Dangerous Nonsense: Trade War with China

04/06/2010 9:59 am EST

Focus: MARKETS

John Mauldin

Chairman, Mauldin Economics

John Mauldin, editor of Thoughts from the Frontline, says the threat of punitive tariffs on China over its exchange-rate policies sounds like the Great Depression all over again.

I think the US will “muddle through” what promises to be a period of below-trend growth and a long-term secular bear market. It will not be pleasant or fun—there will be a lot of pain—but we will get through the coming crisis (note: I think the Big One is still in our future).

But there is one caveat that turns me from a Muddle Through-er into a real doom-and- gloom type, and that is the threat of protectionism and trade wars. As in Smoot-Hawley, which made the Depression into something much worse than it should have been.

Yet that is the prescription that Paul Krugman is advocating. In a commentary [recently] in the New York Times, he called for an across-the-board 25% tariff on Chinese goods:

"In 1971 the United States dealt with a similar but much less severe problem of foreign undervaluation by imposing a temporary 10% surcharge on imports, which was removed a few months later after Germany, Japan, and other nations raised the dollar value of their currencies. At this point, it's hard to see China changing its policies unless faced with the threat of similar action—except that this time the surcharge would have to be much larger, say 25%."

Krugman doesn't think the Chinese can really retaliate by dumping their hoard of dollars. He points out:

"It's true that if China dumped its US assets, the value of the dollar would fall against other major currencies, such as the euro. But that would be a good thing for the United States, since it would make our goods more competitive and reduce our trade deficit. On the other hand, it would be a bad thing for China, which would suffer large losses on its dollar holdings. In short, right now America has China over a barrel, not the other way around."

I probably shouldn't take on a Nobel Laureate who got his prize for his work on trade, but this truly scares me.

First, the Chinese have got to be wondering what they have to do to make these guys happy. In 2005 they were demanding a 30% revaluation of the Chinese yuan. And over the next three years the yuan actually rose by 22% at a gradual and sustained pace. Then the credit crisis hit, and China again pegged their currency. From their standpoint, what else were they to do? Force their country into a recession to appease our politicians?

But the reality is that the Chinese will do what is in their best interest. My prediction? The Chinese will begin to allow the yuan to rise again some time this year, just as they did three years ago, because it will be to their advantage. It will be 5% to 7% a year, so as not to create a shock to their export economy. Not 25% at one time. And at some point they will allow the yuan to float against the dollar.

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