First, it is hard to characterise China's exchange rate regime as mercantilist. While China does seem to have adopted an
Second, whatever the motivation for China's exchange rate policy, RebelEconomist is sceptical whether it necessarily gives China any economic advantage at the expense of the USA. On the contrary, RebelEconomist can think of two arguments why China's currency regime actually ought to be a disadvantage for China, and by implication, potentially advantageous for the USA.
To appreciate the first argument, a brief reminder of the operations involved in pegging an exchange rate may be helpful. Initially, in order to hold the exchange rate at the peg level, the authorities undertake to exchange as much of their currency for the peg currency as the market requires at that level. In China's case, this intervention usually obliges the authorities to buy foreign currency, mainly because, at the peg exchange rate, Chinese products are cheap in foreign markets, meaning that the supply of foreign currency from exporters selling their foreign currency revenue for renminbi outweighs demand for foreign exchange from Chinese importers needing to pay for imports. Also, the fact that the Chinese government restricts its citizens' freedom to buy foreign currency financial assets reduces Chinese demand for foreign currency. Then, in order to accommodate the currency flows generated by their intervention, the authorities normally buy and sell financial assets, typically bonds. In China's position, this entails selling bills to domestic banks to raise renminbi to sell, and buying mostly US government and agency bonds to invest the dollars that China buys. The bonds purchased are retained as foreign exchange reserves, allowing the foreign exchange intervention to be unwound if the market flows reverse. In theory, now that China holds more than enough foreign exchange reserves to meet any foreseeable need for reverse intervention, the Chinese government could spend some dollars on American products instead of bonds, but for strategic reasons, the US government bans American companies from selling China many of the type of defence and technological goods that the Chinese might like to buy. Naturally, the concentration of Chinese dollar investment in US government debt raises bond prices and therefore lowers the interest rates payable by the US government. In short, China's intervention involves
The second argument against the idea that China's exchange rate policy gives them a competitive advantage applies regardless of how the policy is implemented. This argument, which appeals to RebelEconomist's mathematical pretensions, is simply that the currency peg imposes a restriction on the Chinese economy, and calculus teaches us that a constrained optimum cannot be superior to the unconstrained optimum.
The idea that mercantilism is a disadvantage to the mercantilist is not new. The British economists who did most to discredit mercantilism, such as Adam Smith and David Hume were arguing against the advocates of mercantilist policies for their own country, such as Thomas Mun. They drew their conclusions from somewhat different reasoning, however. Smith explained that the proceeds of trade are generally better spent on enhancing the productive capacity of a nation rather than being saved at low interest rates (admittedly, the key reserve asset when Smith was writing in the 18th century was gold) and Hume described how accumulated trade wealth could be expected to bid up domestic prices so that a trade surplus would prove unsustainable anyway.
Provided that America can organise itself to exploit this apparently irrational behaviour by China, such as in the ways that RebelEconomist has suggested in a previous post, China's exchange rate policy need not be a problem for the US. Even if particular American industries suffer from