The peg threatens American recovery. It is in effect a Chinese trade war against America, ongoing for years.
Many economists haven't yet really wrapped their minds around the reality that if exports are heavily subsidized (relative price held down) by a currency peg during an imbalance, then it is no longer "free trade."
We do not have free trade with China.
"Free trade" is effectively an ideology in recent times. Economists understand the advantages of free trade -- how it increases most everyone's absolute wealth (buying power in goods). It's understood the disruption and economic damage the raising of trade barriers would cause. All true.
But not enough. The thinking simply needs to continue beyond this basic level of understanding.
When a government intentionally bends a nation to accomplish an international goal of gaining manufacturing jobs at the expense of other nations (at the expense of jobs in other nations), this is a kind of powerful trade interference. It becomes in effect a trade war.
Damage to the U.S. isn't the only result of this managed effort. The peg actually threatens Chinese stability by extending a reliance on an unsustainable imbalance.
And that raises an open question.
Does China have the smarts to recognize that both alternatives that could follow from maintaining the currency peg are quite harmful to China itself?
It's a multi-trillion dollar question.
Here are the two alternative scenarios I see if China maintains the peg.
A) As Martin Wolf points out, the U.S. is truly forced, without choice, to initiate major tariffs within a few years:
“Yet we do not have that much time. If the US domestic economy remained weak and unemployment high, while our trade deficit soared, particularly our bilateral deficit with China, the pressure to ‘do something’ would become irresistible. I would have to consider the sort of actions that Richard Nixon took in 1971. To force revaluations by Germany and Japan, he threatened a 10 per cent import surcharge. With great regret, I might feel obliged to do the same. I would then argue that China’s determination to thwart needed adjustment in exchange rates had become intolerable. The US is entitled to protect itself against such mercantilism. The trading system would be terribly damaged. But the alternative would be unbearable.”
B) If somehow the U.S. government delayed such a response for little longer based on "free trade" fallacies, then the buildup of political pressure in the U.S. due to joblessness would only lead to a more drastic final U.S. response than the one Martin suggests.
Ideology -- the mental error of trying to maintain "free trade" when the U.S. faces in reality a kind of ongoing trade war -- can only withstand reality only up to a certain limit, at which point the ideology, or illusion, collapses and great political energy is released. America could actually be pushed into a genuine change in ideology.
China by nature should be a natural ally of the U.S. Only the paranoid right has needed to see China as a serious rival.
That could change.
So this question is really a question of smarts. Are they smart enough to see the train coming down the track? Are we smart enough to sound the horn instead of patiently waiting for China to answer a diffident phone call?
Posts on China can be found under the label "China" in the right hand column.