But the prisoners' dilemma arises here. American politicians and commentators will not want to keep quiet since that will lose them the opportunity to take political credit, even if China liberalises the exchange rate policy. In fact, some American politicians may be secretly hoping that China does not do anything. Many of them understand perfectly well that revaluation of renminbi will not bring jobs back to the US If that happens, then they will have to find a new scapegoat for the double digit unemployment problem. In the meantime, the Chinese government is reluctant to make any significant change under foreign pressure. This is why Krugman's intervention only makes things worse.

Let's imagine some scenarios in which Krugman gets what he asks for: the US Treasury Department names China as a currency manipulator and the Obama administration launches trade war against China. If this were to happen, the most likely scenario is that China would then stick to its current exchange rate regime and retaliate with trade sanctions against America. This would reduce trade between the two countries but, more importantly, seriously damage investor confidence worldwide. Trade war between the two largest economies is a non-trivial event for the world economy. In face of much more uncertain economic future, investors would scale back their investment plans and consumers would cut back their spending.

A less likely scenario is that China would be forced to appreciate the currency sharply by, say, 40 percent. This is likely to cause significant difficulties for Chinese companies if the exchange rate adjustment were forced abruptly. Again, there could be two possible outcomes. The first is that Chinese companies would no longer be able to export because of sudden loss of competitiveness. The market vacuum newly made available by exit of Chinese products would be taken up by products from other low-cost countries like Vietnam and India. American companies would not be able to compete with these countries. So this would not add new jobs in the US, but the inflation rate would move higher.

Since exports account for more than one-third of the Chinese economy, collapse of exports would cause serious difficulties for China. Chinese growth would decelerate sharply, as happened in late 2008. This would be unfortunate since most major economies are still struggling with recovery. And sudden weakening of the world's most dynamic economy would send chilling messages across the world markets. Investor confidence would again fall sharply.

The second possible outcome is that China would continue to export to the US market, at higher prices but lower profits. This would push up inflation rates significantly in the US and force the Fed to tighten monetary policy quickly. Both steps could hurt the momentum of America's recovery, which is still not yet on steady footing. New difficulties in the US and China, the two largest economies of the world, would impact global investor confidence negatively.

In either case, global economic growth would be about 1.5 percentage points lower, not higher, if China revalued the currency as Krugman demands. The magnitude is probably exaggerated, but the direction is certain.

Yiping Huang is professor of economics at the China Center for Economic Research at Peking University and in the Crawford School of Economics and Government in the ANU

(Source: en.ccer.edu.cn March 18, 2010)