China has a large and growing manufacturing base, America's manufacturing base is in decline. I agree that China's currency is very undervalued compared to the US Dollar, and that's helped fuel the large trade deficit. Over the past two decades or so, its been a gradual process. Economists actually believed that the US didn't need the manufacturing base for a healthy economy; we'd just make it up in services.

The problem with this theory is that more of our service base is going overseas - mainly to India, where a large number of well-educated, English-speaking workers are ready, willing and able to do the same work at 10-20% of what Americans will do it for. It will take many years - if not decades - to regain our manufacturing base.

China is making and selling Americans more goods than America is selling the Chinese. It's as simple as that. Until US companies re-commit to rebuilding a solid manufacturing base in America, this will continue to be a problem.

3) The Smoot-Hawley Act helped plunge the US into the Great Depression in the 30s. Legislating a 2006 version of Smoot-Hawley is economic and fiscal insanity. Especially when you're trying to strong-arm your 2nd biggest lender to do things your way - and you don't have any leverage. A verse in Proverbs says, "The borrower is servant to the lender."

China will eventually revalue their currency to a more 'fair ' rate. Some Americans should be careful what they wish for. When the Chinese do this, it will increase prices on imported Chinese goods. The doo-dads and geegaws that were cheap at Wal-Mart will be more expensive. Since consumer spending makes up about 70% of GDP, that will slow down the economy. The economic correction and strong financial medicine will have to be taken - it's just a matter of being sooner or later.

No country can borrow and spend their way to prosperity. Lord knows Americans are trying their darndest to make this work. A household, business or government can only prosper when there is real savings, investment and profits. When you borrow and spend too much, you eventually will pay the piper. Or in this case, VISA, Washington Mutual and GMAC.

There won't be a quick fix for the trade or budget deficits. Americans will be forced to go back to these old-fashioned economic ideas (instead of a borrowing and spending blingfest) if they want to see things improve.