David Wessel responds: That's a good question, and I don't have a specific answer. The companies that would benefit most are those that compete with China to export to a third market; some of those companies are U.S. manufacturers, but many are in other parts of Asia and in Latin America. Chinese exporters would be hurt, of course, and some U.S. multinationals that have invested substantially in Chinese factories might be hurt as well. China will continue to have a strong export industry -- its wages are so cheap -- but a higher currency could restrain its export growth.

Q: I would like to know the long-term impact of China keeping its currency fixed. I have an MBA and work in manufacturing, but I do not have a firm handle on the exact implications to China and the world if China keeps its currency fixed. You described what happened to Japan when the currency was floated, but I was wondering what the opposite would mean.

A: If China keeps its currency fixed against the dollar, and other countries (including those in Europe and Latin America) allow their currencies to float, then China's exporters will sometimes get an advantage (when the dollar is sinking) and sometimes get a disadvantage (when the dollar is rising.) Flexible exchange rates are a way for economies to adjust when their economies diverge from other economies. If China doesn't allow its exchange rate to fluctuate, then it is likely to have more volatility in other aspects of its economy -- including prices, wages and employment. It's hard to imagine that China can keep growing as it has been and continue to fix its currency against the dollar indefinitely. It might allow the currency to move a bit up or down, trading in what's known as a band, or it might set its value against a basket of currencies (the dollar, the yen, the euro).

Q: I was wondering about the part where you said that the Clinton treasury stopped trying to get the China currency changed when the Asian currency crisis hit in 1997. I have a theory that the 1997 currency crisis was caused by the 1995 move by China to change the value of their currency from 5.75 to the dollar to at the time 8.75 to the dollar. As you know, now the currency is about 8.25 to the dollar. My theory is that when China changed in 1995 the effect was to start a process where all the countries in the area were put at a competitive disadvantage by the 1995 currency devaluation. With the China change in the currency all the other economies had to adjust so about two years later there is a currency crisis in the region that spread to the entire world after it went thru Asia. Now, in order to avoid a world deflation problem, China's currency has to be raised against the dollar and all other currencies. If this does not happen soon, in the next three to six months, the U.S. economy will not improve since half of our trade problem is the four countries that are manipulating their currencies to have a competitive advantage on products produced in U.S. dollars. These four countries are China, Japan, South Korea and Taiwan. Look at the trade numbers that came out Friday, June 13: the four counties listed are half of the U.S. trade deficit or about $250 billion a year. As all of us know the prospect of $500 billion trade deficits and $100+ billion trade deficits with China is going to become a major economic and political problem for President Bush. The Midwest is hurting and in the election of 2004 the president needs the Midwest. For the first time this past weekend I heard a lifelong Republican tell me that he thinks we have to have a change since NO ONE in D.C. cares about the domestic manufacturing economy. The next couple of months will be very interesting.

A: The origins of the Asian financial crisis is a great subject, and there are those who argue that changes that China made to its exchange rate helped precipitate it. But it seems to me there was a whole lot more to it, and more than one book has been written on the subject. I agree that trade deficits with China could be a big political issue. I don't think that all of the success of China, Japan, South Korea and Taiwan in exporting has to do with their currencies.

Q: I'm a 55 year old computer engineer changing careers by returning to school; that means that I'm taking an economics course to meet degree requirements. I've long been a student of economics, Milton Friedman is my "hero" -- I've read much of "A Monetary History of the United States 1850-1950," for example. However, as I'm working through microeconomics, I'm now finding so many more questions to ask, but I lack the knowledge to answer them. (Economists use words in such specific and non-intuitive ways.)

Here's my question in regard to China's policy on exchange rate:

If China were to let the yuan float, would that really improve the U.S. economy? Given China's lack of oil resources, wouldn't China be more likely to increase its demand for oil rather than increase its demand for U.S. goods. Wouldn't high prices for goods imported from China plus higher prices for imported oil act as a drag on the U.S. economy? If China doesn't redirect products into the Chinese economy as a result of less demand in the U.S., thus increasing demand for energy for transportation, doesn't that mean that the world production is reduced, contributing to the world-wide weak economy?

As a matter of principle, I agree that currency rates should float, but that's to limit the power of governments to distort the market system. It's not obvious to me that China's economy is grossly distorted as a result of the pegged currency. And changes in China's policies are reducing the distortions resulting from the command economy.

I guess my bottom line is:

• Would getting China to float the yuan actually improve the U.S. economy?

• Would voters understand the alleged benefit of this action when there has been no visible result?

A: Wow! Sounds to me like you should be teaching the economics classes, not taking them.

You correctly point out that a change in an exchange has more than one effect, some tend to boost an economy's growth, others tend to retard its growth. If you try to boil it all down to one question: How would an appreciation of the yuan against the dollar affect the growth rate of the two countries, I think it's safe to say that it would tend to boost the U.S. economy because the U.S. imports so much more than it exports (both from China and the rest of the world) and would have the opposite effect on China (because it exports so much more from the rest of the world.) The effects on the U.S. economy would be small: Most of our trade is NOT with China, and trade is not that big a share of the U.S. economy. Most of what we make we consume, and most of what we consume we make.

Whether voters would understand is another question. Manufacturers and their unions do make very loud noises about these matters, and that can influence executives and workers.

Q: This is an interesting topic that deserves a lot more discussions from many different perspectives.

In the last decade, economists have discovered how much more difficult development is than just promoting trade and free markets. Successful economic development requires a lot more ingredients than trades. Phenomenons like path dependency (e.g. Hollywood will stay in LA, and the PC revolution moved the hi-tech center from Boston to San Jose and it would not reverse). Wasn't it Ronald Regan who espoused the "strategic trade" model? Now the American politicians and the economists they employ continue to trump "free trade" when it is self-serving and tramp it when it hurts (e.g., steel, lumber, agricultural products).

To me, there is nothing unnatural about underdeveloped countries, whose past natural economic development was interrupted and stunted by the earlier rise of other industrialized nations (e.g. colonialism), to take the unconventional nontextbook paths.

Today, the Chinese yuan is only exchangeable if it's used for actual merchandise trade. Barred from the scene is hot money that often runs one hundred times the volume of the underlying trades. A tightly controlled currency and capital flow, if handled well, gives a country much need leeway to handle shocks better. The 1997 Asian Financial Crisis and its aftermath showed just that. It was the countries that who didn't follow the "gospel" of raising interest rates, close budget gaps, and allowing capital to flee that fare the best -- Indonesia and China. The opposite goes to Thailand.

Most importantly, an artificially depressed currency is not just a means of developing strategic industries but also a means to direct national savings away from pure personal consumption toward investments in projects that yield long-term benefits (e.g. infrastructure) -- an Eastern collectivism culture at its best. This was not just the model of Japan as mentioned in your article but also Taiwan and a few other Asian success stories in their paths to prosperity. On the other hand, India has never adopted the "Taiwan model", and has never invited outside capital in any significant way to flow in. This may in part explain its less stellar growth.

The outside capital is only looking for an environment of low production costs and short term political stability. When the country becomes richer and the cost of production rises, the outside capital will leave to search for alternative environments with lower production costs. Eventually the host country must graduate and shift into a course of self reliance when the exodus of the outside capital begins. You can be certain that China will indeed allow the yuan to appreciate. But it will be on its terms and much, much later.

Shouldn't we stop being dishonest and using the term "free trade"? How about "more trades" or simply "globalization"?

Q: In response to your recent column about China's exchange rate, there is no puzzle to the yuan's value. It's set artificially low, so that China can devour the world's supply of manufacturing jobs at the expense of its trading partners' domestic labor markets. The column suggested that the U.S. has few compelling arguments to offer China about floating the yuan. Nothing could be further from the truth, particularly in light of our current economic situation. There are three valid arguments:

1) By artificially devaluing their currency they are exporting deflation by robbing other countries' manufacturers of domestic pricing power.

2) Job loss occurs in the countries that are net importers from China, further exacerbating the current global deflationary risk.

3) The Chinese are using nationalistic justifications for their devalued currency when in fact the scale of their trade surplus has elevated them to the status of a major player in the global economy. The conference of that status requires that they balance their self-interest with the needs of the global trading community and the need to maintain world monetary stability.

Deflation is a very real threat. For instance, a 30-year mortgage at 5.21% isn't jump-starting an economic recovery, the five-year government bond is at 2.01%, the Fed is widely expected to reduce rates further, rapidly approaching Fed fund impotence, and confirming the reality of this threat, the Fed is publicly discussing the possibility of buying long bonds. China's exports to the U.S. are exacerbating this deflationary environment. Using dollars as a unit of measure, the magnitude of China's $100 billion trade surplus with the U.S. (the largest gap ever between two countries) is among the most serious deflationary elements in the world today. China's possible argument that freeing the yuan to float upward might have deleterious consequences similar to Japan's malaise in the 1990's is specious: Japan's appreciating currency didn't cause their asset inflation. After WWII, Japan adopted currency controls which forced their gargantuan balance of trade surplus into the domestic economy, driving up asset prices inexorably until they reached irrational levels. Japan went down the slippery slope of deflation when the capital controls were lifted and their asset valuations had to compete with returns on other assets in the global market place. The "Japanese argument" is further flawed because even with an appreciating currency, Japan's balance of trade surplus with the U.S. remains intractably high to this day.

Since China, like Japan, won't willingly give up the economic steroids of an artificially cheap currency, the U.S.'s only hope is that George W. Bush, who doesn't suffer military foes lightly, won't suffer economic foes either.

A: I said that the U.S. has few compelling arguments to make to convince the Chinese that revaluation is in that country's self-interest. Whatever the merits of your three points, none of them would convince me if I were the Chinese finance minister or central banker. As for deflation, China, too, is worried about deflation. Allowing its currency to appreciation would exacerbate -- not relieve -- the deflation threat there.

Q: Your article addresses one aspect of what can be arguably considered the most important issue for the U.S. economy of the 21st century: the disappearance of all U.S. manufacturing and a significant part of U.S. services by products and services from China (and possibly, India).

The central argument of the article is that the yuan is overvalued (see Big Mac comparison), and that a realistic, i.e. possible, revaluation of it versus the U.S. dollar will make the cost of U.S. manufactured products comparable to China's, and therefore, reduce or eliminate the negative impact of the flood of Chinese products to the U.S.

A simple examination of the facts regarding labor cost differentials and possible revaluations percentages shows that the implications of the argument can't be supported. The article quotes the Economist's comparison of Big Mac prices in China and the U.S., which indicates that the yuan is 56% undervalued against the dollar. This level of revaluation may be considered achievable over time. But China is not exporting Big Macs to the U.S., it is exporting all kinds of other manufactured products; and the cost differential for those products is in the order of 1 to 50, not 1 to 2! It has been extensively reported that the labor cost in China (using the current 8.28 yuan/dollar conversion rate) is $0.20 per hour for industries where the corresponding labor cost in the U.S. is $10 per hour. Any level of revaluation which is realistic would still leave the U.S. cost several orders of magnitude over the Chinese cost, and the import flood unchanged.

An accepted thesis in economics states that as unemployment among Chinese workers is reduced through the growing export trade, labor costs in China will go up, eventually closing the gap with the U.S. But when we consider the enormous size of the reserve of unemployed Chinese people living on subsistence agriculture and ready to join new industrial jobs -- several hundred million -- we realize that this may take an extraordinary length of time to occur.

It has been posited as an alternative that even if all manufacturing activity is transferred from the U.S. to China, American workers would still find meaningful employment in the service area. Aside from obvious issues of national security, early developments are already showing that a large number of service jobs will be subject to the same destiny as manufacturing: computer programming done at less cost from India, bank and other back office operations moved to Mexico, customer-service centers performed from Mexico and Argentina, etc.

Quantitative analysis of the critical situation under discussion shows that the answer will not be found in revaluation of the yuan. As unemployment rises to unacceptable levels in the U.S. the consensus will converge inexorably to the answer: managed trade.

A: There is no doubt that China, with its vast pool of labor and its cheap wages, has a substantial advantage in global manufacturing. It appears that this advantage is being super-charged by keeping the currency low. An increase in the value of the yuan would restrain -- not eliminate -- the growth of China's exports, although many of the winners are likely to be in Mexico and other parts of Asia, which compete with China for factories to make goods that are sold to U.S. consumers.

I'm not prepared to declare that trade, even with low-wage countries, will kill American prosperity. There are losers, especially unskilled manufacturing workers and now, as you point out, call center workers. There are winners, including nearly every consumer in the U.S. (who gets to buy things cheaper and better because we trade) and businesses that export to foreign consumers and businesses who wouldn't have any money if they weren't exporting to us. But the dimensions of China's labor force make mean that we need to think a lot harder about the arguments you make.

Q. Will the U.S. have the power to ask China to stop pegging its currency to the dollar? What if China refuses to do so?

A: The U.S. power to force China to revalue its currency is limited, which is why it is important for the U.S. to think from China's perspective and answer the question: Why is this in China's interest. Richard Nixon did force Japan to revalue in the early 1970s with tariffs and bluster. The U.S. did get China to agree to change some of its economic policies in return for supporting China's accession to the World Trade Organization. And, over time, China and the U.S. will negotiate on all sorts of things -- from North Korea and Taiwan to tariffs and rules for foreign investment. Currency issues will be part of those negotiations, I suspect.