The End of Chimerica

Just as the global economy is tentatively re-establishing its footing in the aftermath of the financial crisis, a fresh wave of controversy threatens the nascent stability. Since his first trip to China in November 2009, President Obama has increasingly expressed concern that the weakness of China’s currency may disrupt the fragile balance of world trade. He has not been alone in his concern — the European Central Bank, the International Monetary Fund and many Western economists have also called for China to revalue the yuan to be more in line with the U.S. dollar and other major global currencies. Most estimates of the yuan’s undervaluation fall between 25 percent and 50 percent, an undervaluation that effectively subsidizes China’s exports and imposes a tax on its imports.

The Chinese government rejects the notion that its exchange rate policy has given it an unfair advantage and suggests that a stronger yuan would be tantamount to a consumption tax on American and other consumers. Although China clearly has growing fears about overheated domestic growth and inflation — it twice tightened credit earlier this year by raising the level of bank reserves it requires — it has not seemed concerned that undervaluation of the yuan could exacerbate bubbles in its economy.

Still, it is widely believed that a stronger yuan would make China’s economy less dependent on exports and put its future growth — and the global economy — on more sustainable paths. A recent research paper entitled “The End of Chimerica” goes even further, suggesting that a historically unique financial symbiosis between China and America, a phenomenon the authors call “Chimerica,” has dominated the world economy for the better part of the last decade and now must end. One of the paper’s authors, Niall Ferguson, a professor at Harvard, is also the author of “The Ascent of Money” and the creator and host of the PBS series of the same name. Both the book and the series discuss the origins and implications of the Chimerica relationship. In “The End of Chimerica,” Ferguson and co-author Moritz Schularick, an economics professor at the Free University of Berlin, assert that the relationship, though initially beneficial, has become a dysfunctional one that contributed to and was then made untenable by the financial crisis of 2007-9.

What went wrong? China’s economic rise resulted from its adoption of a strategy, employed by post-World War II Germany and Japan, of export-led growth, the authors say. However, China’s rise was marked by currency intervention and a corresponding accumulation of reserves that, in combination with highly integrated and under-regulated financial markets, produced a debt-fueled asset bubble in the West unlike anything seen in the postwar decades.

When China embraced foreign trade and foreign direct investment during the 1990s as cornerstones of its new development strategy and its exports and GDP multiplied, Chinese authorities consistently bought dollars to prevent their currency from appreciating. These currency interventions served two goals: to promote export-led industrialization and to build a cushion against future financial crises. The result was a vast accumulation of dollar-denominated securities in government reserves. In 2000, China had currency reserves of $165 billion, slightly above 10 percent of GDP, and by 2009 currency reserves reached $2.3 trillion, representing more than 50 percent.

“With a combination of governmental capital controls, tight regulation of credit and a huge pool of unorganized labor, Beijing was able to operate a consistently undervalued real exchange rate without generating high inflation,” Ferguson and Schularick write. This helped create the macroeconomic backdrop for the recent financial crisis.

Bankrolled by China, the U.S. economy overdosed on debt and indulged in a decade-long orgy of consumption, with households spending more than they earned. From 2000 to 2008, total spending in the United States was 45 percent higher than total income. The authors emphasize that Beijing cannot be blamed for reckless lending and borrowing by Western financial institutions. Yet, they write, “Had it not been for the Chinese willingness to fund America’s consumption and real estate speculation habit, long-term interest rates in the United States would almost certainly have been substantially higher, acting as a circuit breaker for the housing bubble.”

Ferguson and Schularick believe the lesson of German and Japanese history is that export-led growth can work only when major gains in productivity are accompanied by significant exchange rate appreciation.

“The world economy’s key structural imbalance is that the second biggest economy in the world has pegged its currency to that of the largest economy at a strongly undervalued exchange rate,” they say. “That poses two massive threats to the global economy. First, it limits U.S. recovery by overvaluing the dollar in key Asian markets. Second, as the dollar weakens against other developed world currencies — notably the euro and the yen — the burden of adjustment falls disproportionately on Europe and Japan.”

The authors cite three compelling reasons that a major exchange rate revaluation is in the United States’ interest:

If the yuan does not increase in value against the U.S. dollar, the United States’ only option to regain competitiveness against Asia would be deflation, which is out of the question for such a highly leveraged economy.

Exchange rate adjustment would allow the United States to import demand from abroad, lessening its potentially dangerous reliance on its own public policy to stimulate domestic demand.

Revaluation is also in China’s interest, the authors contend. It would decrease the amount of U.S. government debt and dollars in circulation — good news for the biggest holder of U.S. Treasuries — and ensure a healthier balance of trade between China, the United States and Europe. To be sure, with revaluation China would incur significant losses on its dollar reserves, but Ferguson and Schularick argue that is a “modest price to pay for a development model that propelled China from third world status to an economic powerhouse in less than 15 years.” The price would be even more modest if they added in the avoided cost of China possibly losing its newfound stature if it fails to revalue. It remains to be seen whether the Chinese agree with this assessment.