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With China growing about 10% per year and the United States growing at about 2% per year, I'm really getting tired of U.S. economic policy makers telling the Chinese government how to run its economy. They think that if China's leaders would just hear their cogent arguments, China would change course.

Take, for example, Treasury Secretary Timothy Geithner. In his written testimony at his January 2009 Senate confirmation hearing, he wrote:

More generally, the best approach to ensure that countries do not engage in manipulating their currencies is to demonstrate that the disadvantages of doing so outweigh the benefits. If confirmed, I look forward to a constructive dialogue with our trading partners around the world in which Treasury makes the fact-based case that market exchange rates are a central ingredient to healthy and sustained growth.

Or take Federal Reserve Chairman Ben Bernanke’s advice to China in his November 17 2010 speech. He said:

Third, countries that maintain undervalued currencies may themselves face important costs at the national level, including a reduced ability to use independent monetary policies to stabilize their economies and the risks associated with excessive or volatile capital inflows.... Perhaps most important, the ultimate purpose of economic growth is to deliver higher living standards at home; thus, eventually, the benefits of shifting productive resources to satisfying domestic needs must outweigh the development benefits of continued reliance on export-led growth.

This statement is incorrect in two ways. First, China is not practicing "export-led" growth. It is practicing "mercantilism." If it were practicing export-led growth, its trade would be balanced, but currently it is running trade surpluses of about 5% of its GDP each year. Second, China is not hurting its long-term standard-of-living by practicing mercantilism, it is hurting ours.

Modern Mercantilism

At some point, Geithner and Bernanke and the rest of our arrogant policy makers are going to have to take the time to learn about mercantilism. And they have no excuse now that the key mathematical analysis of modern mercantilism is online, Heng-Fu Zou's 1997 Dynamic Analysis of the Viner Model of Mercantilism, originally published in the Journal of International Money and Finance. Zou is Senior Economist at The World Bank with appointments at both China’s Shenzhen and Wuhan Universities. China’s current policies may be based upon that paper.

Modern mercantilism is based upon the twin goals of mercantilism as explained by University of Chicago economist Jacob Viner: (1) maximizing a country's power through accumulation of foreign assets while (2) maximizing long-term consumption by delaying present consumption in favor of future consumption.

In order to accomplish these ends it places tariffs (and other barriers) upon foreign products while at the same time buying foreign assets (mainly interest-bearing bonds today; gold in the past). In other words, mercantilist governments maximize their power and their people's future consumption through the combination of import barriers and foreign loans.

Zou demonstrated mathematically that Viner’s goals are compatible. First, he found that the more that the mercantilist country was willing to sacrifice present consumption by accumulating foreign assets, the more power the mercantilist government would gain and the more consumption the mercantilist people would have in the long-run. This was the first of the propositions that he demonstrated:

Proposition 1: The stronger the mercantilist sentiment, the larger the long-run consumption and asset accumulation....

The reason for this proposition is quite clear. As a nation highly values its wealth and power in the world, it saves more and consumes less in the short run in order to run a current account surplus and accumulate more foreign assets. More foreign asset holdings means more interest income, which in turn leads to more consumption in the long run. Proposition 1 is a very strong argument for mercantilism if a nation intends to maximize its citizens’ long-run consumption.

Zou also found that the more successfully a mercantilist government applied tariff barriers to foreign consumer products, the more it would gain in wealth and power and its people would gain in long-run consumption. This was the second of the propositions that he demonstrated:

Proposition 2: A permanent increase in the tariff rate raises the total long-run consumption and asset accumulation....

Proposition 2 provides support for the mercantilist protection policy, namely the ‘fear of goods’ (Hecksher, 1955), if attainment of a higher long-run consumption is the national objective. Both proposition 1 and proposition 2 indicate the long-run harmony between wealth and power. Indeed from the mercantilist perspective, ‘there is a long-run harmony between these two ends, although in particular circumstances it may be necessary for a time to make economics sacrifices in the interest of … ‘long-run prosperity’ (Viner, 1991, p. 136). Following an increase in the tariff, short-run consumption will be cut because people invest more in foreign asset. But in the long-run, the increased foreign asset accumulation gives rise to more consumption and more power for the nation.

Zou did not address the effect of mercantilism upon its victims. In fact, he assumed for the purposes of mathematical tractability that the mercantilist country was a small economy with little effect upon its victims. But the effects upon its victims can be predicted as exactly in the opposite direction as the effects upon the mercantilist country. In the short-run the victim countries gain consumption, while in the long-run the victim countries lose both power and consumption.

These effects are quite apparent in the United States of the last 12 years. During the house price bubble from 1998-2006, the United States got more consumption than normal by accepting the mercantilist loans from mercantilist governments. (When a mercantilist government buys another country's financial assets, it is giving that country a loan.) These loans financed first and second mortgages on homes.

Now the United States is trying to maximize current consumption by using loans from China and the other mercantilist governments to finance huge budget deficits. We get more consumption in the present, but become debt ridden at the same time. Eventually the loans have to be paid back in some form or another and so we will get less future consumption. In the meantime the United States government continuously loses power on the world stage.

Back to Bernanke

Bernanke's November 19 speech contained a paragraph what can be either read as a warning to China or as more arrogant advice. If it it is a warning, he is telling China that the United States will not continue to permit mercantilist predations. If it is arrogant advice, Bernanke is telling China that if they prevent American economic growth, they will be hurting themselves. Bernanke said:

First, as I have described, currency undervaluation inhibits necessary macroeconomic adjustments and creates challenges for policymakers in both advanced and emerging market economies. Globally, both growth and trade are unbalanced, as reflected in the two-speed recovery and in persistent current account surpluses and deficits. Neither situation is sustainable. Because a strong expansion in the emerging market economies will ultimately depend on a recovery in the more advanced economies, this pattern of two-speed growth might very well be resolved in favor of slow growth for everyone if the recovery in the advanced economies falls short. Likewise, large and persistent imbalances in current accounts represent a growing financial and economic risk.

If the above paragraph is a warning, then Bernanke is telling China that he will advocate unilateral policies to balance trade if China does not move in that direction. The scaled tariff could be his best option. Its rate goes up when our trade deficit with a mercantilist goes up, down when our trade deficit goes down, and disappears when our trade deficit with that country disappears, it would force China and the other mercantilists to buy our products so that they could export to us.

If the above paragraph is economic advice, then Bernanke has failed to understand mercantilism. Power is one of the twin goals of mercantilism. The Chinese government would like nothing better than to bury us. The eventual result of continuing U.S. inaction in the face of mercantilism is predictable, China will eventually replace the United States as the dominant power on the world stage. Given the nature of the two governments, this means that totalitarianism will replace democracy as the world's dominant political philosophy, all because our economic leaders wouldn't take the time to learn about mercantilism.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I own Chinese yuan through CYB.

Source: I'm Tired of American Economic Leaders Giving Advice to China