The US won't fire its label gun
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One fact that people often neglect is that the yuan is pegged only to the US dollar, so its undervaluation against other currencies, if it exists, is an automatic result of the US dollar's devaluation. That is, if the United States really wants to help other countries, it should not devalue its currency. The yuan's peg to the dollar, in a way, affects the whole world: It prevents a free fall of the dollar.
Depreciation of the dollar is a natural choice for the United States to adjust its economy, just like it did in the 1970s and 1980s, but it is at the expense of other countries.
Therefore, other countries are not likely to join the US against China. In particular, the EU is engaged in a bitter fight over its own financial issues. While Germany runs large amounts of current account surpluses, other countries are deep in debts. The recent debates on Greece's bailout highlight the agony within the EU.
Krugman called for the US government to square up to China in a trade war because he believed that China would back down "precisely because the United States can get what it wants". He might be overly confident about his knowledge (or ignorance) on China by underestimating China's resolve when faced with a confrontation. From a pure academic point of view, Krugman has also failed one basic principle of a social scientist: looking at both sides when he thinks about a conflicting issue.
The exchange rate is ultimately a domestic issue. There is a tradeoff between long-term economic growth and short-term macroeconomic stability. There are theories and empirical evidence showing that pegging to a major world currency provides an anchor for a developing country and accelerates its structural transformation. However, the peg also causes major macroeconomic problems. The central bank's offsetting policy is accumulating debts and can be a time-bomb of inflation if things go wrong in the future.
Balancing between long-term growth and short-term stability, a sensible approach is to adopt a manageable floating policy that allows the yuan to appreciate gradually based on the gap of unit product costs between China and the US. Defending a completely fixed exchange rate is costly and corners China into dealing with other countries. Gradual appreciation is not a sign of weakness, but is in China's best interest.
The author is a professor of Peking University and director of its China Center for Economic Research.
