Dean Baker
China/U.S. Focus, September 14, 2012

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With China’s economy slowing in the second half of 2012 and the U.S. economy still operating far below its full-employment level of output, trade is likely to again be a source of tension between the world’s two largest economies. While this might appear to be a zero sum game, where reduced U.S. imports from China save jobs in the U.S. at China’s expense, this need not be the case. The key issue will be whether trade between the two countries can be put on a sounder path that will benefit both.

As it stands, China’s currency policy effectively subsidizes its exports to the United States. By buying up hundreds of billions of dollars of U.S. government bonds and other dollar-based assets each year, China’s central bank has raised the value of the dollar relative to the yuan. This has the effect of reducing the price of imports from China.

This is an effective subsidy from the Chinese government since it is virtually certain that they will end up taking a loss on their dollar assets. The returns are already low measured in dollars; however, since the dollar is virtually certain to fall relative to other currencies once China cuts back the size of its dollar purchases, China will be paid back in dollars that are worth considerably less than the dollars it purchased.

In the short-term this policy may be an effective way to develop key industries and maintain high rates of employment; it is difficult to see it as an effective long-term strategy. It is hard to imagine that in 20 years China will still be buying up hundreds of billions of dollars of U.S. bonds each year in order to maintain its export market to the United States.

If China’s government needs to maintain demand in its economy, it should be much easier to subsidize the demand of its own population. The money that China is likely to lose on its bond holdings could instead be used on domestic stimulus, building up infrastructure and improving the health care and education systems in China.

To some extent this was the lesson of China’s stimulus package in 2009. The country was able to maintain strong growth even as its exports plunged with one of the most aggressive stimulus packages in the world. Of course, the workers and companies who got jobs and profits from the stimulus were not the same ones who were hurt by plunging exports. However, this is a question of transition and adjustment, not one about overall growth. With enough time and the right policies there is no obvious reason that China could not continue and accelerate its evolution toward a more domestically based economy.

If China were to pursue the higher yuan/lower dollar route it would hugely improve the near-term outlook for the U.S. economy. The growth rate of employment and output over the last two years would not return the U.S. economy to full employment until the middle of the next decade, so China’s decision to let the yuan rise could prove enormously beneficial. In exchange for this favor, it would be reasonable for China to demand concessions from the United States of equivalent value.

The obvious target would be U.S. patent and copyright protections. The United States government has made stronger enforcement of patents and copyrights on U.S. products a top priority in its trade negotiations with China and other countries. These forms of intellectual property are in fact enormously costly forms of protectionism. They have far more impact on prices to consumers than other forms of protectionism and in the case of patents on prescription drugs, can jeopardize the health and life of millions of patients. 

Patents on prescription drugs currently add close to $270 billion a year (at 1.8 percent of GDP) to what people in the United States pay for prescription drugs. In addition, because they create an enormous gap between the patent monopoly price and the cost of production, they provide an enormous incentive for rent-seeking by drug companies. It is rare that a month passes without a story of a major drug company misrepresenting the benefits of its drugs, concealing evidence of harmful side effects, or finding some way to pay off doctors or other providers to increase the use of their drugs.

There are similar, if not as harmful, abuses associated with copyright and its enforcement. Requiring consumers pay large amounts of money for recorded music or movies, which would otherwise be transferred at zero cost, inevitably leads to large amounts of waste, especially from enforcement costs.

Rather than follow the United States blindly down the path of ever stronger patent and copyright laws, China could opt for more efficient mechanisms to support innovation and creative work. Its quid pro quo for ending its policy of supporting the dollar could be that it will allow a free market internally in the items where U.S. companies claim patent and copyright protection.

This would be an enormous boon to China’s economy and its consumers, with the dividends growing rapidly through time. Imagine that all new drugs could be sold in China for just a few dollars per prescription. Suppose that all recorded music, movies, books, videos and consumer software were available at no cost on the web.  

The gains from going this route should compensate China many times over from the transition costs associated with a reduced export market to the United States. In the longer term, as China develops more efficient mechanisms for supporting innovation and creative work, it will likely should past the United States and other wealthy countries in these areas.

The key to moving forward is to break with a pattern of development that is now destructive to both countries. This is a path to trade policy that can allow both the United States and China to be big winners.

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