Richard Pozen's Solution to Solve the US-China Trade Deficit

Robert Pozen wrote an op-ed for the WSJ yesterday arguing that the best way to shrink the trade deficit is for Chinese companies to increase wages, rather than faster yuan appreciation: Bashing Beijing Will Not Help Our Trade Deficit. He argues this because wages are the most expensive input for most of the goods exported from China to the US. And if wages increase, then Chinese will have more money to spend in China resulting in more of China's goods being purchased in China.

He also attacks yuan appreciation as an effective tool for the 3 following reasons:

1. Exports from China to the US are assembled in China while the component manufacture takes place in other countries. Chinese input costs are typically about 10%, so even a substantial appreciation would not result in a large increase in prices.
2. Appreciation of the yuan would push low-end manufacturing to other countries, but the overall exports to the US would be the same, just not from China.
3. The volume of high-end exports to the US is driven by competition with Germany and Japan, which depends more on the value of the euro and yen.

There are some significant problems with Mr. Pozen's argument.

First, if Chinese input costs are not significant, then higher wages will have no different effect on the trade deficit than a more valuable yuan.

Second, wage increases would also result in low-end manufacturing migrating to other countries. Also, many of the products manufactured in China for the US market are never sold in China. If wages increase, then Chinese might have more money to spend on the goods, but the goods would not be sold in the Chinese market anyway. The overall US trade deficit would remain the same, and jobs would likely be lost in China because the goods currently being manufactured for the US market cannot likely be re-purposed for the Chinese market.

Third, if the volume of high-end exports from China is driven by competition with Germany and Japan, and the value of the euro and yen is a strong factor in determining which country customers purchase goods from, then surely the value of the yuan would also be a strong factor if it appreciated to its true value due on freely convertible exchange.

Lastly, and most importantly, either a wage increase or an increase in the value of the yuan would produce the same end, but it is impossible to use a stick to force Beijing to raise the minimum wage in China. It is possible and legal to use sanctions against a country if they are manipulating their currency. That is not to say that China is manipulating their currency under the law, but the yuan is certainly undervalued.

Mr. Pozen's real concern is that American politicians' declarations that China is a currency manipulator only provoke resistance, and that they should instead promote higher wages. I certainly agree that yelling in front of cameras that China is a currency manipulator is not the most effective method to get China to act, and I wish Mr. Pozen had restricted his argument to this point because telling China that their workers don't earn enough certainly can't be any more effective.

However, hasn't Washington been fairly effective at getting Beijing to loosen up its currency Policy? It reminds me of the classic and instructive South Park episode when Cartman travels back to 1776 and learns Benjamin Franklin's important policy that a republic can have its cake and eat it too by voting to go to war while being anti-war. In this case, Senator Chuck Schumer and legislative branch can play bad cop, while Timothy Geithner and the executive branch play good cop, and concessions are reached.