Paul Krugman started out 2010 right.  He submitted the column I wrote for him, word for word (ha, ha), which was published on 1/1/10.   Krugman attacked, head on, China’s predatory export strategy with a focus on their currency manipulation.

But today I want to focus on currency policy. …  The bottom line is that Chinese mercantilism is a growing problem, and the victims of that mercantilism have little to lose from a trade confrontation.

This is the second column in four months where Krugman addresses currency.  On October 23, 2009, he said:

Something must be done about China’s currency.

Today’s column was a direct hit.  And the Wall Street Journal, owned by Rupert Murdoch who has a Chinese wife and extensive investments in China, wasted no time hurling epithets, like "protectionist", in response.

The Nobel Prize-winning economist endorses protectionism as a response to American under-employment, defying the very broad consensus among mainstream economists for free trade, and basically dares China to respond by dumping its holdings of U.S. Treasurys.

That piece is in the WSJ’s China edition, called "China Realtime Report." 

But Krugman’s explanation of the currency problem was pretty good for general readership that does not sit around the holiday festive table thinking about currency manipulation.

Here’s how it works: Unlike the dollar, the euro or the yen, whose values fluctuate freely, China’s currency is pegged by official policy at about 6.8 yuan to the dollar. At this exchange rate, Chinese manufacturing has a large cost advantage over its rivals, leading to huge trade surpluses.

Under normal circumstances, the inflow of dollars from those surpluses would push up the value of China’s currency, unless it was offset by private investors heading the other way. And private investors are trying to get into China, not out of it. But China’s government restricts capital inflows, even as it buys up dollars and parks them abroad, adding to a $2 trillion-plus hoard of foreign exchange reserves. 

He connects China with job loss – future job loss – directly:

Meanwhile, that trade surplus drains much-needed demand away from a depressed world economy. My back-of-the-envelope calculations suggest that for the next couple of years Chinese mercantilism may end up reducing U.S. employment by around 1.4 million jobs.

He goes after those that defend this horrific global economic problem, first making Prime Minister Wen look silly when he talks of protectionism directed at China.

The Chinese refuse to acknowledge the problem. Recently Wen Jiabao, the prime minister, dismissed foreign complaints: “On one hand, you are asking for the yuan to appreciate, and on the other hand, you are taking all kinds of protectionist measures.” Indeed: other countries are taking (modest) protectionist measures precisely because China refuses to let its currency rise. And more such measures are entirely appropriate.

The line "And more such measures are entirely appropriate" will not persuade the hard core free traders, but the casual free traders – those whose paychecks don’t depend upon defending the system – will increasingly feel silly spouting the same old lines.

Krugman then goes into myth/fact mode, saying the two main reasons given to prevent action are wrong.

First is the "China is our banker and we can’t offend our banker" line.  He says they really have zero leverage, and that China selling dollars is actually good.

There’s the claim that we can’t confront the Chinese because they would wreak havoc with the U.S. economy by dumping their hoard of dollars. This is all wrong, and not just because in so doing the Chinese would inflict large losses on themselves. The larger point is that the same forces that make Chinese mercantilism so damaging right now also mean that China has little or no financial leverage. 

Again, right now the world is awash in cheap money. So if China were to start selling dollars, there’s no reason to think it would significantly raise U.S. interest rates. It would probably weaken the dollar against other currencies — but that would be good, not bad, for U.S. competitiveness and employment. So if the Chinese do dump dollars, we should send them a thank-you note.

Then, he goes after the crowd that reflexively shouts "protectionism."  He says they learned Econ 101 from the wrong people.

Second, there’s the claim that protectionism is always a bad thing, in any circumstances. If that’s what you believe, however, you learned Econ 101 from the wrong people — because when unemployment is high and the government can’t restore full employment, the usual rules don’t apply.

Let me quote from a classic paper by the late Paul Samuelson, who more or less created modern economics: “With employment less than full … all the debunked mercantilistic arguments” — that is, claims that nations who subsidize their exports effectively steal jobs from other countries — “turn out to be valid.” He then went on to argue that persistently misaligned exchange rates create “genuine problems for free-trade apologetics.” The best answer to these problems is getting exchange rates back to where they ought to be. But that’s exactly what China is refusing to let happen.

I hadn’t heard the Samuelson doctrine that mercantilism works when employment is not full.  That is a fundamental concept, because the free traders say mercantilism does not matter in the modern economy.  Again, if we don’t have full employment, then mercantilism must be neutralized because it is not benign.

Of course our experience shows that mercantilism is bad.  But it is a happy result when theory converges with fact.

The only quibble I have is with tone.  It is not protectionism, as Krugman says it is, to neutralize the predatory export strategy of another country.  It is that other country that is doing the protectionism (and in China’s case, mercantilism too).  Krugman would do well to point out that addressing the currency problem brings us closer to free and fair trade.