The U.S.-China Trade Balance and the Theory of Free Trade: Debunking the Currency Manipulation Argument

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Abstract

The U.S.-China trade imbalance is commonly attributed to a Chinese policy of currency manipulation. However, empirical studies failed to reach consensus on the degree and kind of RMB misalignment. We argue that this is not a consequence of poor measurement but of theory. The conventional principle of comparative advantage suggests real exchange rates will adjust so as to balance trade. Therefore, the persistence of trade imbalances tend to be interpreted as arising from currency manipulation. In contrast, the Smithian-Harrodian theory explains trade imbalances as the outcome of free trade and sees unequal real competitiveness as the root cause of the U.S.-China trade imbalance.