Some political-economic & cognitive-psychological reasons why climate change is such an intractable policy problem (2019)

Not knowing the first thing about climate change and climate policies, in what follows I offer a few thoughts as to why from a political-economy perspective tackling climate change proves so difficult, even as it is virtually impossible to deny that human behavior is the major cause of global climate change. The world appears to be in the midst of a sixth – this time man-made – extinction (Kolbert 2014). Some estimates put the speed of species extinction at 1,000-10,000 their natural rate. World temperatures are rising and it is pretty clear that man-made carbon emissions are responsible for the lion’s share of these adverse developments. While planet earth will survive, the survival of the human species for another millennium is not a forgone conclusion. This is so for a whole range of reasons (West 2017), including climate change. So why then is not more being done to fight climate change? Here are is non-exhaustive list of obstacles related to well-known problem of collective action (Olson 1965) and individual-level cognitive biases (Kahneman 2011).

First, the tragedy of the commons illustrates the obstacles faced by global cooperation on climate change (Hardin 1968), that is, self-interested actors undermine necessary cooperation. Public goods don’t get produced and common-pool goods are exhausted as self-interested behavior undermines the collective interest. Free-riding tends to undermine attempts at cooperation. Limiting freeriding is difficult. Any successful attempt requires mechanisms to impose penalties for non-cooperative behavior and, importantly, requires actors who are willing and able to bear the costs of enforcing cooperation.

Second, self-interested actors are often able to internalise the benefits of their economic behavior, while externalising (a share of) the cost of their behaviour. Companies pollute rivers. Countries pollute the atmosphere.  This complicates the establishment of binding and enforceable agreements, at least internationally, to the extent that actors well-positioned to externalise environmental costs while internalising much of the benefits of their behavior will be less willing to forego these policies and incur higher net costs than others.

Third, uncertainty about whether or not cooperation can be sustained in a world of legally sovereign nation-states will make some states reluctant to bear the costs of climate policies in the first place if the ultimate success of these policies depends on the continued, long-term cooperation of potential defectors. In Brazil and the US, important countries environmentally speaking, climate change skeptics have recently been elected into office. In other words, even if states recognise the need for collective action and cooperation, the inability to force large states to comply with existing agreements not only makes it more difficult to reach agreement. The possibility of their defection due to domestic political changes has the potential not just to undermine cooperation and international climate policies, but their longer-term success as long as there is a commitment problem and the threat of defection. In political-economic terms, the prospect for successful climate policies is weakened by the two-level games problem (Putnam 1988).

Fourth, the in-group/ out-group cognitive bias is not conducive to sustaining inter-group cooperation. While intra-group cooperation and altruism are well-developed in the human society (Wilson 2012), humans are also prone to inter-group competition (Greene 2013). While what constitutes a group remains up for grabs, political entrepreneurs, and especially states, have proven very adept at mobilising in-groups against out-groups. This makes inter-group, especially inter-state, cooperation vulnerable to defection and breakdown. Why should “Indians” accept limitations on carbon emissions given the less developed state of their economy, compared to, for example, “Americans”? This is not meant to suggest that groups necessarily form along national, let alone ethnic lines, just that group-related biases can and often are mobilised, often at the detriment of inter-group cooperation. Romeo and Juliet ran into trouble.

Fifth, at the level of cognitive psychology, hyperbolic discounting is a problem. Humans are prone to opt for immediate rewards over greater rewards in the future. To the extent that climate change is an inter-temporal problem, climate change policies require depend on the various relevant actors extending their time horizons. This is not easy, especially if short-term economic problems outweigh any concerns about the future state of the environment (e.g. poor, rural Indian). The inter-temporal problem becomes even more pronounced if the distribution of inter-generational costs and benefits is to be taken into account. Attempts to internalise costs (lower present standard of living) by one generation in order to confer benefits to the next generation (less future environmental degradation) often run into significant political opposition (e.g. grey majority and pension reform).

Sixth, humans find it intellectually difficult to grasp non-linear behaviour. While the recency effect may lead humans to overestimate certain low-probability events, humans have trouble dealing cognitively with statistical tails. However, complex systems such as the climate are characterised by non-linear behavior, that is, behavior where small events can have outsized (catastrophic) effects (e.g. butterfly effect). The complexity of today’s human societies arguably makes human civilization even more vulnerable to non-linear change than ever before (Tainter 1988). Human cognition geared towards linearity rather than the possibility of non-linearities is a significant problem in generating support for climate change policies. Com’on, how bad can it be? Right?

Last but not least, judging by opinion polls, a surprisingly large number of people remain far from convinced that climate change is real (at least the US) This may be due to a lack of science education, the increasing use of social media etc. At the cognitive level, it is rooted in the fact that humans prefer simplicity to complexity (Sloman & Fernbach 2017). This may explain creationism’s popularity at the expense of evolution. To the extent that it is necessary to convince people, especially in democratic countries, to support climate policies, it will be necessary to help them overcome these biases and evaluate the odds that climate change is “real” objectively. Populism, social media, the weakening of traditional gatekeepers and the attacks on “experts” aren’t helping.

This is by no means an exhaustive list of the cognitive and political obstacles the formulation and especially the implementation of forward-looking, effective climate policies face. This is not meant to suggest that failure to tackle climate change is inevitable, just that the political and psychological obstacles to be overcome are significant. Perhaps the best hope to tackle climate change is to keep one’s fingers crossed and hope that new technologies (e.g. fusion) will solve the problem. This is presumably what a stalwart of economic liberalism like The Economist would predict that  market solutions to environmental problems will emerge; just leave it to self-interest and the invisible hand. As the price of unpolluted food goes up, higher prices will elicit a supply-side response. It is rather more advisable not to pin one’s hopes solely on the emergence of market-based technological solutions. Market failure is more persuasive than orthodox liberals have us believe. Relying on markets at the expense of forward-looking government policies and international cooperation to tackle climate change is bound to prove too little, too late for human civilization – and perhaps even for the human species. 

Eco-systems (and human civilizations) did collapse in the past (Diamond 2004). To extent that tackling climate requires forward-looking policies, agreement on the distribution of costs and benefits between actors as well as over time will be a crucial component of any successful solution. Such policies should be flanked by more effective policies to help people (voters and decision-makers) overtime those cognitive biases that help prevent the formulation and implementation of policies aimed at tackling climate change. Such policies will also need to start from the recognition that sustaining cooperative behaviour among self-interest actors is a major challenge.

Advanced economies > Latin America .... (2019)

Latin America seems to be experiencing increasing political and economic instability. Governments in Bolivia, Chile and Ecuador have been rocked by protests. The Bolivian president has just been chased out of the country. In Argentina, economic populists defeated the economically relatively orthodox government of President Macri at the ballot box. The release of former President Lula in Brazil may lead to increasing polarization by paving another presidential run in 2022. Venezuela is in the midst of a major humanitarian crisis. Venezuela is also in default on its external debt and the new government in Argentina will have little choice but to restructure or at least reschedule its external liabilities. In Mexico, the second-largest regional economy after Brazil, AMLO, the country's left-wing president, is pursuing a less market-friendly policy than his predecessor. Last but not least, many of the smaller Central American and Caribbean economies have also been struggling with low economic growth and rising debt as well as occasional civil unrest (Nicaragua). Some countries even managed to default on their debt more than once in the past decade (Belize, Jamaica). The economic outlook for the region ranges from disappointing to dismal. This is all the more remarkable given the relatively favourable global economic backdrop. 

Economic growth has been disappointing. If the IMF’s forecasts are to be believed, five-year average real GDP growth in the region reached a mere 1.0% last year. It is set to fall to 0.6% this year. This compares poorly even to the performance of an advanced economies whose growth rate averaged 2.1%. Five-year average real GDP growth in both Argentina and Brazil has actually been negative, while in Chile, Colombia and Mexico it amounted to 2.0-2.5%. Only Peru will manage to eke out economic growth of slightly more than 3%, down from an average of 7% at the beginning of the decade. Last but not least, Venezuela’s economy is collapsing.

Source: IMF

Not only is Latin America doing poorly compared to the rest of the world. The region is also faring poorly compared to its past economic performance. Throughout much of the past decade, Latin America was riding high on the back of a commodity boom and, generally speaking, improved macroeconomic policies. Today it is difficult to see what could help lift the region out economic stagnation. Add to this the Eichengreenian middle-income trap and worsening demographics and the region’s growth rate will remain stuck around 2-3% over the medium term - at best. Downside risks abound. For a start, there is a risk then that low growth will lead to a further increase in political instability, less or no economic reform and continued economic stagnation. It is not difficult to see how this could quickly turn into a vicious political-economic cycle.

Source: IMF

The global macro backdrop is unlikely to improve. The US and European economies have slowed down. The US-China trade conflict continues to weigh on global trade and investor confidence. Advanced economies’ manufacturing sectors are in the doldrums and their fiscal and monetary policy space, though it varies somewhat, is generally limited. Advanced economies’ interest rates are already very low and it is unlikely that further Fed rate cuts would lead to a significant increase of capital flows to Latin America given worsening global sentiment and increasing risk aversion. Furthermore, China’s structural shift away from investment-intensive to greater consumption-led economic growth means that another commodity super-cycle is unlikely to come to Latin America’s rescue. In short, global economic growth has likely peaked. Even if a broader downturn can be avoided, it is difficult to see any upside as far as Latin America growth is concerned.

The outlook for growth-enhancing economic is far from encouraging. In countries like Argentina and Mexico, left-wing and populist presidents are unlikely to pursue major structural reform. Rising public discontent and increased political polarisation will make it harder to implement many of the reforms necessary to reinvigorate economic growth in absence of favorable global economic conditions. True, Brazil just passed an important pension reform. While undoubtedly welcome, it is worth remembering that the reform will only help avoid medium-term public-sector insolvency. Little has so far been done to reduce the infamous custo Brasil and address Brazil’s low productivity and dilapidated infrastructure. Moreover, the release from prison of former President Lula risks increasing political polarizationm, while the prospect of the left returning to power after the next presidential elections in 2022 will do little to lift the economy’s ‘animal spirits’. This will likely be true even if Bolosnaro surprises and manages to push through further structural reform through congress. Venezuela may prove a bright spot, but only if the Maduro government is replaced and a new Venezuelan government quickly resolves its external debt problems. Even then, necessary economic adjustment may prove more contentious, and the political transition more acrimonious, than many markets analysts anticipate. In short, the outlook for growth-enhancing structural economic reform in the region’s three largest economies, Argentina, Brazil and Mexico, which account for 2/3 of regional, is somewhere between modest (Brazil) and poor (Argentina, Mexico). The fact that economic fundamentals remain relatively sound in Chile, Colombia and Peru in spite of elevated but generally manageable political risks does not alter the fact the outlook for Latin America as a whole will remain poor.

Many Latin American countries arguably continue to be plagued by their colonial past, paternalistic-corporatist state structures and an over-reliance on commodity exports (North, Summerhill & Weingast 1999; Rodrik, Subramanian & Trebbi 2002). Government-owned companies continue to play an important economic role and often offer opportunities for corruption and mismanagement. The rent-seeking of various politically influential economic and societal groups causes economic inefficiencies. The continued dependence on commodity exports renders Latin American economies vulnerable to repeated terms-of-trade shocks. The legacy of an inward-looking development strategy has not been completely overcome and many economies have failed to integrate themselves into global supply chains - Mexico and several Central American economies excepted. While some countries have made some progress with respect to several of these challenges (Chile, Colombia, Peru), others have been less successful (Argentina, Brazil, Venezuela). It is therefore not very surprising that Argentina is due for another external debt restructuring and Venezuela is in default. Neither Brazil nor Mexico is at risk of a near-term external payments default. However, their sovereign credit profile has weakened in the past few years due to rising public debt. Once one realises that the deterioration in economic fundamentals has taken place against the backdrop of solid global economic growth and record-low global interest rates, it is worth asking two questions. What will happen to the region’s economic outlook, should advanced economies experience a further slowdown or even a recession? How will a further deterioration of regional economic conditions affect political stability, more broadly, including the ability of the various governments to pursue stability-oriented economic policies?

Sino-US relations - from strategic patience to strategic competition (2019)

Sino-US relations are poised to shift towards ‘strategic competition’ - for good. Congress and parts of the US business community have begun to take a more reserved, even adversarial stance towards China. So has the US administration, and not just as far as economic relations are concerned. US defence officials are by nature always concerned about states whose military capabilities are expanding and are acquiring significant asymmetric capabilities. Former Assistant Secretary of State for East Asian Affairs and long-time Asia hand Kurt Campbell & Jake Sullivan have pointed out the limited practical usefulness of many catchphrases containing the term ‘strategic’ in terms of providing guidance to actual policies. ‘Strategic ambiguity’, for example, just reflects uncertainty about what to do, while ‘strategic patience’ – US policy towards China under President Obama – reflects uncertainty about what to signal. Campbell & Sullivan also point out that ‘strategic competition’ – the doctrine adopted by the present US administration (National Security Strategy 2018) – is problematic in that it fails to answer what the competition is about and what it means to win. Others have proposed concepts such as ‘strategic reassurance’ (James Steinberg & Michael O'Hanlon (2014)) that are not significantly more useful from a practical point of view.

US strategy towards China used to agonise over whether to compete with China or whether to cooperate with it and seek to turn it into a ‘responsible stakeholder’ (Robert Zoellick). The stakeholder concept assumed that China would recognise the benefits it derived from the existing international order, while hoping that economic development would lead to the emergence of a domestically and internationally liberal China embracing, broadly speaking, existing international structures and norms. Ironically, it is the US that is now riding roughshod over international economic regime at least as much if not more than China. China may not be living up to the spirit of, for example, WTO rules, but it rarely violates the letter of the rules.

Washington looks like it is abandoning its policy of ‘strategic patience’ in favour of a gradual shift towards ‘strategic competition’. Our best theories about how international politics works point towards increasing competition (Gilpin 1981, Kennedy [1987] 2010, Mearsheimer [2001] 2003, Mearsheimer 2001, Organski 1958, Waltz [1979] 2010). Hegemonic states are, only with rare exceptions, challenged by ascending powers. Thucydides perhaps put it most memorably: “It was the rise of Athens and the fear it inspired in Sparta that made war inevitable”. While great power war has become obsolete given the existence of nuclear weapons, competition and conflict will play out in different ways. While traditional International Relations Realists (Morgenthau) focus on human nature as the source of international conflict, neo-realists emphasise the anarchic state system as inducing competition (Waltz). Neo-realism is a systemic-level theory that offers predictions about how states behave by suggesting how systemic pressures affect state policies (unit behavior). First, the potential for competition and conflict arises from the security dilemma. A rising power’s increasing influence international affairs will lead to challenge the status quo, thereby diminishing the security and relative position of hitherto dominant power. The status quo power becomes more fearful and the rising power, knowing that it is being watched by the status quo power, becomes more concerned about actual or potential attempts by the dominant power to hold it down. Second, the rising power has increasingly broader interests. This will increase the potential for conflict with the status quo power. It also makes the rising power feel more vulnerable given its dependence on, for example, global trade. A reduction of the rising power’s vulnerability will typically translate into an increase in the dominant power’s vulnerability. This is called the security dilemma or zero-sum game. Third, in light of actual or potential competition, hawks on each side are likely to carry the day. They will urge a move away from cooperative policies. More hawkish policies will then lead to more hawkish policies on the other end. Doves simply have a harder time prevailing domestically – and especially once a shift towards international competition is underway. The dominant state and its challenger end up in a prisoner’s dilemma situation. In order to gain support for and to justify more adversarial policies, hawks then often invoke ideological differences, nationalism and chauvinism, making it harder for more moderate voices to gain a fair hearing.

It is this logic that underpins China’s greater international assertiveness. China’s impressive economic rise has allowed it to take a more assertive stance on several territorial issues (South and East China Sea) and to expand its military capabilities, including those focused on the ‘near seas’ (e.g. asymmetric capabilities, aircraft carriers). Greater diplomatic assertiveness backed by increased military capabilities are a reflection of China’s expanding international economic, financial and political interests. China is keen to enhance its ability to defend these interests and equally keen to mitigate the vulnerability that arises from its increased integration into the global economy (e.g. energy imports). China has various options to mitigate this vulnerability, including through diversifying its overseas trade and lessening its dependence on maritime trade by building connectivity in continental Asia. China is also seeking to more directly enhance its ability to protect its sea lines of communication by expanding its military capabilities. This in turn challenges the US’s relative position, and not just security-wise. China’s economic rise is also beginning to challenge US technological and economic leadership. From the US perspective, renminbi internationalization, Belt Road Initiative and China 2025 have become synonymous with China’s strategic challenge, while from China’s point of view these initiatives are just ways to mitigate its own increased vulnerability. 

Source: Economist

Having been the dominant power in Asia-Pacific since the end of WWII, the US feels its relative military advantage is eroding just as China is seeking to modify the status quo (e.g. maritime claims and freedom of navigation). As Thucydides would have recognised, hegemonic powers feel anxious about rising, dynamic, status quo challenging powers. A shift or drift towards US-China competition therefore looks difficult to avoid. This does not necessarily mean that economic cooperation will break down completely. After all, the European state system prior to WWI managed to preserve a relatively open and cooperative international economic regime. But the multilateral economic order that emerged from the ruins of WWII in the so-called West and that was extended globally after the end of the Cold War is bound to feel increasing strains. And this is not least due to recent US policies that have sought to ‘weaponise’ or leverage, if you will, economic interdependence. Not only do such policies weaken the relatively rule-based, multilateral economic order, but it will also make other countries, including China, more distrustful and look for ways to mitigate its vulnerability. 

Reliance on trade to foster economic growth and development is only one aspect of China’s vulnerability under conditions of complex interdependence. Should Washington’s goal be to isolate China more broadly, not just in terms of trade, but also in terms of investment and technology, China will make a concerted effort to wean itself off its dependence on the US as quickly as possible and double down on its efforts to develop key technologies indigenously (e.g. semi-conductors). Regardless, China is very unlikely to abandon its quest to enhance its ability to secure its foreign trade and access to strategic commodities. True, China’s relative vulnerability will decline as the share of trade in GDP declines and the Chinese economy shifts from investment and exports to domestic consumption as the main source of demand. This will reduce it somewhat and, but it won’t eliminate the risk of potentially being cut off from critical overseas markets and imports (e.g. energy). 

Source: US Department of Defense

Recent US attempts to pressure China economically will do little to make Beijing want to intensify its relations with and dependence on the United States. China regards US actions as an attempt at coercion and will be reluctant to agree to anything that would further increase China’s vulnerability in the event of a future breakdown in bilateral relations. It is likely that the formation of a multilateral coalition of advanced economies to pressure China into making economic changes would have been more promising than relying on US bilateral pressure only. But being forced into making concessions by whomever will do little to make China embrace multilateralism and liberal (non-statist) economics more enthusiastically. This does of course not mean that China will abandon international economic cooperation altogether; but it will be focused on mitigating the concomitant political and economic risks. In the security realm, the US has taken a more multilateral approach including its East and South-East Asian allies. While this makes it more costly for China to change the status quo in the region, such a multilateral security policy will not make China feel more secure, either. With China’s rise continuing and other states adjusting to it, strategic security competition will be difficult to avoid.

Conceptually, US-China economic relations over the past 20-30 years raise an interesting question. From a Realist perspective, it looks puzzling that the dominant power would offer the rising power access to its markets, capital and, if less so, technology, as this facilitates the rise of a potential challenger. The opening of China in the early 1970s was both rational and strategic in the context of the US-USSR superpower competition. Economic cooperation throughout the 1980s and maybe even 1990s was mutually beneficial and did not seem to pose a direct challenge to US supremacy. However, China’s subsequent dramatic economic rise, IR Realism suggests, should have led the US to seek to slow down China’s rise rather than help accelerate it (e.g. Chinese WTO membership 2001). Conceptually and empirically, this is where the distinction between absolute gains and relative gains is useful. Absent strategic (security) competition, the US derived absolute economic benefits from cooperation with China. Once the relationship shifts towards security competition and becomes a zero-sum game, relative gains become more important. In this sense, it may be argued that the US failed to pursue a long-term forward-looking policy towards China, as its pursuit of absolute economic gains over the past three decades created the very conditions that have led to relative US decline. From a Realist, as opposed to a liberal-institutionalist perspective, the US pursued absolute gains for too long.

Another interesting question is how Asian states will respond to the continued rise of China and intensifying US-Chinese rivalry. Will they fold in the face of overwhelming Chinese economic and military power? Or will they seek to counter-balance China with US support? Most states in the region hope to be able to avoid such a binary choice. After all, most Asian states are increasingly more dependent on China in economic terms than the US. (This dependence is what TTP was supposed to mitigate.) Understandably, East Asian countries don’t want to become dependent on China in security terms, too, as this would make them excessively vulnerable to potential Chinese pressure. China’s more assertive stance in various territorial disputes has not helped calm such concerns. Neither does China’s occasional resort to economic sanctions to penalise countries in the context of diplomatic disputes help (e.g. Korea/ THAAD). States in East and South-East Asia may be forced to make difficult choices if US-China competition intensifies. Until then, it may even be tempting to play one side against the other (e.g. Philippines), but it is rational to maintain cooperative relations with both China and the US. It is clear, however, that the US remains a crucial player in the region. East and South-East Asian state are less fearful of US power given that Washington has no territorial claims, guarantees freedom of navigation and access to its markets, while playing the role of an offshore balancer. Economically most states in the region are increasingly pulled into China’s orbit, but this makes them keener for the US to ultimately underwrite their security. Most of the countries in the region will seek to reap the economic benefits from their trade and investment relationship with China, while intensifying, if necessary, its security cooperation with the US as long as Washington remains credibly committed to a strong military presence in the region.

Source; New York Times

China’s geographic and geopolitical position is less than enviable and it is not difficult to see how ‘fear of encirclement’ is of much greater concern to the China than the US. As suggested, China also feels vulnerable given its increasing reliance international trade, including commodity and energy imports. A powerful US navy has the ability to cut China off international trade. Such concerns are all the greater in China’s case given its post-WWII policy of economic self-reliance and quasi-autarky. Security concerns are at least as intense in countries that are equally dependent on foreign, such as Japan. Creating a sustainable regional security architecture, even with US involvement, will prove difficult. China 'feels'a sense of strategic vulnerability. After all, China fought several wars in the 20th century, not just with Vietnam and in Korea, but also with India and the USSR, not to mention Japan. Going back further in history, it was repeatedly invaded by peoples from Asian steppes. Last but not least, external security threats may look even more challenging given the potential brittleness of China’s political regime. The regime derives its legitimacy from continuously increasing economic prosperity and, arguably, intensifying nationalism. This further contributes to China’s sense of vulnerability. For all these reasons, inter- and intra-regional security competition in East and South-East will be difficult to avoid and the relationship between soft (economic) and hard (military) power will be fascinating to study in the process.

US-China trade tensions – US policymakers should have read Keohane/ Nye and Katzenstein (2019)

As the US-China trade conflict is about to enter its third year, Washington has little to show for it. A lasting settlement does not look within imminent reach. Washington’s ‘asks’ are known and include the reduction of the bilateral trade deficit, greater access to Chinese markets for US exporters and investors, greater protection of intellectual property rights as well as restrictions on the activities of Chinese state-owned enterprises, including their role in government-sponsored industrial policies. What is less clear is what Washington’s ultimate objective is. Is it the reduction of the bilateral trade deficit? Is it the opening up of China’s economy? Is it to prevent China from achieving technological supremacy? While these objectives are not necessarily mutually incompatible, they are not necessarily compatible, either. Would the US accept Chinese technological dominance if it emerged in the context of a more open Chinese economy and less interventionist Chinese economic policies? Would the US accept continued large bilateral trade deficits even if China reduced trade barriers to US levels? It is far from clear that the modification of Chinese behavior or institutional changes to bilateral economic relations would lead to the outcomes sought by the US, whether they are to do with trade imbalances or technological leadership.

As long as there is a lack of clarity about US strategic objectives, it is not entirely clear which US policy measures vis-à-vis China will prove permanent and which will prove temporary. Tariffs and the threat of further tariffs may be a tactical measure to force China to the bargaining table or they may be regarded as more permanent measures to reduce the US trade deficit. (Whether tariffs will help achieve is doubtful from an economic perspective.) Or tariffs might be a more permanent feature of US policy towards China in an attempt to disrupt China-centred supply chains. Similarly, tighter US investment regulations and a revamped export control regime may be meant to help the US gain bargaining leverage. Or these measures may prove permanent in view of slowing Chinese technological progress. (In practice, these measures are bound to prove more permanent, not least because legislation puts certain limits on executive action, even if in practice the government does have some wiggle room. 

Washington has sought to use China’s dependence on foreign trade as a pressure point to extract trade and other economic concessions from Beijing. China is more dependent on trade with the United States than vice versa. Moreover, the Chinese government depends more on economic growth as far as political stability is concerned than the US. This is not to suggest that US presidents faced with recurrent elections do not have a similar interest in economic growth. But for the Chinese leadership, the stakes are higher. A US president may be voted out of office. The Chinese government may be overthrown. The legitimacy of China’s political system, long based on communist ideology, today largely rests on a combination of generating economic progress and, increasingly, patriotism and nationalism. It is therefore imperative for Beijing to maintain support of the prospering middle and upper-middle class. If Beijing is looking for a reminder, how brittle regime stability is, it need look no further than Hong Kong.

Source; IMF

While China is economically and – over the longer term – politically more susceptible to a disruption of foreign trade and its economic consequences, its ability to offset external economic pressure through domestic policy is greater than that of the US. Put differently, China is more sensitive to trade disruption than the US on account of its greater dependence on exports, but it also better positioned to deal with the economic headwinds from trade tensions than the US. Washington may (or may not) have correctly assessed China’s (economic) sensitivity. But it seems to have overestimated its (economic) vulnerability. It is beginning to look as if the present US administration has overplayed its hand. 

China is more sensitive than the US in terms of foreign trade, but it is less sensitive than export figures suggest. First, while China’s gross goods exports – whether measured in terms of dollars, share of total exports or as a share of GDP – to the US are significantly larger than respective US exports to China, they overestimate China’s dependence on the US. The more relevant measure in terms of economic sensitivity is value-added exports. Given the large share of imported content embedded in Chinese exports, value-added exports to the US are significantly smaller than gross exports. Second, if services exports are added into the mix, China’s relative greater dependence looks even smaller. US services exports to China are considerable and the US runs a sizeable services surplus, compared to a large goods deficit. This makes the US relatively more sensitive than China (e.g. tourism). Third, and this is more significant from a political than an economic point of view, the sales of US subsidiaries in China are sizeable. If they were added to the bilateral trade in goods and services, the bilateral ‘trade balance’ would be almost balanced. Leaving aside the economics, the reliance of US companies on the Chinese market makes them sensitive to Chinese retaliatory measures (e.g. regulatory changes, tax inspections). This helps rebalance somewhat China’s greater political-economic susceptibility arising from China’s greater export dependence. Given the much smaller sales of Chinese subsidiaries in the US, this gives China greater opportunity to retaliate against the US economic interest than vice versa. (It is worth noting that if Washington’s ultimate objective is to get US companies to leave China altogether and/ or to disrupt global supply chains running through China, Beijing’s more hostile policy towards US companies in China would be playing right into Washington’s hands.) The long and short of it is that China is less vulnerable to US pressure than the focus on bilateral goods trade suggests, even if in the end China does remain economically and politically more sensitive than the US in case of a trade war.

Source; WTO

China is more sensitive than the US in terms of foreign trade, but its vulnerability (as opposed to sensitivity) is more limited due to its significant ability to offset some of the negative economic consequences due to US policies. This where Keohane & Nye (1977). Sensitivity can be defined as how quickly changes in one country bring costly changes in another. Or less awkwardly: sensitivity captures the costs incurred by a state due to another state’s actions. Vulnerability captures the capacity of a state to counter and offset such costs by taking the appropriate measures. While China is more sensitive than the US in terms of trade tensions, its vulnerability is much more limited on account of its greater ability to offset the economic costs of US trade policies (and other economic measures). The US is relatively more vulnerable in the sense that its ability to counteract any costs through economic policies is much more limited. Taken together, this makes the ‘asymmetric interdependence’ between the US and China less asymmetric. 

China has at its disposal important tools to mitigate the direct economic growth effects of hostile US trade policies. This is where Katzenstein (1977) comes in handy, conceptually. China has a ‘strong’, centralised state that faces a ‘weak’ society. Moreover, China has important policy tools at its disposal to intervene in the economy. First, China has greater control over its financial system given the significant share of state-owned banks and/ or banks where the government remains an important shareholder. A combination of government ownership and regulatory influence (e.g. window guidance) allows a ‘strong’ Chinese state to pursue a counter-cyclical credit policy. Second, even though China has liberalised interest rates in recent years, the PBoC is not independent. Combined with window guidance, this allows the authorities to more directly influence domestic monetary and credit conditions. The PBoC is less likely to ‘push on a string’. Third, the Chinese authorities have significant control over fiscal policy, including quasi-fiscal policy. After all, the government does not rely on the approval of a politically independent legislative body to conduct fiscal policy. And while there is justifiable concern over Chinese contingent liabilities, especially at the provincial level, the central government can simply instruct other levels of government to crank up investment in order to stimulate the economy. Fourth, China also has far greater control over its exchange rate in spite of having move to a more market regime in the past few years. Restricted current account convertibility and significant influence over domestic banks give China greater influence over the value of its currency. (The Trump administration has of course noticed this leading it to designate China a currency manipulator.) Fifth, even though the Chinese regime is politically more sensitive to economic stability, it benefits from greater short-term political flexibility. The government (or regime) does need to run for (re) election and this gives it more leeway in terms of negotiating with the US, even it China’s structural political vulnerability is greater than that of US. In short, a higher degree of centralization, a statist political economy and the availability of important economic tools lessen China’s relative vulnerability as opposed to its sensitivity. As it happens, and US rhetoric notwithstanding, Chinese economic growth has suffered relatively little so far (Lardy 2019).

By comparison, the US appears relatively more vulnerable. The US government has far fewer tools at its disposal to deal with the negative economic consequences (of its own trade policies). The US political system of government is more decentralized. Societal influence tends to have a greater influence on US economic policies, the political system is more fragmented ad the executive has fewer tools and controls fewer policy tools that would allow it to intervene in the economy. The US is less sensitive than China, but its ability to offset costs is more limited. First, the US government cannot simply decree credit growth. Second, unlike the PBoC, the Fed is independent and cannot be instructed to ease policies. The independence of the Fed reduces US bargaining power (and the president, correctly, seems to understand this). Third, the US government has much less flexibility in terms of switching on or off the fiscal taps, let alone conduct a quasi-fiscal policy. US states cannot be instructed by the federal government to increase fiscal spending or public investment, not to mention that they are generally constrained by balanced budget rules. And the federal government is arguably more constrained – both economically and politically – in terms of fiscal space and flexibility. Congress needs to sign off on major changes to fiscal policy. Fourth, the US has little influence over the value of the dollar given that exchange rate policy is legally vested in the Treasury, but the Fed is responsible for monetary policy. In the presence of an open capital account, this, for all practical purposes, circumscribes the ability of US policymakers to determine the value of the dollar. They can of course seek to influence it indirectly, but this is typically not very effective. Fifth, while the US is arguably less dependent on economic growth as far as political instability is concerned, US governments/ presidents are held to account every four years and, one might argue, every two years in the mid-term elections, whose outcomes matters greatly to the president’s political standing. Economic conditions are typically a very important factor in determining US elections. Short-termist political concern limit the willingness of the US government to incur economic costs in view of longer-term economics gains. In other words, the incentives to escalate US-China tensions to the point where it slows the US growth – whether due to the direct impact of tariffs or the indirect impact of tariffs on market confidence – not only limits the flexibility of US policies, it also makes threats to escalate further somewhat less credible.

Differences in terms of state strength may also help explain why US policy towards China appears somewhat less consistent than China’s policy towards the US. US policy may be more subject to short-term tactical concerns (see presidential tweets) rather than the outcome of a long-term strategy. China, by comparison, should be able to take a longer-term view given the lesser degree of short-term accountability. China is often said to take a long-term view of things. This is often attributed to China’s strategic culture or national character. The most famous anecdote has China’s foreign minister, Zhou Enlai, respond, when asked in the 1971 what he thought about the French revolution: it is too early to tell. (It has recently been suggested that Zhou Enlai believed that the question referred to the 1968 student protests in France rather than the French Revolution in 1789. Lesson: never let facts stand in the way of a good story. Be that as it may, the inclination to adopt a longer-term view may or may not be rooted in culture, but the ability to do so is almost certainty attributable to a domestic political structure that is fairly centralized and can afford a certain degree of lack of short-term responsiveness to societal demands. This provides a distinct advantage to China in its present negotiations with the US.

China in spite of its relatively greater economic sensitivity looks much less vulnerable to US economic pressure once state strength is factored into analysis – at least in the short- to medium-term. How about the longer term? The US political regime less likely to experience severe instability or a breakdown, while China’s political regime looks comparatively fragile. After all, if China goes the way of other East Asian countries in terms of economic development, social modernization and democratization, the Chinese regime must feel vulnerable. In the short term, China has a significant capacity to offset foreign economic pressure, while the US government is much more constrained. In the longer term, the Chinese political system looks distinctly less well-positioned in terms stability than the US if it fails to safeguard economic prosperity. (Of course, continued economic progress is likely set to increase the pressure on China’s political system in terms of political liberalisation. But that’s another story.

Fundamentally, China’s political regime is characterized by ‘fragility’, while the US, in spite of its present domestic constitutional and political challenges, exhibits – arguably – robustness,if not necessarily anti-fragility. If you are looking for a good read about what might go wrong in the US and why my prediction may turn out to be wrong, I recommend Ziblatt & Levitsky's How Democracies Die (2018). Many years ago, a chance acquaintance of mine, who had studied at Cambridge in the 1930s, told me that back then his professor had compared Britain’s democracy to a raft: it may be occasionally dip under water in stormy seas, but it will stay afloat. By contrast, the fascist and communist regimes of the day were more like huge ocean liners, massive and powerful and indestructible (looking). However, if they hit an iceberg, they will sink, while the raft will remain afloat. The analogy turned out to be apt. This is not meant to suggest that China’s political regime is fascist, let alone communist in the sense resembling the regimes of the 1930s. But it is to suggest that China’s more monolithic and centralized political regime is ultimately more fragile that US democracy. It may look solid, but when sufficiently shocked, it may break quickly break. In metaphysics, fragility is a dispositional term. 

What does all of this suggest for the future of the China-US economic conflict? Regardless of Washington’s ultimate objectives, US diplomacy will probably need to reduce its ‘asks’ if it wants to reach an agreement with Beijing. To the extent that protectionist measures weigh on US economic growth and risk tipping the US into recession, a further escalation will lack credibility, not least because Beijing has important policy levers at its disposal to counteract the short-term negative consequences of more hostile US policies. This does not mean that China would not be prepared to sign up to an agreement around intellectual property rights safeguards, a reduction of the bilateral trade imbalance through increased Chinese purchases and a further opening of the Chinese economy in exchange for an end to US tariffs. But Beijing will be extremely reluctant to agree to a significant revamp of its domestic political economy, especially if such a reform were to decrease China’s future ability to deal with external pressure and exogenous shocks as well as its ability to catch up with US economically and technologically. Put differently, a fundamental reform of the political economy that might weaken government control of the economy, thereby leading to an increase in its vulnerability, is very unlikely. Such a reform would almost certainly weaken – or be seen to weaken by Chinese policymakers – China’s ability to catch up (and maybe overtake) the US in economic and technological terms. A failure to do so would prolong China’s sensitivity to US pressure in the context of a bilateral relationship that is bound to become more contentious over time, both economically and politically (e.g. security competition in East Asia). If this analysis is correct, the US will find it difficult to credibly threaten a broader escalation of trade and economic tensions and China will resist making changes to its domestic political economy that would prevent it from lessening its sensitivity and might even increase its vulnerability to US policies against the backdrop of an emerging strategic rivalry. True, US policy measures such as export controls and investment restrictions are bound to have a significant impact on China’s longer-term economic growth. 

China will not be prepared to dismantle its economic model in exchange for a (in practice) revocable US promise to reduce export controls and inward investment restrictions, either. As long as China believes that it can only compete with, or outcompete, the US with the help of interventionist economic policies and as long as China believes that the US is prepared to politicise bilateral economic relations, as it surely is, Beijing has next to no incentive to abandon the very development model, including industrial policies, that would help make it less dependent on the US over the longer term. In addition, Beijing’s recognition of the fragility of its political system will provide Beijing with a significant additional incentive to intensify its efforts to reduce its sensitivity to US actions, while retaining sufficient to keep its vulnerability to a minimum. Washington's ‘weaponisation’ of (asymmetric!) economic interdependence may lead Beijing to reach out to other large, advanced economies in an attempt to manage its continued dependence on the US – whether the dependence concerns trade, supply chains, dependence on US export markets, the dollar, critical technology etc. At the same times, Beijing will likely to intensify efforts to make itself less dependent on the US, economically and technologically, rather than increase its sensitivity and vulnerability in the wake of a 'deal' with the US. As long as Beijing believes that its domestic political economy is key to catching up with the US as well as crucial to mitigating present and future US pressure, it is not going to make any modifications to it that might increase its sensitivity and vulnerability. 

If Washington's strategic objective is to prevent China from becoming a technological leader rather than create a 'fairer' and more 'balanced' economic relationship with China, then demanding wide-ranging changes to China's political economy makes sense. Either Beijing gives up its support for SOEs and China 2025 or it will be forced into increasing isolation from the US economy in terms of trade, investment and technology. Moreover, US demands for fundamental changes to China's political economy regime may lead China itself to make the conscious decision to limit its susceptibility to US economic power by pursuing more inward-looking economic development policies. Washington might well prefer for China to abandon its state-interventionist policies. But if this cannot be achieved, then slowing China's economic and technological advance by disruption supply and limiting China's access to US markets and US technology, while giving Beijing incentives to further reduce its present sensitivity and vulnerability to disruptive US policies, would constitute a second-best outcome from Washington's perspective.

The puzzle of German fiscal rectitude (2019)

The New York Times and the Financial Times have criticised Germany’s reluctance to adopt an expansionary fiscal policy in the face of a weakening global economy. With the effectiveness of monetary policy in doubt, they argue that fiscal policy is even more than important than ever to counteract what appears to be an intensifying economic downturn that risks morphing into prolonged (secular) stagnation and deflation. Given that Germany is not only the largest economy in the euro area, but also the economy with the largest fiscal space, international commentators find it difficult to understand Berlin’s reluctance to go for a fiscal stimulus. They find this even more incomprehensible in light of the fact that the export-oriented German economy appears to have been more affected by weakening global economic conditions than other large economies. The German economy seems poised to tip into recession.

Germany has historically been more reluctant than many other countries to resort to counter-cyclical fiscal policies (aka Keynesian demand management). During the euro area crisis, Germany resisted expansionary fiscal policies that would have helped provide a much-needed stimulus to the peripheral euro area economies. This effectively increased the adjustment burden on the peripheral crisis economies. In the terminology of Charles Kindleberger (1973), Germany acted as a ‘lender-of-last-resort’ by offering financial support. But it did far less to "open markets to the distressed countries" in the sense of generating additional demand for the peripheral economy exports than it could have done. Germany deflected the burden of macroeconomic adjustment and stuck to its macroeconomic policy preferences.

Compared to other countries, Keynesianism’s popularity in Germany was short-lived. In the late 1960s and early 1970s, the German government under the leadership of Finance Minister Karl Schiller resorted, to but quickly abandoned a demand management oriented fiscal policy (so-called Globalsteuerung). The Keynesian experiment came to an end with the first oil shock and economic stagflation. This experience has contributed to Keynesianism’s lack of popularity ever since. Besides the historical experience, there is perhaps also an economic argument that limits the popularity of Keynesian policies. In an export-oriented, open economy with an independent central bank, fiscal stimuli tend to be less effective than in less open economies where the central bank acts in a more accommodating manner (Scharpf [1987] 1991). Admittedly, lack of monetary accommodation is probably not something the German government should be worrying too much about at the present moment.

Financially speaking, Germany can certainly afford a limited fiscal stimulus - and certainly a time-limited one. At less than 60% of GDP, Germany’s government debt burden is low by international standards. The ratio compares very favourably to the US (106%), the UK (87%), France (99%), not to mention Japan (237%). Unlike in the other major economies, it has also been on a downward trajectory since after the global financial crisis thanks to a small fiscal deficit and decent economic growth. Gross government debt fell from 81% of GDP in 2010 to just below 60% of GDP in 2018 and it is set to fall below 50% of GDP by 2022. Few, if any, of the other major economies are projected to see their debt ratios decline in the medium term. If that weren’t enough, Germany has also one of the lowest interest rates in the world, besides Japan and Switzerland. The German government has just issued 30-year debt at a negative yield. Provided the government can identify investment projects that are sufficiently profitable to repay the principal, increasing public investment would seem to be a no-brainer. 

Source: IMF

Germany does face large implicit pension and health-care related liabilities due to a rapidly aging population– more so than the other major economies. The IMF puts the net present value of pension and healthcare spending at respectively 40% and almost 50% of GDP during 2015-2050. This is a relatively large amount. It therefore makes good sense to maintain a strong fiscal position. However, a temporary fiscal stimulus worth 1-2% of GDP won’t make much of a difference in terms of the long-term health of public finances. The key term here is temporary. Keynesian fiscal policy foresees that the stimulus be withdrawn once economic activity returns to potential. But even if Germany decided in favour of a permanent increase in spending or decrease in revenues of 1% of GDP, this would keep the debt ratio on a downward trajectory over the medium term. Germany’s cyclically-adjusted or structural budget balance was 1.2% of GDP (surplus) last year and is projected by the IMF to remain above 0.5% of GDP. Assuming modest) nominal GDP growth of, say, 2%, Germany could easily provide 1% of GDP worth of stimulus, even permanently, and the debt ratio would continue to decline. All of this is to say that Germany could afford a fiscal stimulus – especially a temporary one.

Source: IMF

Critics find Germany’s reticence to loosen fiscal policy all the more puzzling given allegedly large infrastructure investment needs. Why not borrow at no cost and upgrade Germany’s supposedly deteriorating infrastructure? It is less obvious that it may at first appear that (1) Germany is in need of significant (public) infrastructure investment and that (2) the government is well-placed to identify sufficiently profitable public investment projects. Interestingly, liberal economists are typically quite skeptical about a state’s ability to pursue a successful industrial policy and yet they want the German government to increase investment spending significantly. Critics contend that Germany’s investment needs are tremendous, ranging from broken bridges, a decrepit railway system and a digital and technological infrastructure that is severely lagging. Germany would no doubt benefit from upgrading its infrastructure, especially in light of its Industrie 4.0 targets. But it is also worth putting things into perspective. Germany ranks number in terms of the World Bank’s Logistics Infrastructure Performance Index. So identifying investment projects with high financial and social returns may be more difficult that is sometimes suggested. After all, repeated Japanese attempts to drag the economy out of stagnation and depression arguably yielded little – even though how successful or unsuccessful these policies were depends on one’ counterfactual – in terms of short- and long-term growth. This argument is debatable, admittedly. However, as far as large-scale infrastructure investment is concerned, it is advisable to proceed carefully. 

Naturally, a fiscal stimulus does not need to rely on public infrastructure investment and is actually bound to be more effective in terms of its counter-cyclical impact if it focuses on consumption. Counter-cyclical fiscal policy should be timely, targeted and temporary. Investment often requires significant lead times, while a consumption-oriented stimulus generally kicks in more immediately, especially if it is time-limited. It is also easier to set and credibly commit to such a time limit, compared to investment projects whose costs and length are often difficult to predict with much precision. Germany did exactly that in response to the global recession following the global financial crisis in 2008-09. The so-called cash-for-clunker scheme successfully supported domestic German demand and more specifically the German car industry in a timely, temporary and targeted way. None of this is to suggest that Germany would not be well-advised to examine very closely ways to boosting infrastructure investment. But there may be more cost-effective way of going about providing short-term support to the economy. And if fiscal space is meant to do more than provide a temporary stimulus, the government should draw up investment plans and funding, perhaps involving private-sector participation to make them more effective and less costly for the government. While an investment-focused (deficit-financed) spending programme is desirable from a longer-term productivity and growth perspective, a short-term stimulus will be more effective from a short-term stabilization point of view.

Is there then an economic rationale for not deciding in favour of a fiscal stimulus? At present, German unemployment is near all-time lows and labour participation is very high. Granted unemployment is a backward-looking indicator. But the urgency of a fiscal stimulus is limited from a political perspective. The German government also seems to be uncertain about the economic outlook and about how temporary or prolonged or severe the economic slowdown will be. The Fed, for example, is facing a similar dilemma. Until recently the US data looked reasonably solid, but the markets and commentators were increasingly negative on the outlook and forced the Fed into policy easing. Moreover, the German budget has significant built-in automatic stabilisers, making discretionary measures less necessary and urgent than in countries with smaller budgets and/ or fewer fiscal stablisers (e.g. United States). Then  there is the issue of getting the timing right. The economic indicators arguably are sending somewhat mixed signals (or did) and the German government may consider it premature to open the fiscal tabs, or turn on the fiscal tabs, but then the slowdown proves temporary. Last but not least, fiscal stimulus policies tend to less effective in a very open economy (low fiscal multiplier due to leakage of domestic demand abroad). A coordinated fiscal expansion would be more effective, but this would run into German political concerns about loosening hard fought for constraints on euro area member fiscal policies. None of these arguments points to a complete ineffectiveness and political unwillingness to move towards a looser fiscal policy stance. But they seem to make it more justifiable to proceed cautiously and sensibly. 

What are the political factors accounting for Germany’s greater fiscal restraint? First, the German constitution puts limits on fiscal flexibility, more specifically the size of the fiscal deficit (so-called Schuldenbremse). (The constitutional provision should perhaps best be seen as a reflection of Germany’s cautious attitude towards Keynesian policies rather than as the source of Germany’s restraint.) Second, the present (like the previous) finance minister is reluctant to abandon the commitment to the so-called “black zero” (no deficit) – or is at least reluctant to abandon it if that can avoided. Acting too rashly is not a desirable choice. Third, ordo-liberalism has always had a strong foothold in German economic thinking and culture. Given the uncertainty that continues to attach the economic outlook, this also helps explain German caution. The commitment to ordo-liberalism makes Germany not only – rightly or wrongly – skeptical about discretionary market intervention and policies. It also makes German policymakers less certain about their ability to get the timing right. Once again, none of this suggests that a fiscal stimulus won’t be forthcoming. Just that German policymakers are more cautious and that the political consequences of slower economic growth have been negligible so far.

It made sense to resist fiscal expansion during the euro area crisis when Germany’s economy was operating at close to full capacity in order to save fiscal space for the next downturn. We may now be witnessing this very downturn. Should the economic outlook deteriorate further and, in particular, should labour market conditions deteriorate sharply, Germany is very likely to move towards a modest fiscal stimulus. Germany is more skeptical about the usefulness and effectiveness of demand management policies for historical and economic reasons. A strong political commitment to fiscal rectitude - strengthened recently in the context of euro area governance reform - also makes the German government more reluctant to shoot - or to be seen to shoot - from the hip. Nonetheless, Germany will in the end recognize that it is in its self-interest to opt for a modest degree of fiscal expansion. It did so in 2009 and it will do so again should the economic situation deteriorate further. For all the reasons analysed above, however, German policymakers are and will remain reluctant or - if you will - cautious Keynesians.

US Treasury names China a currency manipulator - so what? (2019)

The Treasury has designated China a ‘currency manipulator’. The last time the Treasury has named a country a currency manipulator was in 1994 (China). The recent decision was a surprise, for the Treasury must have changed the criteria it uses to establish currency manipulation. The decision appears to be politically motivated. This is supported by a Washington Post article that says that the White House put significant pressure on the Treasury to name China a currency manipulator.

Two statutes regulate the issue of currency manipulation. US legislation pertaining to currency policy consists of (1) the Omnibus Foreign Trade and Competitiveness Act (1988) and (2) the Trade Facilitation and Trade Enforcement Act (2015). As recently as May 2019, the Treasury assessed currency manipulation on the basis of three criteria it had established pursuant to the 2015 legislation For a country to be designated a currency manipulator it needs to meet all of the following criteria. It must:

1. Run a substantial bilateral trade deficit with the US defined as exceeding USD 20 bn 
2. Run a current account surplus in excess of 2% of GDP 
3. Engage in sizable one-sided currency intervention translating into net FX purchases larger than 2% of GDP (previously 3%) 

China only seems to meet the first of the three criteria at the moment. As Brad Setser points out, the Treasury may have followed the 1988 Omnibus Act, where currency manipulation is not defined numerically, rather than the 2015 statute, and this gives the Treasury more leeway. Alternatively, the Treasury may have changed or adjusted the criteria it uses to assess currency manipulation. Either way, the decision undoubtedly points to the increasing politicization of the assessment process.

Source: IMF

Designating China a manipulator is economically problematic. First, China’s equilibrium exchange rate is not significantly mis-aligned and the current account is close to balance. So China does is not manipulating its currency in order to keep the RMB artificially undervalued. True, China does run a large bilateral trade surplus with the US. But economically this is a fairly meaningless measure. Even if bilateral (rather than global) trade balances mattered in economic terms, China’s contribution to the overall US trade deficit is far smaller in (economically relevant) value-added terms than in dollar terms. The lack of logic of focussing on bilateral balances becomes readily apparent if one imagines what would happen if all countries sought to reduce their individual bilateral trade balances to close to balance. 

China does have greater control over its exchange rate than many other countries. Capital controls, tight oversight of the on-shore FX markets, dealers and financial institutions combined with USD 3 tr worth of FX reserves do give the Chinese authorities significant influence over the RMB and allow China to operate a managed exchange rate. China’s exchange rate was undoubtedly undervalued a decade or so ago when its current account surplus reached 10% of GDP. To the extent China has sought to influence its exchange rate more recently, however, it has sought to prevent excessive currency weakness (e.g. 2015). Politically, this makes sense because a sharp currency weakening would have further inflamed the trade conflict. Admittedly, it is not for the Treasury to opine on whether a large bilateral surplus warrants the currency manipulation designation. The legislation says it does. It is obviously also possible to say that an economy with a managed exchange rate manipulates its currency. But it is difficult to make sense of the Treasury’s decision on the basis of the conditions it established pursuant the 2015 Act.

Source: IMF

Naming China a currency manipulator will not help Washington prosecute its trade war against China more effectively. The statute(s) do oblige the Treasury to take remedial action in case another country runs “significant bilateral trade surpluses with the US” and they demand that the Treasury start negotiations with the designated manipulators. The 2015 legislation is a little more concrete in terms of the actions to be taken and the sanctions to be imposed. These (1) denial of financing/risk insurance on new investment (in China) through the Overseas Private Investment Corporation; (2) denying (Chinese) firms access to the US government procurement market; (3) seeking additional IMF surveillance; and (4) taking into account (Chinese) currency practices in the negotiation of new trade agreements. The economic and financial impact of measures (1) and (2) is very modest. It is difficult to see how the IMF will take on one of its major shareholders on the issue. (It did not work last time (Walter 2014) and the prospect of signing a trade agreement appears far off and, if it happens, will of course have to address currency issues. Washington will make sure it does. 

By invoking national security, the US administration already has substantial leeway to take strong economic measures against China (Section 232, 1962 Trade Act), not to mention measures on the grounds of intellectual property rights theft and industrial policy practices (Section 301, 1974 Trade Act) and safeguards (Section 201, 1974 Trade Act). Moreover, the updated CFIUS legislation (Foreign Investment Risk Review Modernization Act, 2018) now allows for greater vetting of Chinese investment in the US and the new export control regime (Export Control Reform Act, 2018) effectively allows the US to restrict (broadly defined) technology goods exports and transfers, allowing the US to target individual Chinese companies (so-called Commerce Department Entity List). The most recent suggestion that the US administration might invoke the 1977 International Emergency Economic Powers Act (IEEP) to force US companies, theoretically at least, to stop doing business with China. The policy options offered to the US administration on the basis of currency manipulation pale in comparison to the IEEP Act. 

Some analysts have suggested that designating China a currency manipulator might be a first step towards taking more radical measures, such as counter-veiling currency interventions. Countervailing currency intervention was first proposed by Bergsten & Gagnon (2012). In order to get countries that consistently undervalue their currency to adjust, they proposed the US undertake ‘countervailing currency intervention’, that is, buying the same amount of currency that the manipulating country purchases in order to neutralize the effect of the latter’s policy on the exchange rate. Acknowledging that this policy won’t work in the case of a (relatively) non-convertible currency like the RMB, they also suggested second-best measures such as a tax on the earnings of dollar assets held by the manipulating country or even restrictions on the purchase of dollar assets altogether. If this does not work, they advocate countervailing imports duties to offset what they regards as an implicit export subsidy, namely an undervalued exchange rate. 

The snag is that the US Treasury is bound to have insufficient firepower to make good on such a threat unless the Fed can be persuaded to support the policy. The White House seems to have persuaded Treasury to disregard its own rulebook when it comes to currency manipulation. Getting it to decide in favour of countervailing currency intervention won’t be too difficult and the Treasury has jurisdiction over currency policy, including the discretionary use over the Exchange Stabilization Fund (Henning 1999). The problem is that the fund’s firepower is very small. And even if the Fed were to match Treasury FX intervention, as it has done in the past, the intervention amount would be too limited to make a significant difference to the exchange rate. First, the Fed intervenes in the FX only rarely. It bought Japanese yen in 1998, euros in 2000 and sold Japanese yen in 2011. The Fed will be very reluctant to commit to massive, potentially open-ended currency intervention targeting China It would risk undermining its crediblity and independence and might weaken its ability to meets its statutory objectives. The Fed risks triggering major international and domestic economic and financial stability by supporting such an economically aggressive policies. 

True, the size of the RMB off-shore market is small and much of it is quite illiquid and it therefore may not take much FX intervention to move prices. On the other hand, the PBoC (and state-owned Chinese banks) would seek to stabilize markets through counter-intervention and through administrative controls seeking to insulate the domestic market and stablise the external value of the RMB. This would no doubt be disruptive, not least psychologically for global financial markets. For US threats to be credible and effective, the Treasury would very likely need to the Fed’s buy-in. This seems unlikely to be forthcoming. Moreover, US policy would need to be able to impose significant economic pain on China, before China will make concessions. After all, Beijing would be loath to be seen as giving in for fear of encouraging further US pressure. So there are real question markets over US policy in terms of their technical success, their domestic-political feasibility and their international political effectiveness.

Naming China a currency manipulation may primarily reflect increasing sense of US frustration about its continued failure to coerce China into a trade agreement. The limited success of the trade war and increasing concerns that a prolonged war could tip the US and the world economy into a recession. With signs of the global economy slowing or at least becoming more fragile, in part because of trade tensions, further trade measures would weaken the US economy less than 15 months before the next presidential elections. A weakening US economy strengthens China’s bargaining position. It therefore makes sense for Washington to up the ante and make very strong threats in order to (be seen as) get to an agreement with China. 

For threats to be effective, however, they need to be credible. Brinkmanship is an important element of threat bargaining. Designating China a currency manipulator and threatening to force US business to cut ties with China are then perhaps just part and parcel of a maximum pressure campaign – a campaign whose credibility is somewhat in doubt. To the extent that the global economy is weakening and the 2020 presidential elections are approaching, the credibility of US threats is beginning to decline. This does not mean that the US is not going to make good on these threats. But if Washington wants to use threats to persuade China to come to an agreement, it needs to convince Beijing that it is serious about carrying them out. Credibility requires that carries out some of the threats (signaling). Recent US actions are casting doubt on Washington’s willingness to incur substantial economic costs in the pursuit of an agreement. The US refrained from imposing tariffs on China to the full extent threatened during the recent round of retaliation, currency manipulation does not provide the administration with new and more threatening tools to cajole China and threatening to cut economic ties with China does appear to be a bluff given the economic and political consequences this would have in the US and the political opposition it would mobilise domestically. The bottom line is that the decision to name China a currency manipulator is economically dubious. It is concerning in terms of the Treasury’s institutional independence. But it is not going to be a game-changer as far as the US-China economic conflict is concerned.