The large and persistent U.S. trade deficit with China, which reached $233 billion in 2006, is causing increased tension in China-U.S. relations. A new coalition has arisen between hawks on Capitol Hill, who see China as a security threat, and protectionists, who blame China for "stealing" American jobs through "unfair trade practices." James A. Dorn, China specialist and Vice President for academic affairs at the Cato Institute in Washington, D.C., however, warns, imposing trade sanctions on China would not eliminate the U.S. bilateral trade deficit--but would endanger the global liberal trading order. Correcting trade imbalances requires flexibility, not rigidity, he says.

A country's overall balance of payments must always balance as a matter of double-entry accounting. Countries that run persistent current-account deficits must be running surpluses in their capital (financial) accounts. The fact that China is running a large current-account surplus with the United States means savings must exceed investments in China, and the excess savings are being used to finance the U.S. twin deficits. In effect, China is providing the resources for U.S. consumers and taxpayers to live beyond their means. Should we bash China for those favors?

The primary reason for the growing U.S. trade deficit with China is that it is so cheap to process manufactured goods in China. That comparative cost advantage will not last forever. As incomes increase and markets open, China will find it beneficial to increase imports and let the yuan appreciate against the dollar. It makes little sense for a capital-poor country like China to hold $1.3 trillion in foreign exchange reserves while depriving its citizens of higher returns at home.

Foreign-invested firms now account for the bulk of Chinese exports. The clear winners are U.S. consumers, including industrial users of Chinese products, as well as domestic firms that have benefited from increased demand as consumers switch to U.S. goods with a comparative cost advantage.

Although U.S. manufacturing is still the most productive in the world and the American economy continues to create millions of jobs, the U.S.-China Economic and Security Review Commission (also known as the U.S.-China Commission or USCC) asserted in its 2005 Report to Congress, "China's undervalued currency has contributed to a loss of U.S. manufacturing, which is a national security concern."

The truth is that net job losses in U.S. manufacturing since 2000 have been due largely to the sharp increase in U.S. productivity, not to Chinese imports or an undervalued yuan. Daniel Griswold, a trade analyst at the Cato Institute, estimates that annual net job losses due to imports from China "account for only about 1 percent of overall job displacement."

The Commission further argues, "China is an authoritarian regime and has a non-market, command economy still controlled by the Communist Party." The Commission, no doubt, would be surprised to learn that there is a statue of Adam Smith on the campus of the Southwestern University of Finance and Economics in Chengdu, and that GlobeScan found more support for the free market in China than in the United States. Moreover, most prices in China are market determined and, for the first time, the five-year plan's title has been changed to "program." Two of the main goals of the 11th Five-Year Program are to deepen economic reforms, including trade liberalization, and to build a "harmonious society."

Although China is still a market socialist economy and has not yet grasped the "Big Market, Small Government" model of Hong Kong, it is clearly not the "non-market, command economy" assumed by the U.S.-China Commission. Yet that type of hyperbole is often heard today on Capitol Hill.

There are legitimate concerns about China, but it is best to look at concrete actions rather than try to divine intentions. Indeed, it is dishonest to use the guise of national security to protect U.S. interest groups when there is no real security threat, which was clearly the case when CNOOC tried to acquire Unocal.

In his dissenting opinion on the 2005 USCC Report, Commissioner William Reinsch criticized the majority's view for its "negative tone."

The report's perspective is simple and simplistic: We are right; China is wrong; the only issue is how to force them to do what we want. The recommendations are equally simplistic--we should tell them what we want them to do and then sanction them if they don't do it. The report consistently implies the Chinese deserve blame for acting in their own interest rather than ours…Despite overwhelming evidence that unilateral sanctions fail to achieve their objectives and at the same time impose significant costs on the sanctioning nation, the commission continues to recommend their imposition or expansion.

The danger is that the 110th Congress might actually take the U.S.-China Commission's advice. There are a number of bipartisan bills aimed at sanctioning China for unfair trade practices. The most likely to be passed is the Currency Exchange Rate Oversight Reform Act of 2007, which the Senate Finance Committee recently approved by a 20-1 vote. Senator Charles Schumer (D-NY), one of the bill's sponsors, believes the sanctions in the bill will "force" China to change its exchange rate policy. But since when is it the duty of the Senate to tell other countries what their exchange rate policies should be? (During the Asian currency crisis in 1997, the Congress was quite pleased with China's pegged exchange rate.)

Neither Senator Schumer nor other members of Congress know what the equilibrium exchange rate should be. Threatening China with anti-dumping duties to correct for an undervalued currency would set a dangerous precedent. It is in China's self-interest to let the yuan appreciate, or suffer inflation as the People's Bank of China (PBOC), China's central bank, accumulates larger and larger dollar reserves, which become more difficult to "sterilize" (the PBOC sells bonds to offset the base money it creates when it buys dollars to keep the yuan from appreciating). It would be less costly for China to normalize its balance of payments by allowing the nominal exchange rate to adjust than to adjust nominal incomes and the overall price level through inflation.

Of course, if China further opens its capital (financial) account, some pressure could be taken off the yuan-dollar rate. But Congress is concerned about foreign U.S. investment, especially if it comes from a communist country, and could block that path of adjustment. However, if Senator Schumer got his way and the yuan appreciated by at least 27 percent against the dollar, his protectionist ploy could backfire: The PBOC would have an incentive to hold fewer dollar assets, which would increase U.S. interest rates, depress asset prices, and possibly lead to a recession. Rather than trying to "force" China to change, a more constructive approach to U.S.-China trade is to follow Secretary Henry Paulson's call for Strategic Economic Dialogue.