China and Mercantilism

My colleague Tracy Miller has an excellent post, contra Paul Krugman, refuting the notion that a trade war with China would be a good thing for the U.S. economy. Among other things, he points out that China's policy of devaluing its currency actually harms the Chinese and benefits American consumers (i.e. all of us). Miller also notes a link between Krugman's Keynesianism and his mercantilism.

Mercantilism and Keynesianism have much in common and represent a faulty understanding of how an economy works. The large US trade deficit is not the cause of high unemployment in the US. Trade deficits mean that instead of buying US goods with the dollars they obtain from trade, foreign citizens or their governments are purchasing US financial assets. The Chinese government uses the dollars it accumulates from trade surpluses to buy US government securities. This increases the supply of savings in the US, which, by reducing interest rates, should lead to more investment. Krugman argues from the paradox of thrift, that in a time of mass unemployment, if anyone (including the Chinese government) tries to save more, demand and investment fall because there is excess capacity in the economy.

I've often found it ironic that American politicians and even some economists get overwrought about the Chinese government purposely devaluing its currency. These same people embrace the Federal Reserve and which has been devaluing the dollar since 1913.

The mercantilist mindset is driven by a conflict mentality. It assumes when one party benefits from trade the other party must be a loser. From this ideological perspective mercantilism appears reasonable, because there are no trade partners, only trade rivals, so why not stick it to the Chinese. Doing so, however, does not exactly promote loving thy neighbor.