April 13, 2006, 8:17 a.m.
Graham-Schumer-Push Inflation?
Tariffs against China could lead to a new catch phrase.

Continued improvement in the labor market has a few of the “bad news” bearers shifting their focus. Heretofore, the gloom-and-doom crowd fixated on the slow creation of jobs during this economic cycle and on the idea that outsourcing and illegal immigration were combining to steal American jobs. But at the current unemployment rate of 4.7 percent, any argument that the economy is not creating enough jobs can only be met with laughter. The naysayers, however, are flexible. Now they’re saying that despite a good jobs picture, workers will soon demand too much money relative to their productivity and that inflation will rise in a “cost-push” manner.

Inflation has been described in a variety of ways over the decades. Demand-pull inflation is where the demand for products and services is so high that prices rise. Cost-push inflation occurs when a strong labor market forces prices upward. And then there’s the old helicopter theory of inflation, which has the Federal Reserve effectively flying over the country and dumping out cash (i.e., printing too much money relative to the demand for that money).

Taken together, these descriptions of inflation place the blame for the phenomenon on any one of three sources: corporations, workers, or the Fed. But I have a fourth option: politicians.

One reason why inflation has remained low is the proliferation of low-cost imports from China. By building a dynamic manufacturing base complemented by low-cost labor, China has become a major U.S. trading partner. Since China’s growth rate is one of the fastest among industrialized economies, the Chinese government’s monetary policy has been one of price stability. To achieve this stability, the Chinese have benchmarked their currency relative to the dollar and, as such, have enjoyed strong economic growth and low inflation. This policy has also tended to keep interest rates low in the U.S., as the Chinese have invested close to $1 trillion of dollar reserves in U.S. government securities.

And there’s nothing unique about this relationship. Dollar-linkage has long been good business for both the U.S. and many of its trading partners, and any politician who says otherwise either lacks an understanding of international monetary policy or is lying (or perhaps both).

Today, two politicians in Washington are at least proving they could use a refresher course in the economics of free trade. Senators Charles Schumer of New York and Lindsay Graham of South Carolina don’t like the fact that the Chinese have fixed their currency to the dollar. Their complaint is that currency stabilization is currency manipulation — at least in the case of China. And they want to do something about it: If the Chinese don’t “float” their currency relative to the U.S. dollar, the senators propose a 27.5 percent tariff be placed on imports from China. To the best of my knowledge, I don’t believe either senator has offered a viable reason why Americans would be better off with higher-priced Chinese goods.

This story isn’t new — yet it persists amidst reports of a rising U.S. trade deficit with China. At present, the Graham-Schumer legislation sits in Congress while other senators concoct “less-Draconian,” yet still harmful, bills that would damage an important trade relationship.

Imagine what would happen if Graham-Schumer, or any of our elected federal officials, are successful in “retaliating” against China. If this is the case, U.S. consumers will have to absorb the price increases that would come with the importation of Chinese goods. Given our heavy imports from China, a rise in the prices of domestic goods and services would undoubtedly push the traditional measures of inflation a lot higher. Since the Fed doesn’t ask questions, and only reacts to rising prices, a pop in the inflation numbers would mean tighter money and higher interest rates. Meanwhile, if the Chinese retaliate against our retaliation, either through tariffs or quotas, then more than a few American laborers will be put out of work. Such a downward spiral in standards of living in the name of fighting inflation would not be welcome by most Americans.

Key Chinese politicians are visiting the U.S. over the next few weeks in an attempt to mollify politicians and keep the yuan from a free float. Chinese resistance to these pressures may be weakening and a change in their policy may be in the offing.

If not, and if a 27.5 percent tariff on Chinese imports makes it into law, economists will have the opportunity to stick a new catch phrase on inflation. Demand-push? Cost-push? Try Graham-Schumer-push.

— Thomas E. Nugent is executive vice president and chief investment officer of PlanMember Advisors, Inc., and principal of Victoria Capital Management, Inc.