As Chinese President Hu Jintao visits the U.S., the ongoing dispute over the value of the yuan is thrust to the forefront again.
As U.S. politicians struggle to regain economic momentum and create jobs in the aftermath of the financial crisis, the issue will not go away any time soon.
The key question is this: can the U.S. force China to revalue the yuan?
The answer is 'yes,' history shows.
In 1971, the U.S. faced a trade deficit with European countries and Japan. In response, President Richard Nixon, among other dramatic measures, slapped a 10 percent tariff on all imports.
In just a few short months, Europe and Japan agreed to revalue their currencies. In 1973, the United States briefly regained its trade surplus with the world.
In the 1980s, the U.S. again ran into the problem of running large trade deficits, this time with Japan, Germany, and certain emerging markets economies.
As a result, Democrats in the Congress agitated for import tariffs again. They introduced bills that would impose tariffs as high as 25 percent on countries that had large trade surpluses with the U.S.
Both the Reagan administration and the Japanese acquiesced to the pressure. In 1985, the governments of five major nations agreed to coordinate a depreciation of the U.S. dollar versus the Japanese yen and Deutsche mark. This was known as the Plaza Accord.
This time, however, the U.S. trade deficit with the world didn't really budge.
There are three important lessons to be learnt from these two historic examples.
One, in the giant global poker game of trade tariffs, no one will dares to challenge the U.S. if it raises the stakes.
Some may cite the Smoot-Hawley Tariff as an example of retaliatory measures by foreign countries. However, back in 1930, the U.S. wasn't the super-power it is today, nor was it the world's 'consumer of last resort.'
Nowadays, countries in general don't make large retaliatory trade policies; instead, they prefer to back down.
The U.S., for example, allowed China to get away with an undervalued currency for over ten years. Now, with voters screaming for jobs, the most U.S. officials have done is perhaps use quantitative easing to competitively depreciate the dollar.
Two, exporting countries forced to revalue their currencies turned out fine. In fact, after Japan revalued the yen in 1971, it went on to have two decades of 'miraculous' economic growth. Their exporting industries also prospered greatly during that period.
Some argue that the Plaza Accord was responsible for Japan's asset collapse and subsequent lost decade in the 1990s. However, the real culprit was Japan's loose monetary policy, which was unwisely enacted to soften the blow of yen appreciation on exporters.
Three, currency revaluation doesn't always reverse trade deficits because structural issues are the root causes.
Critics often use this fact to squash the idea of making the Chinese revalue the yuan.
However, that argument is misguided because there is absolutely no logical reason to allow the gross misvaluation of the yuan.
Indeed, the yuan is unquestionably misvalued; the government doesn't even allow it to trade freely on the market.
This misvaluation distorts the real economy and there is no reason why it should be allowed to continue.
If China allowed the yuan to rapidly appreciate, manufacturers of tradable goods -- some that exist in the first place because of distorted Chinese government policy -- will undoubtedly feel the squeeze and complain to the government.
However, instead of repeating Japan's mistake by caving in to these complaints, China should make the necessary adjustments by cultivating domestic consumption and use its higher-valued currency to advantageously invest abroad.
Email Hao Li at email@example.com