How to Combat an Arrogant China?

How to Combat an Arrogant China?
By Larry Kudlow
1/20/2011

Is there a new Cold War developing between China and the United States? That's a question hovering over President Hu Jintao and his entourage as they come to Washington to discuss military, trade and financial flash points with the Obama administration.

Hu told The Wall Street Journal that "we should abandon the zero-sum Cold War mentality." But is he to be believed?

Everyone agrees that this is a new, muscular and more aggressive China. The more the Chinese strengthen economically, the more rambunctious they become with their foreign policy. Americans are increasingly irritated by this arrogance.

Just last week -- and just as the Pentagon plans to cut back on the modernized F-22 stealth fighter -- China insulted Defense Secretary Robert Gates by test-flying its own J-20 stealth bomber during his visit. Adm. Mike Mullen, head of the Joint Chiefs of Staff, wondered out loud why China is boosting its high-tech weaponry. He said, "Many of these capabilities seem to be focused very specifically on the United States."

Surely the J-20 flight was a snub to Washington. Surely China's whole military buildup is aimed directly at us. And surely China is of no particular help when it comes to the nuclear operations of North Korea and Iran.

Then, of course, are the numerous trade violations being committed by China. Commerce Secretary Gary Locke wants a level playing field on trade. As a strong free-trader myself, I recognize the many benefits free and open trade offers both China and the United States. But like many others, my free-trade patience with China is wearing thin.

They're stealing our technology, violating all sorts of patent-protection laws, hacking into Google and infringing on intellectual-property rights. In fact, 80 percent of Chinese software is reportedly pirated from American companies.

A new Chinese requirement for joint ventures with the U.S. -- where China gets 51 percent, and our companies only 49 percent -- looks like another attempt to snake our technology. Chinese local-content prescriptions prevent our firms from doing business with China's state and local governments. The China curb on rare-earth materials, important both for U.S. technology and defense security, is yet another free-trade violation.

Everyone wants cooperation rather than confrontation. Creating trade barriers for Chinese exports would damage American consumers and businesses, each of whom enjoy access to decent quality, low-cost Chinese goods. But if China continues to violate World Trade Organization rules, something has to be done.

On the financial side, the great yuan debate goes on. I have never believed the yuan value should be linked to the U.S.-China trade deficit. Two-way trade is exploding. That's good for growth. However, Treasury Sectary Tim Geithner's new angle on the China inflation bubble has merit.

In order to hold down the yuan, China's foreign-exchange reserves jumped another $200 billion in the fourth quarter of 2010. Those reserves now total $2.85 trillion. With these massive foreign-reserve purchases, China's money supply is growing by 20 percent. Its inflation rate is rising above 5 percent.

Surely, if the Fed were not printing so many excess dollars -- which circulate to China -- the Chinese money-supply problem wouldn't be so great. Nevertheless, holding back the yuan is creating what looks suspiciously like a big asset bubble. When that bubble is finally punctured, it could do great damage to the economies of China, the U.S. and the rest of the world.

Both the Chinese yuan and the U.S. dollar have depreciated substantially relative to gold. That tells me each currency is way undervalued because money is too loose in both countries. As Columbia University economics professor Robert Mundell has counseled, U.S.-China currency stability is greatly to be desired. That desire can only be accommodated with a high degree of currency- and monetary-policy cooperation, however -- of a sort that is nowhere on the radar screen. Why not look to a gold reference point for both currencies?

At the end of the day, the best thing the U.S. can do to protect its own interests with respect to China is to adopt Ronald Reagan's strategy toward the Soviet Union. The Gipper knew that maximum security abroad requires maximum economic growth at home. That's why the new Republican Congress, hopefully doing business with a more centrist President Obama, must follow through on its pledge to reduce spending, lower the corporate tax rate and roll back unnecessary regulations.

China has gotten cocky because it is growing at 10 percent while our unemployment rate is close to 10 percent. But greater economic strength at home will give the U.S. more leverage to deal with China on all fronts.

This was Reagan's great lesson.