Smith Faculty Opinion Article	March 23, 2007
By Dr. Peter Morici, Professor of International Business E-MAIL WEB SITE

China Ties Ben Bernankes Hands

Stagflation is rearing its head. The economy is dancing along the precipice of recession, and inflation remains stubbornly high.

The Federal Reserve cannot do much. Cutting interest rates to boost growth would accelerate inflation. Raising rates to slow inflation would be futile. Most pressure on prices stems from tight global petroleum supplies, slowing productivity growth and labor shortages, all exacerbated by Chinese abuses of globalization.

The current economic expansion began in the fourth quarter of 2001, and China was admitted to the World Trade Organization in November of that year.

Membership gave China, with 100 million plus underemployed workers, unbridled access to the U.S. market, and Beijing gave U.S. consumers an unlimited line of credit to buy whatever those workers could make.

Chinas strategy is simple. It encourages exports with subsidies and an undervalued yuan. Beijing, recognizing the U.S. market for manufactures from cheap hands has limits, requires foreign firms selling more sophisticated products in China to establish production and transfer technology.

General Motors, Intel and Caterpillar are making cars, microprocessors and heavy equipment in China, despite shortages of skilled labor and adequate suppliers. Their Chinese partners acquire know how to move up the industrial ladder and ultimately export more sophisticated products to Europe and North America.

Consequently, Chinas trade surplus with the United States has grown from $83 billion in 2001 to $236 billion in 2006. Those imbalances create an excess demand for Chinas yuan and should push up its value, but China, to keep its currency cheap, sells yuan for dollars and invests the proceeds, mostly, in U.S. securities.

Following China, other Asian governments pursue similar strategies, and the U.S. non-oil trade deficit with the region now exceeds $350 billion.

All this affects U.S. and monetary policy in three important ways.

First, large trade deficits push U.S. workers out of manufacturing and service industries that could export much more to Asia but for mercantilist trade practices.

Approximately two million U.S. manufacturing jobs, above those lost to labor-saving technologies, have fallen victim to imports. Meanwhile, finance and other service industries go begging for workers, because those displaced from manufacturing lack skills to handle the high-paying jobs service activities offer. Productivity suffers, wages rocket for college graduates with the right skills, and inflation bounces higher.

Second, China uses oil inefficiently to generate electricity. Every time a manufacturing job moves to China, more petroleum is required to power factories and provide amenities for workers that relocate from the countryside.

With global oil supplies and refining capacity tight, rising gasoline and electricity prices in the United States are among the untallied cost of inexpensive Chinese imports. Again, more inflation.

Third, the Federal Reserve, nervous about inflation, began pushing up short-term interest rates in June 2004, but Chinese and other Asian central banks have frustrated U.S. monetary policy with large purchases of U.S. securities to keep their currencies cheap and Americans spending.

Since the second quarter of 2004, the Federal Reserve, by purchasing U.S. short-term securities, has added about $78 billion to currency circulation and U.S. bank reserves, which back up loans to businesses and consumers. That is not much in a $13 trillion economy, and the prime rate on short-term business loans has risen from 4 to 8.25 percent.

Meanwhile, Chinese and other foreign central banks have purchased more than $750 billion in U.S. securities, and the rate on a 30-year conventional mortgage is still about 6.2 percent. That has permitted housing prices to rise another 28 percent, kept consumers spending through home equity loans, and pushed up prices for everything from apparel to zucchini. Again, more inflation.

Now, the housing boom and consumers have finally run out of steam, the economy has slowed substantially but inflation continues to nettle. Cutting interest rates to stimulate growth would add to the liquidity provided by foreign central banks and inflation would soar.

That leaves Ben Bernanke with only his bully pulpit.

Instead of lecturing Congress and the President about the evils of budget deficitsthey dont listen anywayhe should focus their minds on the productivity losses, needlessly wasted skills and inflation provoked by Chinese mercantilism.

Without an effective U.S. response to Chinese economic nationalism, Bernanke cant do much to steer the U.S. economy to safety but talk.

Peter Morici is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.