Introduction: Despite the launch of indirect, “proximity” talks between Palestinians and Israelis, Palestinian President Mahmoud Abbas continues to resist a resumption of direct negotiations with Israel absent a full settlement freeze. As chairman of the Palestine Liberation Organization (PLO) and president of the Palestinian Authority (PA), Abbas also insists that any new negotiations pick up where previous talks left off in December 2008 and that the parties spell out ahead of time a clear “endgame,” including a timetable for concluding negotiations. While these may seem like unreasonable preconditions, Palestinian reluctance to dive headfirst into yet another round of negotiations is rooted in some genuine, hard-learned lessons drawn from nearly two decades of repeated failures both at the negotiating table and on the ground.

Not only have negotiations failed to bring Palestinians closer to their national aspirations but the peace process itself has presided over (and in some ways facilitated) a deepening of Israel’s occupation and an unprecedented schism within the Palestinian polity. Such failures have cost the Palestinian leadership dearly in terms of both its domestic legitimacy and its international credibility. While it remains committed to a negotiated settlement with Israel based on a two-state solution, the PLO/PA leadership has been forced to rethink previous approaches to the peace process and to negotiations, as much for its own survival as out of a desire for peace.

Haunted by past failures, Palestinian negotiators are now guided, to varying degrees, by six overlapping and sometimes conflicting lessons:

1. Realities on the ground must move in parallel with negotiations at the table.

2. Don’t engage in negotiations for their own sake.

3. Agreements are meaningless without implementation.

4. Incrementalism does not work.

5. Avoid being blamed at all costs.

6. Don’t go it alone.

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Recently, Brookings has posted two articles commenting on proposals to raise the full retirement age for Social Security retirement benefits from 67 to 70. One revealed a fundamental misunderstanding of how the program actually works and what the effects of the policy change would be. The other proposes changes to the system that would subvert the fundamental purpose of the Social Security in the name of ‘reforming’ it.

A number of Republican presidential candidates and others have proposed raising the full retirement age. In a recent blog, Robert Shapiro, a Democrat, opposed this move, a position I applaud. But he did so based on alleged effects the proposal would in fact not have, and misunderstanding about how the program actually works. In another blog, Stuart Butler, a conservative, noted correctly that increasing the full benefit age would ‘bolster the system’s finances,’ but misunderstood this proposal’s effects. He proposed instead to end Social Security as a universal pension based on past earnings and to replace it with income-related welfare for the elderly and disabled (which he calls insurance).

Let’s start with the misunderstandings common to both authors and to many others. Each writes as if raising the ‘full retirement age’ from 67 to 70 would fall more heavily on those with comparatively low incomes and short life expectancies. In fact, raising the ‘full retirement age’ would cut Social Security Old-Age Insurance benefits by the same proportion for rich and poor alike, and for people whose life expectancies are long or short. To see why, one needs to understand how Social Security works and what ‘raising the full retirement age’ means.

People may claim Social Security retirement benefits starting at age 62. If they wait, they get larger benefits—about 6-8 percent more for each year they delay claiming up to age 70. Those who don’t claim their benefits until age 70 qualify for benefits -- 77 percent higher than those with the same earnings history who claim at age 62. The increments approximately compensate the average person for waiting, so that the lifetime value of benefits is independent of the age at which they claim. Mechanically, the computation pivots on the benefit payable at the ‘full retirement age,’ now age 66, but set to increase to age 67 under current law. Raising the full retirement age still more, from 67 to 70, would mean that people age 70 would get the same benefit payable under current law at age 67. That is a benefit cut of 24 percent. Because the annual percentage adjustment for waiting to claim would be unchanged, people who claim benefits at any age, down to age 62, would also receive benefits reduced by 24 percent.

In plain English, ‘raising the full benefit age from 67 to 70' is simply a 24 percent across-the-board cut in benefits for all new claimants, whatever their incomes and whatever their life-expectancies.

Thus, Robert Shapiro mistakenly writes that boosting the full-benefit age would ‘effectively nullify Social Security for millions of Americans’ with comparatively low life expectancies. It wouldn’t. Anyone who wanted to claim benefits at age 62 still could. Their benefits would be reduced. But so would benefits of people who retire at older ages.

Equally mistaken is Stuart Butler’s comment that increasing the full-benefit age from 67 to 70 would ‘cut total lifetime retirement benefits proportionately more for those on the bottom rungs of the income ladder.’ It wouldn’t. The cut would be proportionately the same for everyone, regardless of past earnings or life expectancy.

Both Shapiro and Butler, along with many others including my other colleagues Barry Bosworth and Gary Burtless, have noted correctly that life expectancies of high earners have risen considerably, while those of low earners have risen little or not at all. As a result, the lifetime value of Social Security Old-Age Insurance benefits has grown more for high- than for low-earners. That development has been at least partly offset by trends in Social Security Disability Insurance, which goes disproportionately to those with comparatively low earnings and life expectancies and which has been growing far faster than Old-Age Insurance, the largest component of Social Security.

But even if the lifetime value of all Social Security benefits has risen faster for high earners than for low earners, an across the board cut in benefits does nothing to offset that trend. In the name of lowering overall Social Security spending, it would cut benefits by the same proportion for those whose life expectancies have risen not at all because the life expectancy of others has risen. Such ‘evenhandeness’ calls to mind Anatole France’s comment that French law ‘in its majestic equality, ...forbids rich and poor alike to sleep under bridges, beg in streets, or steal loaves of bread.’

Faulty analyses, such as those of Shapiro and Butler, cannot conceal a genuine challenge to policy makers. Social Security does face a projected, long-term funding shortfall. Trends in life expectancies may well have made the system less progressive overall than it was in the past. What should be done?

For starters, one needs to recognize that for those in successive age cohorts who retire at any given age, rising life expectancy does not lower, but rather increases their need for Social Security retirement benefits because whatever personal savings they may have accumulated gets stretched more thinly to cover more retirement years.

For those who remain healthy, the best response to rising longevity may be to retire later. Later retirement means more time to save and fewer years to depend on savings. Here is where the wrong-headedness of Butler’s proposal, to phase down benefits for those with current incomes of $25,000 or more and eliminate them for those with incomes over $100,000, becomes apparent. The only source of income for full retirees is personal savings and, to an ever diminishing degree, employer-financed pensions. Converting Social Security from a program whose benefits are based on past earnings to one that is based on current income from savings would impose a tax-like penalty on such savings, just as would a direct tax on those savings. Conservatives and liberals alike should understand that taxing something is not the way to encourage it.

Still, working longer by definition lowers retirement income needs. That is why some analysts have proposed raising the age at which retirement benefits may first be claimed from age 62 to some later age. But this proposal, like across-the-board benefit cuts, falls alike on those who can work longer without undue hardship and on those in physically demanding jobs they can no longer perform, those whose abilities are reduced, and those who have low life expectancies. This group includes not only blue-collar workers, but also many white-collar employees, as indicated by a recent study of the Boston College Retirement Center. If entitlement to Social Security retirement benefits is delayed, it is incumbent on policymakers to link that change to other ‘backstop’ policies that protect those for whom continued work poses a serious burden. It is also incumbent on private employers to design ways to make workplaces friendlier to an aging workforce.

The challenge of adjusting Social Security in the face of unevenly distributed increases in longevity, growing income inequality, and the prospective shortfall in Social Security financing is real. The issues are difficult. But solutions are unlikely to emerge from confusion about the way Social Security operates and the actual effects of proposed changes to the program. And it will not be advanced by proposals that would bring to Social Security the failed Vietnam War strategy of destroying a village in order to save it.

On the eve of the first anniversary of the Iran nuclear deal, Tehran has announced that Iranian-American Siamak Namazi (who has been detained since last October) and three other dual nationals have been charged with unstated crimes. Tehran’s acknowledgement of the charges—and the Obama administration’s anemic response to these arrests to date—underscore that managing tensions in the post nuclear-deal era remains complex, both for Washington and Tehran.

Siamak’s story

Last week, in a welcome but unavoidably symbolic gesture, Rep. Ed Royce (R-CA), chairman of the House Foreign Affairs Committee, and Rep. Gerry Connolly (D-VA) introduced a bipartisan resolution demanding that Tehran release Siamak, as well as his father Baqer. Siamak is a forty-something consultant who spent his formative years in the United States; his father, Baqer, served as a provincial governor under Iran’s monarchy and as a UNICEF official during his post-revolutionary exile. Outside their day jobs, both men long campaigned for greater engagement between Washington and Tehran. Like many in the Iranian diaspora, they returned to Iran whenever country’s shifting political winds seemed hospitable. 

It is a particularly cruel irony—and grotesquely consistent with the tactics of the Islamic Republic—that the diplomatic breakthrough that both Namazis hoped for precipitated their current nightmare. On the heels of the nuclear deal, Iranian security forces prevented Siamak from leaving the country; he was interrogated for months before he was brought to Iran’s infamous Evin Prison in October 2015. Then in February, Baqer was lured back to Iran on the false premise of visiting his jailed son; instead, he was arrested upon his arrival at the Tehran airport.

Unfortunately, their plight is not unique. Even after Tehran’s much-heralded release of five imprisoned Americans, including Washington Post reporter Jason Rezaian, in January, Tehran has arrested several other dual nationals on trumped-up charges. This includes Nizar Zakka, a Lebanese technology expert who holds a U.S. green card; Homa Hoodfar, a Canadian-Iranian academic; and Nazanin Ratcliff, a British-Iranian woman who was seized at the airport with her toddler daughter. They follow in the painful footsteps of many other dual nationals and countless Iranians arrested without cause.

Paranoia blues

You probably haven’t heard much about Siamak, Nizar, Nazanin, or Homa in the press. Some have deliberately avoided the spotlight, traumatized by their experience or hoping that an “inside strategy” to exert pressure within the system will generate results. It’s not hard; in the post-nuclear deal era, Iran’s abuses are overshadowed by ISIS atrocities, Brexit anxieties, and an unusually absurd American presidential campaign.

But Tehran’s targeting of Americans and others with foreign ties is a pattern that warrants public and policymakers’ attention, because it exposes the nature of Iran’s ruling system and the landscape for American influence in post-nuclear deal Iran. It may be tempting to dismiss these arrests on the grounds of bad luck or individual foolishness or the vagaries of Iran’s enduring power struggle. But none of those rationalizations—while perfectly plausible—does justice to the scope of the problem.

[T]hese arrests are purely political, the inevitable byproduct of a ruling system that is steeped in a culture of paranoia, particularly toward the West.

In fact, these arrests are purely political, the inevitable byproduct of a ruling system that is steeped in a culture of paranoia, particularly toward the West. As Iran’s leaders reopened to the world via the resolution of the nuclear impasse, they have instinctively sought to reinforce the ideological antipathies on which they built the post-revolutionary state. After all, flexing the muscles of theocratic authoritarianism offers a convenient way to persuade a population that is eager for change to steer clear of the temptations of globalization and “Westoxication.” Tehran’s deep-seated fears of a Western-orchestrated conspiracy to undermine the regime are echoed elsewhere; Egypt, China, and Russia have similarly clamped down on international organizations, with Americans and other foreign nationals caught in the crossfire.

For the Islamic Republic, seizing U.S. citizens is also a well-honed tactic for aggravating its foremost adversary in Washington. From the 1979 hostage crisis through the detention of U.S. sailors earlier this year, Iran’s insecure leadership appreciates the efficacy of using individual Americans as pawns in stoking bilateral tensions. It’s a maneuver that conveniently highlights the limits on Washington’s capacity to protect its own nationals abroad. As I wrote at the time of Rezaian’s arrest nearly two years ago: 

“When an Iranian-American is seized by the system, the world's sole superpower is forced to fall back on the least satisfying instruments of diplomatic influence: eloquent statements from the podium, third-party consular inquiries, and quiet efforts through cooperative interlocutors.”

The Congressional resolution appealing for the Namazis’ release represents an additional step in the right direction, but it also demonstrates the weakness of U.S. leverage in the wake of the nuclear deal. At the family’s behest, the resolution does not propose specific penalties that might; Siamak himself was a fierce critic of Washington’s use of sanctions as an instrument for influencing Iran policies. Unfortunately, that deference was probably unnecessary, as the Obama administration is particularly loathe to deploy new economic pressure against Tehran in these early days of the accord’s implementation. 

Shot in the foot

So these arrests go essentially unanswered, and the ripple effects deter Americans and Europeans from engaging in precisely the places and on precisely the issues where their contributions are most valuable. And when Washington appears unable to protect its own citizens from the long arm of Iranian repression, American advocacy on broader human rights issues carries even less credibility with Tehran. Given the proliferation of these cases around the world—launched by authoritarian regimes that fear a democratic contagion—Washington needs to devise an across-the-board strategy to counter intensifying efforts to target Western individuals and institutions. Imposing sanctions for each individual case would not be realistic or effective, but Washington should be prepared to deploy a clear, predictable and escalating set of responses for governments that routinely use American citizens as pawns for their authoritarian agendas.

For Tehran, dual nationals may seem like easy pickings, but ultimately these arrests—and the broad campaign of repression that has continued almost without interruption since the 1979 revolution—pose profound challenges for Iranian interests. After all, its far-flung, disproportionately well-educated, and wealthy diaspora could furnish Iran with a vast pool of talent and capital for its future development. But how many Iranian expatriates will trust their investments—and their personal freedom—to a system that baits 80 year old men into imprisonment and cleaves mothers from their young daughters (and then confiscates the baby’s British passport)? How can any foreign investor rely on official assurances and legal protections from a government that arrests individuals arbitrarily on the basis of wild-eyed conspiracy theories?

[U]ltimately these arrests...pose profound challenges for Iranian interests.

The risks should not be underestimated, and their repercussions will in time hit Iran hardest. This latest round of repression strikes at the very heart of what the nuclear deal was intended to accomplish—Iran’s rehabilitation from pariah status and its full reintegration into the global economy. Iranian leaders seem impervious to the one of the key lessons from their previous efforts to reopen the economy to the world: that provocative policies will undercut access to finance and the inclination of international investors.

Fundamentally, as I commented in January, after the Saudi embassy in Tehran was torched: 

“the requirements of any kind of resilient reentry to the global economy and achieving the stature that Iranians crave are simply incompatible with aspects of Iran’s official ideology. A state that refuses to rein in—or, more accurately, still relies on—semi-official vandalism will inevitably find its ambitions curbed instead…to fully come in from the cold, Tehran will have to disavow the revolution’s ideological imperatives.”

For an Iranian leadership that has complained incessantly about the slow pace of sanctions relief, there is an unabashed hypocrisy in this kind of self-sabotage, whose implications extend well beyond the economy. The arrests of dual nationals represent the tip of an iceberg of injustice that underpins—and will eventually undermine—the Islamic Republic. The stalwarts of the Iranian system have constructed an elaborate ideological and bureaucratic edifice aimed at preserving their own power. In the end, their disdain for rule of law and their phobias about Western influence represent greater vulnerabilities than any of the perceived threats that motivate the crackdown.

Event Information

On February 29, the Africa Security Initiative at Brookings held a discussion on Nigeria, nine months after the inauguration of President Muhammadu Buhari, the country’s first president to take office in a peaceful transition of power from one party to another. President Buhari, who previously ruled Nigeria in the mid-1980s after a military coup, inherits a country facing burgeoning population, low oil prices for its top export, and the Boko Haram extremist insurgency in the northeast. Buhari also inherited other problems such as unrest in the country’s delta and southeast regions, and a culture of corruption and human rights abuse and impunity throughout much of the country’s armed forces and police.

Less than a year into his presidency, Buhari has made progress in reforming the military, sacking some military leaders and injecting a bit more energy into the counter-Boko Haram campaign. But has he chosen the right priorities for Nigeria and fundamentally headed in the right direction, and what has been the impact on civilians, particularly in the northeastern part of the country? What additional role, if any, could the United States and the broader international community play to support additional reform?

We convened a panel to discuss these subjects. The panel, made up of independent experts with deep knowledge ranging from human rights to economics and finance to broader political and security sector reform, included EJ Hogendoorn of the International Crisis Group, Madeline Rose from Mercy Corps, Mausi Segun of Human Rights Watch, and Amadou Sy from The Brookings Institution. Senior Fellow Michael O’Hanlon, who directs the Africa Security Initiative at Brookings, moderated the discussion.

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• Examining the current state of Nigeria

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• Transcript (.pdf)

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• 20160229_nigeria_transcript

The Chinese currency, or renminbi (RMB), has been a contentious issue for the past several years. Most recently, members of Congress have suggested tying China currency legislation to the upcoming votes on the free trade agreements with South Korea, Colombia and Panama. While not going that far, the Senate Majority Leader, Harry Reid, and Senator Charles Schumer have promised a vote on the issue some time this year.

The root of the conflict for the United States—and other countries—is complaints that China keeps the value of the RMB artificially low, boosting its exports and trade surplus at the expense of trading partners. Recent government data show that the bilateral trade deficit between the U.S. and China grew nearly 12 percent in the first half of 2011—fueling efforts to boost job creation domestically by authorizing import tariffs and other restrictions on countries that manipulate their currencies.

Although the U.S. Treasury has repeatedly stopped short of labeling China a “currency manipulator” in its twice-yearly reports to Congress, it has consistently pressured China to allow the RMB to appreciate at a faster pace, and to let the currency fluctuate more freely in line with market forces. The International Monetary Fund (IMF), the World Bank and many economists have also argued for faster appreciation and a more flexible exchange rate policy as part of a broader program of “rebalancing” the Chinese economy away from its traditional reliance on exports and investment, and towards a more consumer-driven growth model. Partly in response to these pressures, but more because of domestic considerations, China has allowed the RMB to rise by about 25 percent against the U.S. dollar since mid-2005. Yet the pace of appreciation remains agonizingly slow for the United States and other countries in Europe and Latin America whose manufacturing sectors face increasing competition from low-priced Chinese goods.

The international conversation over the RMB remains perennially vexed because China and its trade partners have fundamentally divergent ideas on the function of exchange rates. The United States and other major developed economies, as well as the IMF, view an exchange rate simply as a price. Consistent intervention by China to keep its exchange rate substantially below the level the market would set is, in this view, a distortion that prevents international markets from functioning as well as they could. This price distortion also affects China’s own economy, by encouraging large-scale investment in export manufacturing, and discouraging investment in the domestic consumer market. Thus it is in the interest both of China itself and the international economy as a whole for China to allow its exchange rate to rise more rapidly.

Chinese officials take a very different view. They see the exchange rate—and prices and market mechanisms in general—as tools in a broader development strategy. The goal of this development strategy is not to create a market economy, but to make China a rich and powerful modern country. Market mechanisms are simply means, not ends in themselves. Chinese leaders observe that all countries that have raised themselves from poverty to wealth in the industrial era, without exception, have done so through export-led growth. Thus they manage the exchange rate to broadly favor exports, just as they manage other markets and prices in the domestic economy to meet development objectives such as the creation of basic industries and infrastructure. These policies do not differ materially from those pursued by Japan, South Korea and Taiwan since World War II, or by Britain, the United States and Germany in the 19th century. Since the Chinese leaders perceive that an export-led strategy is the only proven route to rich-country status, they view with profound suspicion arguments that rapid currency appreciation and markedly slower export growth are “in China’s interest.” And because China—unlike Japan in the 1970s and 1980s—is an independent geopolitical power, it is fully able to resist international pressure to change its exchange-rate policy.

A second issue raised by China’s currency and trade policies is the persistent trade surplus since 2004 which has contributed about three-quarters of the nearly US$3 trillion increase in China’s foreign exchange reserves over the past eight years. Close to two-thirds of these reserves are invested in U.S. treasury debt. Some fear that China has become the United States’ banker, and could cause a collapse in the U.S. dollar and the U.S. economy by dumping its dollar holdings. Others suggest that China’s recent moves to increase the international use of the RMB through an offshore market in Hong Kong signal China’s intent to build up the RMB as an international reserve currency to rival or eventually supplant the dollar. All of these concerns are based on serious misunderstandings of both international financial markets and China’s domestic political economy. China is not in any practical sense “America’s banker;” it is more a depositor than a lender, and its economic leverage over the United States is very modest.

And while China’s leading position in global trade makes it quite sensible to increase the use of the RMB for invoicing and settling trade, it is a huge leap from making the RMB more internationally traded to making it an attractive reserve currency. China does not now meet the basic conditions required for the issuer of a major reserve currency, and may never meet them. Most importantly, the RMB is unlikely to become more than a second-tier reserve currency so long as Chinese leaders cling to their deep reluctance to allow foreigners a significant role in China’s domestic financial markets.

China’s Currency Policies

China’s exchange-rate policy must be understood within the context of two political-economic factors: first, China’s overall development strategy which aims to build up the nation’s economic and political power with market mechanisms being tools to that end rather than ends in themselves; and second, China’s geopolitical position.

The Chinese development strategy, which emerged gradually after Deng Xiaoping began the process of “reform and opening” in 1978, is based on a careful study of how other industrial nations got rich—and in particular, the catch-up growth strategies of its east Asian neighbors Japan, South Korea and Taiwan after World War II. A key lesson of that study is that every rich nation, in the early stages of its development, used export-friendly policies to promote domestic industry and to accelerate technology acquisition. In earlier eras, when the use of the gold standard made it impossible to maintain permanently undervalued exchange rates, countries used administrative coercion and high tariffs to achieve the same effect of favoring domestic manufacturers over foreign ones. Britain’s policies of using colonies as captive markets for its manufactured exports, and prohibiting the colonies from exporting manufactures back to Britain, were important components of that nation’s rise as the world’s leading industrial power in the late 18th and 19th centuries. Resentment of those policies was one cause of the American Revolution; once independent, the United States spurred its economic development through the “American system,” which featured high tariff walls (often 40 percent or more) through the 19th and into the early 20th century. Germany used similar protective policies to foster its industries in the late 19th century. Countries did not become advocates for free trade until their firms were secure in global technological leadership and the need for protection waned for Britain, this occurred in the mid-19th century; for the United States, the mid-20th.

After World War II, undervalued exchange rates became an important tool of export promotion, partly because new global trading rules under the General Agreement on Tariffs and Trade (GATT, which morphed into the World Trade Organization in 1995) made it more difficult to maintain extremely high levels of tariff protection. The testimony of post-war economic history is quite clear. Countries that maintained undervalued exchange rates and pursued export markets enjoyed sustained high-speed economic growth and became rich. These countries include Germany, Japan, South Korea and Taiwan. Countries that used other mechanisms to block imports and encouraged their industrial firms to cater exclusively to domestic demand—so-called “import substitution industrialization,” or ISI, which usually involved an overvalued exchange rate—in some cases grew quite rapidly for 10 years or more. But this growth could not be sustained because the ISI strategy includes no mechanism for keeping pace with advances in global technology. Most ISI countries, including much of Latin America and the whole of the Communist bloc, experienced severe financial crisis and fell into long periods of stagnation.

As it tried to accelerate growth by moving from a planned to a more market-driven economy in the 1980s, China gradually depreciated the RMB by a cumulative 80 percent, from 1.8 to the dollar in 1978 to 8.7 in 1995. Since then, however, the RMB has only appreciated against the dollar, moving up to a rate of 8.3 by 1997, and holding steady at that rate until mid-2005 after which gradual appreciation resumed. Since 2006 the RMB has appreciated at an average annual rate of about 5 percent against the dollar, to its current rate of about 6.4, and it is likely that this average rate of appreciation will be sustained for the next several years. This history demonstrates that supporting export growth, while important, is not the sole determinant of China’s exchange-rate policy. During the Asian financial crisis of 1997-1998, the consensus of most economists held that the RMB was overvalued; despite this, Beijing kept the value of the RMB steady, on the grounds that devaluation would further destabilize the battered Asian regional economy. As a consequence, China endured a few years of relatively anemic growth in exports and GDP, and persistent deflation. The leadership decided that this was a price worth paying for regional economic stability.

Conversely, the appreciation since 2005 reflects Beijing’s understanding that clinging to a seriously undervalued exchange rate for too long risks sparking inflation. This occurred in many oil-rich Persian Gulf countries in 2005-2007, which held fast to unrealistically low pegged exchange rates and suffered annual inflation rates of 20 percent to 40 percent. For Chinese leaders, an inflation rate above 5 percent is considered dangerously high, and the most rapid currency appreciation in the last few years has occurred when inflationary pressure was relatively strong. A second reason for switching to a policy of gradual appreciation was the view that an ultra-cheap exchange rate disproportionately benefited manufacturers of ultra-cheap goods, whose technology content and profit margins were low. While these industries provided employment for millions, they did not contribute much to the nation’s technological upgrading. A gradual currency appreciation, economic policymakers believed, would eventually force Chinese manufacturers to move up the value chain and start producing more sophisticated and profitable goods. This strategy appears to be bearing fruit: China is rapidly gaining global market share in more advanced goods such as power generation equipment and telecoms network switches. Meanwhile, it has begun to lose market share in low-end goods like clothing and toys, to countries like Vietnam, Cambodia, Indonesia and Bangladesh.

In short, China’s exchange-rate policy is mainly driven by the aim of enhancing the nation’s export competitiveness. But other factors play a role, namely a desire to maintain domestic and regional macro-economic stability, keep inflationary pressures at bay, and force a gradual upgrading of the industrial structure. From the point of view of Chinese policy makers, all of these objectives suggest that the exchange rate should be carefully managed, rather than left to unpredictable market forces. While economists may argue that long-run economic stability is better served by a more flexible exchange rate, Chinese officials can point to the excellent track record their policies have produced: consistent GDP growth of around 10 percent a year since the late 1990s, inflation consistently at or below 5 percent, export growth of more than 20 percent a year, and a steady increase in the sophistication of Chinese exports. Until some kind of crisis convinces them that their economic policies require major adjustment, China’s economic planners are likely to stick with their current formula.

International pressure to accelerate the pace of RMB appreciation is unlikely to have much impact. The basic reason is that other countries have very little leverage that they can bring to bear. In the 1970s, the United States was able to pressure Germany and Japan to appreciate their currencies because those countries were militarily dependent on America. (Moreover, the United States was able unilaterally to engineer a devaluation of the dollar by going off the gold standard in 1971.) Japan’s position of dependency forced it to accede to the Plaza Accord of 1985, which resulted in a doubling of the value of the yen over the next two years. China, being, geopolitically independent, has no incentive to bow to pressure on the exchange rate from the United States, let alone Europe or other nations such as Brazil. The only plausible threat is that failure to appreciate the RMB could lead to a protectionist backlash that would shut the world’s doors to Chinese exports. Yet this threat has so far proved empty: even after three years of the worst global recession since the Great Depression, trade protectionism has failed to emerge in the United States or Europe.

Other considerations further strengthen the Chinese determination not to give in to foreign pressure on the exchange rate. One is the Japanese experience after the Plaza Accord. The generally accepted view in China is that the dramatic appreciation of the yen in the late 1980s was a crucial contributor to Japan’s dramatic asset-price bubble whose collapse after 1990 set the former world-beating economy on a two-decade course of economic stagnation. Chinese officials are adamant that they will not repeat the Japanese mistake. This resolve was strengthened by the global financial crisis of 2008, which in China thoroughly discredited the idea—already held in deep suspicion by Chinese leaders—that lightly regulated financial markets and free movements of capital and exchange rates are the best way to run a modern economy. China’s rapid recovery and strong growth after the crisis are deemed to vindicate the nation’s strategy of a managing the exchange rate, controlling capital flows, and keeping market forces on a tight leash.

The Internationalization of the RMB

Despite this generally self-confident view of the merit of its exchange-rate and other economic policies, Chinese leaders are troubled by one headache caused by the export-led growth strategy: the accumulation of a vast stockpile of foreign exchange reserves, most of which are parked in very low-yielding dollar assets, principally U.S. treasury bonds and bills. For a while, the accumulation of foreign reserves was viewed as a good thing. But after the 2008 financial crisis, the perils of holding enormous amounts of dollars became evident: a serious deterioration of the US economy leading to a sharp decline in the value of the dollar could severely reduce the worth of those holdings. Moreover, the pervasive use of the dollar to finance global trade proved to have hidden risks: when United States credit markets seized up in late 2008, trade finance evaporated and exporting nations such as China were particularly hard hit. The view that excessive reliance on the dollar posed economic risks led Chinese policy makers to undertake big efforts to internationalize the RMB, beginning in 2009, through the creation of an offshore RMB market in Hong Kong.

Before considering the significance of RMB internationalization, it is worth addressing some misconceptions about China’s large-scale reserve holdings and investments in U.S. treasury bonds. Because China’s central bank is the biggest single foreign holder of U.S. government debt, it is often said that China is “America’s banker,” and that, if it wanted to, it could undermine the U.S. economy by selling all of its dollar holdings, thereby causing a collapse of the U.S. dollar and perhaps the U.S. economy. These fears are misguided. First of all, it is by no means in China’s interest to cause chaos in the global economy by prompting a run on the dollar. As a major exporting nation, China would be among the biggest victims of such chaos. Second, if China sells U.S. treasury bonds, it must find some other safe foreign asset to buy, to replace the dollar assets it is selling. The reality is that no other such assets exist on the scale necessary for China to engineer a significant shift out of the dollar. China accumulates foreign reserves at an annual rate of about US$400 billion a year; there is simply no combination of markets in the world capable of absorbing such large amounts as the U.S. treasury market. It is true that China is trying to diversify its reserve holdings into other currencies, but at the end of 2010 it still held 65 percent of its reserves in dollars, well above the average for other countries (60 percent). From 2008 to 2010, when newspapers were filled with stories about China “dumping dollars,” China actually doubled its holdings of U.S. Treasury securities, to US$1.3 trillion.

The other crucial point is that China is not in any meaningful sense “America’s banker,” and its economic leverage is modest. China owns just 8% of the total outstanding stock of US Treasury debt; 69% of Treasury debt is owned by American individuals and institutions. Measured by Treasury debt holdings, America is America’s banker—not China. And China’s holdings of all US financial assets – equities, federal, municipal and corporate debt, and so on – is a trivial 1%. Chinese commercial banks lend almost nothing to American firms or consumers. The gross financing of American companies and consumers comes principally from U.S. banks, and secondarily from European ones. It is more apt to think of China as a depositor at the “Bank of the United States”: its treasury bond holdings are super-safe, liquid holdings that can be easily redeemed at short notice, just like bank deposits. Far from holding the United States hostage, China is a hostage of the United States, since it has little ability to move those deposits elsewhere -- no other bank in the world is big enough.

It is precisely this dependency that has prompted Beijing to start promoting the RMB as an international currency. By getting more companies to invoice and settle their imports and exports in RMB, China can gradually reduce its need to put its export earnings on deposit at the “Bank of the United States.” But again, headlines suggesting that internationalization of the RMB heralds the imminent demise of the current dollar-based international monetary system are premature.

The simplest reason is that the RMB’s starting point is so low that many years will be required before it becomes one of the world’s major traded currencies. In 2010, according to the Bank for International Settlements, the RMB figured in under 1 percent of the world’s foreign exchange transactions, less than the Polish zloty; the dollar figured in 85 percent and the euro in 40 percent. There is no question that use of the RMB will increase rapidly. Since Beijing started promoting the use of RMB in trade settlement (via Hong Kong) in 2009, RMB-denominated trade transactions have soared: around 10 percent of China’s imports are now invoiced in RMB. The figure for exports is lower, which makes sense. Outside China, people sending imports to China are happy to be paid in RMB, since they can reasonably expect that the currency will increase in value over time. But Chinese exporters wanting to get paid in RMB will have a difficult time finding buyers with enough RMB to pay for their shipments. Over time, however, foreign companies buying and selling goods from China will become increasingly accustomed to both receiving and making payments in RMB – just as they grew accustomed to receiving and making payments in Japanese yen in the 1970s and 1980s.

Since China is already the world’s leading exporter, and is likely to surpass the United States as the world’s leading importer within three or four years, it is quite natural that the RMB should become a significant currency for settling trade transactions. Yet the leap from that role to a major reserve currency is a very large one, and the prospect of the RMB becoming a reserve currency on the order of the euro—let alone replacing the dollar as the world’s dominant reserve currency—is remote. The reason for this is simple: to be a reserve currency, you need to have safe, liquid, low-risk assets for foreign investors to buy; these assets must trade on markets that are transparent, open to foreign investors and free from manipulation. Central banks holding dollars and euros can easily buy lots of U.S. treasury securities and euro-denominated sovereign bonds; foreign investors holding RMB basically have no choice but to put their cash into bank deposits. The domestic Chinese bond market is off-limits to foreigners, and the newly-created RMB bond market in Hong Kong (the so-called “Dim Sum” bond market) is tiny and consists mainly of junk-bond issuances by mainland property developers.

Again, we can reasonably expect rapid growth in the Hong Kong RMB bond market. But the growth of that market, and granting foreigners access to the domestic Chinese government bond market, remain severely constrained by political considerations. Just as Chinese officials do not trust markets to set the exchange rate for their currency, they do not trust markets to set the interest rate at which the government can borrow. Over the last decade Beijing has retired virtually all of its foreign borrowing; more than 95 percent of Chinese government debt is issued on the domestic market, where the principal buyers are state-owned banks that are essentially forced to accept whatever interest rate the government dictates. There is absolutely no reason to believe that the Chinese government will at any point in the near future surrender the privilege of setting the interest rate on its own borrowings to foreign bond traders over whom it has no control. As a result, it is likely to be many years before there is a large enough pool of internationally-available safe RMB assets to make the RMB a substantial international reserve currency.

In this connection the example of Japan provides an instructive example. In the 1970s and 1980s Japan occupied a position in the global economy similar to China’s today: it had surpassed Germany to become the world’s second biggest economy, and it was accumulating trade surpluses and foreign-exchange reserves at a dizzying rate. It seemed a foregone conclusion that Japan would become a central global financial power, and the yen a dominant currency. Yet this never occurred. The yen internationalized – nearly half of Japanese exports were denominated in yen, Japanese firms began to issue yen-denominated “Samurai bonds” on international markets, and the yen became an actively traded currency. Yet at its peak the yen never accounted for more than 9 percent of global reserve currency holdings, and the figure today is around 3 percent. The reason is that the Japanese government was never willing to allow foreigners meaningful access to Japanese financial markets, and in particular the Japanese government bond market. Even today, about 95 percent of Japanese government bonds are held by domestic investors, compared to 69 percent percent for US Treasury securities. China is not Japan, of course, and its trajectory could well be different. But the bias against allowing foreigners meaningful participation in domestic financial markets is at least as strong in China as in Japan, and so long as this remains the case it is unlikely that the RMB will become anything more than a regional reserve currency.

Implications for U.S. Policy

The above analysis suggests two broad conclusions of relevance to United States policymakers. First, China’s exchange-rate policy is deeply linked to long-term development goals and there is very little that the United States, or any other outside actor, can do to influence this policy. Second, the same suspicion of market forces that leads Beijing to pursue an export-led growth policy that generates large foreign reserve holdings also means that Beijing is unlikely to be willing to permit the financial market opening required to make the RMB a serious rival to the dollar as an international reserve currency. A related observation is that an average annual appreciation of the RMB against the dollar of about 5 percent now seems to be firmly embedded in Chinese policy. An appreciation of this magnitude enables China to maintain export competitiveness while achieving two other objectives: keeping domestic consumer-price inflation under control, and gradually forcing an upgrade of China’s industrial structure.

Generally speaking, these trends are quite benign from a U.S. perspective. In substantive terms, there is little to be gained from high-profile pressure on China to accelerate the pace of RMB appreciation, since the United States possesses no leverage that can be plausibly brought to bear. While the persistent undervaluation of the RMB will present increasing difficulties for American manufacturers of high-end equipment, as Chinese manufacturers gradually become more competitive in these sectors, the steady appreciation of the currency will increase the purchasing power of the average Chinese consumer and the total size of the Chinese consumer market. United States policy should therefore de-emphasize the exchange rate, where the potential for success is limited, and instead focus on keeping the pressure on China to maintain and expand market access for American firms in the domestic Chinese market, which in principle is provided for under the terms of China’s accession to the World Trade Organization.

This paper is part of a series of in-depth policy papers, Shaping the Emerging Global Order, in collaboration with ForeignPolicy.com. Visit ForeignPolicy.com's Deep Dive section for discussion on this paper.

Arthur Kroeber expands upon a recent paper, answering questions about China's monetary policy on the valuation of the renminbi and the political issues this raises.

1. The Chinese currency, or renminbi (RMB) has been a contentious issue for the past several years. What is the root of the conflict for the United States and other countries?

The root of the conflict for the United States—and other countries—is complaints that China keeps the value of the RMB artificially low, boosting its exports and trade surplus at the expense of trading partners. Although the U.S. Treasury has repeatedly stopped short of labeling China a “currency manipulator” in its twice-yearly reports to Congress, it has consistently pressured China to allow the RMB to appreciate at a faster pace, and to let the currency fluctuate more freely in line with market forces. The International Monetary Fund, the World Bank and many economists have also argued for faster appreciation and a more flexible exchange rate policy. Partly in response to these pressures, but more because of domestic considerations, China has allowed the RMB to rise by about 25% against the U.S. dollar since mid-2005. Yet the pace of appreciation remains agonizingly slow for the U.S. and other countries in Europe and Latin America whose manufacturing sectors face increasing competition from low-priced Chinese goods.

2. What impact does exchange rate control have on the economy?

According to foreign observers, consistent intervention by China to keep its exchange rate substantially below the level the market would set is a price distortion that prevents international markets from functioning as well as they could. This price distortion also affects China’s own economy, by encouraging large-scale investment in export manufacturing, and discouraging investment in the domestic consumer market. Thus, it is in the interest both of China itself and the international economy as a whole for China to allow its exchange rate to rise more rapidly. However, Chinese policy makers do not agree with this view, and believe the managed exchange rate is broadly beneficial for economic development.

3. What is the Chinese view of their policies toward exchange rate control?

Chinese officials see the exchange rate—and prices and market mechanisms in general—as tools in a broader development strategy. The goal of this development strategy is not to create a market economy but to make China a rich and powerful modern country. Market mechanisms are simply means, not ends in themselves. Chinese leaders observe that all countries that have raised themselves from poverty to wealth in the industrial era, without exception, have done so through export-led growth. Thus, they manage the exchange rate to broadly favor exports, just as they manage other markets and prices in the domestic economy in order to meet development objectives such as the creation of basic industries and infrastructure.

Since they perceive that an export-led strategy is the only proven route to rich-country status, they view with profound suspicion arguments that rapid currency appreciation and markedly slower export growth are “in China’s interest.” And because China is an independent geopolitical power, it is fully able to resist international pressure to change its exchange rate policy.

4. What are some misconceptions about China’s large-scale reserve holdings and investments in U.S. Treasury Bonds, specifically the idea that China is “America’s banker?”

Because China’s central bank is the single biggest foreign holder of U.S. government debt, it is often said that China is “America’s banker,” and that, if it wanted to, it could undermine the U.S. economy by selling all of its dollar holdings, thereby causing a collapse of the U.S. dollar and perhaps the U.S. economy. These fears are misguided. China is not in any practical sense “America’s banker.” China holds just 8% of outstanding US Treasury debt; American individuals and institutions hold 69%. China holds just 1% of all US financial assets (including corporate bonds and equities); US investors hold 87%. Chinese commercial banks lend almost nothing to American firms and consumers – the large majority of that finance comes from American banks. America’s banker is America, not China.
It is more apt to think of China as a depositor at the “Bank of the United States:” its treasury bond holdings are super-safe, liquid holdings that can be easily redeemed at short notice, just like bank deposits. Far from holding the United States hostage, China is a hostage of the United States, since it has little ability to move those deposits elsewhere (no other bank in the world is big enough).

5. What are the implications for U.S. policy and how should policymakers react?

China’s exchange-rate policy is deeply linked to long-term development goals and there is very little that the United States, or any other outside actor, can do to influence this policy. Also, the same suspicion of market forces that leads Beijing to pursue an export-led growth policy generating large foreign reserve holdings also means that Beijing is unlikely to be willing to permit the financial market opening required to make the RMB a serious rival to the dollar as an international reserve currency.

In substantive terms, there is little to be gained from high-profile pressure on China to accelerate the pace of RMB appreciation, since the United States possesses no leverage which can be plausibly brought to bear. U.S. policy should therefore de-emphasize the exchange rate, and instead focus on keeping the pressure on China to maintain and expand market access for American firms in the domestic Chinese market, which in principle is provided for under the terms of China’s accession to the World Trade Organization.

Following the global financial crisis of 2008, China’s authorities took a number of steps to internationalize the use of the Chinese currency, the renminbi. These included the establishment of currency swap lines with foreign central banks, encouragement of Chinese importers and exporters to settle their trade transactions in renminbi, and rapid expansion in the ability of corporations to hold renminbi deposits and issue renminbi bonds in the offshore renminbi market in Hong Kong.

These moves, combined with public statements of concern by Chinese officials about the long-term value of the central bank’s large holdings of U.S. Treasury securities, and the role of the U.S. dollar’s global dominance in contributing to the financial crisis, gave rise to widespread speculation that China hoped to position the renminbi as an alternative to the dollar, initially as a trading currency and eventually as a reserve currency.

This paper contends that, on the contrary, the purposes of the renminbi internationalization program are mainly tied to domestic development objectives, namely the gradual opening of the capital account and liberalization of the domestic financial system. Secondary considerations include reducing costs and exchange-rate risks for Chinese exporters, and facilitating outward direct and portfolio investment flows. The potential for the currency to be used as a vehicle for international finance, or as a reserve asset, is severely constrained by Chinese government’s reluctance to accept the fundamental changes in its economic growth model that such uses would entail, notably the loss of control over domestic capital allocation, the exchange rate, capital flows and its own borrowing costs.

This paper attempts to understand the renminbi internationalization program by addressing the following issues:

1. Definition of currency internationalization

2. Specific steps taken since 2008 to internationalize the renminbi

3. General rationale for renminbi internationalization

4. Comparison with prior instances of currency internationalization, notably the U.S. dollar after 1913, the development of the Eurodollar market in the 1960s and 1970s; and the deutsche mark and yen in 1970-1990

5. Understanding the linkage between currency internationalization and domestic financial liberalization

6. Prospects for and constraints on the renminbi as an international trading currency and reserve currency

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• China’s Global Currency: Lever for Financial Reform

In his presidential campaign in 1928, Herbert Hoover promised to help impoverished farmers by increasing tariffs on agricultural products; after the election, he also asked Congress to reduce tariffs on industrial goods. In April 1929, well before Black Thursday, U.S. Representative Reed Smoot, a Republican from Utah, introduced a bill that passed the House in May. The bill increased agricultural and industrial tariffs at levels that had not been seen for a century. This was a relatively benign beginning of what would become one of the most tragic policy measures of the 1930s. Within a few months of the bill being passed in the Senate as the Smoot-Hawley Tariff Act, other countries in response raised their own trade barriers, which started a vicious circle of contracting world trade flows and economic activity, and rising unemployment from 1930 to 1933.

There are three main lessons from the policies mentioned above: 

1. “Beggar-my-neighbor” policies are bad.
2. Bad policies can have tragic consequences.
3. Beware of benign measures that can ignite uncontrollable chain reactions.

Indeed, these lessons have been in every policymakers’ mind since the Lehmann Brothers failure. In fact, the creation of the G-20 was a spectacular effort by the major economies of the world to cooperatively answer the challenges raised by the most severe financial crisis since the 1930s. The G-20 coordinated the management of strong macroeconomic policies, including huge deficits and easy monetary policies. These were bold decisions but not radical, and those who condemned government intervention have been rebutted by the urgency of these measures. And it is now widely acknowledged that these unconventional measures successfully avoided the transformation of the Great Recession into another Great Depression.

In the U.S., the recovery is at best shaky, unemployment is artificially reduced by the growing number of discouraged workers who have stopped looking for work, and the median income is dramatically lagging.

Today, there are reasons of hope that have been eloquently described by Roger Altman [1]: it can be argued that in the U.S., and to a lesser degree in Europe, the crisis has inspired significant reforms that have pushed the economy closer to a sound and sustainable growth trajectory. However others rightfull so object that enormous challenges are still facing the populations and their respective governments. The price paid for curing the damages of the global financial crisis is extremely high everywhere. In the U.S., the recovery is at best shaky, unemployment is artificially reduced by the growing number of discouraged workers who have stopped looking for work, and the median income is dramatically lagging. In Europe, austerity is the name of the game in every country except Germany and despair is growing among the populace. Japan has been stuck for two decades in deflation. Many citizens around the world feel that the efforts have gone too far, yet the benefits and retribution have benefitted too few. Electoral frustrations are on the rise as demonstrated in Italy where Mario Monti’s wise policies have been followed by the success of the Five Stars Movement of Beppe Grillo. Italy turning ungovernable is a bad sign for democracies. Could we see a comeback of desperate national policy experiments like the ones that democracies were progressively pushed to adopt after facing insurmountable difficulties in the early 1930s?

Now, a really radical policy experiment is already taking shape in Japan with the introduction of what has been named “Abenomics” after the name of the newly-elected prime minister, Shinzo Abe. It has taken only one election and one nomination at the head of the Bank of Japan to really revolutionize monetary policy. This revolution can be qualified in two ways, one benign, one threatening.

There is first reason to rejoice. After two decades of failed policies, it’s finally good to see bold politicians ready to do whatever it takes to extract Japan from its deflationary trap. Should Mr. Abe succeed, he would unclench the domestic brakes to economic growth, which deflation has so lengthily opposed: declining prices in effect are discouraging consumption (goods will be better and cheaper tomorrow, why spend now?) and investment (facing massive excess capacity of production and weak final demand, why invest now?). The new mission of the governor of the Bank of Japan is to raise inflationary expectations to 2 percent, which would make Japan converge with the world average inflationary trend and monetary policy. Demand would restart and Japan would contribute to an improved global economic outlook. This is the view that the IMF chief recently endorsed. As expected, Mr. Kuroda last week unveiled a much more aggressive package of quantitative easing than what we have previously witnessed, with a view to double the monetary base. Japan’s central bank will buy more long-term government bonds, pushing private investors to invest more in risky assets. Since the election, the Nikkei has risen 34 percent. Different polls and surveys suggest that the public is positively reacting to Mr. Abe’s promises.

Is success already underway? That would be good news for Japan and for the world. But it is clearly too soon to celebrate because this virtuous circle can simply fail to happen. No central bank until now has ever tried to raise inflationary expectations and no one knows if this can turn to be a practical and manageable reality. Inflationary expectations could also easily turn out of control. Before exercising traction on the economy, they could impose higher interest rates that would have devastating consequences for the Japanese Treasury in the management of a huge public debt (more than twice the size of the GDP). But there is something worse than the risk of Abenomics having poor or adverse domestic consequences.

The other side of Abenomics is currency management, a much less propitious theme for a government to communicate in the weeks leading up to the IMF Spring Meetings in Washington. This aspect of the policy is not only bold, it’s actually radical. As a candidate, Mr. Abe made extremely clear that he was willing to help the manufacturing sector by depreciating the yen and that monetary policy would be designed with this goal in mind. Remember that Japan, despite all its woes, remains a formidable exporter with an external surplus close to ¥650 billion in February (approximately $6.5 billion). As my fellow economists at Brookings have recently shown [2], the Japanese bilateral surplus with the U.S., which is $23 billion according to reported trade statistics, would dramatically increase by 60 percent and reach $36 billion if measured in added-value terms. Mr. Abe’s message was well received by investors who quickly after the election started to short the yen. As a result, the yen has slumped 21.5 percent in the past five months— the worst (or the best?) performance among the currencies of the developed economies. Following last week’s announcement that the Bank of Japan was really acting to debase monetary policy, the yen weakened beyond 99 yen per dollar and dropped against 15 major currencies.

A weakening yen also poses challenges for China, complicating the China’s strategy to reach its 8 percent target growth for this year; it could also trigger huge capital flows into China destabilizing the delicate control of financial stability

This is where Mr. Abe and Mr. Smoot cross ways: both are local politicians inspired by the difficulties facing their countries; both are willing to use every available policy tool to soften these difficulties; neither is willing to shock the global economy, which has never been the case when arguing in favor of protectionism or competitive devaluations. But these measures are nonetheless radical because they have the potential to ignite uncontrollable chain reactions. South Korea for one already declared itself very concerned by this aggressive policy, which is totally understandable. For instance, when Toyota and Sony take some advantage of Abe’s policy, the ones that would likely be first to suffer are Hyundai and Samsung. South Korea has vital interests at stake and, over In the last five months, it has been struggling with a pernicious appreciation of its currency. A weakening yen also poses challenges for China, complicating the China’s strategy to reach its 8 percent target growth for this year; it could also trigger huge capital flows into China destabilizing the delicate control of financial stability; SAFE, the financial institution that manages China’s huge official reserves, last week published its yearly report for 2012. Commenting on the global environment, the report emphasized that “a yen’s depreciation can’t solve Japan’s structural problem, … [but] could turn out of control and trigger a suspicion about its sustainability,… and finally have dangerous spill-over-effects”[3]. Chinese officials at the Boao Forum also expressed similar concerns.

We still don’t know the end. Hope is that we could see the positive interpretation of a bold Japanese policy experiment contributing to a better functioning world economy. Experience should nonetheless make us cautious. What the movement by the Bank of Japan does is to increase an already huge excess liquidity, inundating global markets. In addition, the Japanese government has added a dangerous touch of currency manipulation. Both aspects should be alerts for the IMF rather than too quickly fuel the artificial satisfaction of promises regarding higher inflationary expectations and increased domestic demand. In the end, competitive devaluations always prove inefficient and dangerous because they inevitably provoke reactions and retaliations. “Currency wars” have made headlines from time to time in the recent years but these were skirmishes. This time it could be for real, and this should be a major concern for the United States. It is a great thing that Japan recently expressed interest in joining the Trans-Pacific Partnership, but these are words with long delayed potential results. A more constructive and immediate task is to continue the cooperative global approach of exchange rate policies and to strongly discourage any temptation of national radical policy experiments. This should be a central issue next week during the IMF Spring Meetings in Washington.

[1] Roger C. Altman: “The Fall and Rise of the West”, Foreign Affairs, January-February 2013

[2] Kemal Dervis, Joshua Meltzer and Karim Foda: “Value-Added Trade and its Implications for International Trade Policy”, Brookings Opinion, April 2, 2013

[3] http://www.safe.gov.cn/resources/image/076044004f1fb34a9da59ff675a23beb/1365377817854.pdf?MOD=AJPERES&name=2012年中国国际收支报告.pdf

Recently, Brookings has posted two articles commenting on proposals to raise the full retirement age for Social Security retirement benefits from 67 to 70. One revealed a fundamental misunderstanding of how the program actually works and what the effects of the policy change would be. The other proposes changes to the system that would subvert the fundamental purpose of the Social Security in the name of ‘reforming’ it.

A number of Republican presidential candidates and others have proposed raising the full retirement age. In a recent blog, Robert Shapiro, a Democrat, opposed this move, a position I applaud. But he did so based on alleged effects the proposal would in fact not have, and misunderstanding about how the program actually works. In another blog, Stuart Butler, a conservative, noted correctly that increasing the full benefit age would ‘bolster the system’s finances,’ but misunderstood this proposal’s effects. He proposed instead to end Social Security as a universal pension based on past earnings and to replace it with income-related welfare for the elderly and disabled (which he calls insurance).

Let’s start with the misunderstandings common to both authors and to many others. Each writes as if raising the ‘full retirement age’ from 67 to 70 would fall more heavily on those with comparatively low incomes and short life expectancies. In fact, raising the ‘full retirement age’ would cut Social Security Old-Age Insurance benefits by the same proportion for rich and poor alike, and for people whose life expectancies are long or short. To see why, one needs to understand how Social Security works and what ‘raising the full retirement age’ means.

People may claim Social Security retirement benefits starting at age 62. If they wait, they get larger benefits—about 6-8 percent more for each year they delay claiming up to age 70. Those who don’t claim their benefits until age 70 qualify for benefits -- 77 percent higher than those with the same earnings history who claim at age 62. The increments approximately compensate the average person for waiting, so that the lifetime value of benefits is independent of the age at which they claim. Mechanically, the computation pivots on the benefit payable at the ‘full retirement age,’ now age 66, but set to increase to age 67 under current law. Raising the full retirement age still more, from 67 to 70, would mean that people age 70 would get the same benefit payable under current law at age 67. That is a benefit cut of 24 percent. Because the annual percentage adjustment for waiting to claim would be unchanged, people who claim benefits at any age, down to age 62, would also receive benefits reduced by 24 percent.

In plain English, ‘raising the full benefit age from 67 to 70' is simply a 24 percent across-the-board cut in benefits for all new claimants, whatever their incomes and whatever their life-expectancies.

Thus, Robert Shapiro mistakenly writes that boosting the full-benefit age would ‘effectively nullify Social Security for millions of Americans’ with comparatively low life expectancies. It wouldn’t. Anyone who wanted to claim benefits at age 62 still could. Their benefits would be reduced. But so would benefits of people who retire at older ages.

Equally mistaken is Stuart Butler’s comment that increasing the full-benefit age from 67 to 70 would ‘cut total lifetime retirement benefits proportionately more for those on the bottom rungs of the income ladder.’ It wouldn’t. The cut would be proportionately the same for everyone, regardless of past earnings or life expectancy.

Both Shapiro and Butler, along with many others including my other colleagues Barry Bosworth and Gary Burtless, have noted correctly that life expectancies of high earners have risen considerably, while those of low earners have risen little or not at all. As a result, the lifetime value of Social Security Old-Age Insurance benefits has grown more for high- than for low-earners. That development has been at least partly offset by trends in Social Security Disability Insurance, which goes disproportionately to those with comparatively low earnings and life expectancies and which has been growing far faster than Old-Age Insurance, the largest component of Social Security.

But even if the lifetime value of all Social Security benefits has risen faster for high earners than for low earners, an across the board cut in benefits does nothing to offset that trend. In the name of lowering overall Social Security spending, it would cut benefits by the same proportion for those whose life expectancies have risen not at all because the life expectancy of others has risen. Such ‘evenhandeness’ calls to mind Anatole France’s comment that French law ‘in its majestic equality, ...forbids rich and poor alike to sleep under bridges, beg in streets, or steal loaves of bread.’

Faulty analyses, such as those of Shapiro and Butler, cannot conceal a genuine challenge to policy makers. Social Security does face a projected, long-term funding shortfall. Trends in life expectancies may well have made the system less progressive overall than it was in the past. What should be done?

For starters, one needs to recognize that for those in successive age cohorts who retire at any given age, rising life expectancy does not lower, but rather increases their need for Social Security retirement benefits because whatever personal savings they may have accumulated gets stretched more thinly to cover more retirement years.

For those who remain healthy, the best response to rising longevity may be to retire later. Later retirement means more time to save and fewer years to depend on savings. Here is where the wrong-headedness of Butler’s proposal, to phase down benefits for those with current incomes of $25,000 or more and eliminate them for those with incomes over $100,000, becomes apparent. The only source of income for full retirees is personal savings and, to an ever diminishing degree, employer-financed pensions. Converting Social Security from a program whose benefits are based on past earnings to one that is based on current income from savings would impose a tax-like penalty on such savings, just as would a direct tax on those savings. Conservatives and liberals alike should understand that taxing something is not the way to encourage it.

Still, working longer by definition lowers retirement income needs. That is why some analysts have proposed raising the age at which retirement benefits may first be claimed from age 62 to some later age. But this proposal, like across-the-board benefit cuts, falls alike on those who can work longer without undue hardship and on those in physically demanding jobs they can no longer perform, those whose abilities are reduced, and those who have low life expectancies. This group includes not only blue-collar workers, but also many white-collar employees, as indicated by a recent study of the Boston College Retirement Center. If entitlement to Social Security retirement benefits is delayed, it is incumbent on policymakers to link that change to other ‘backstop’ policies that protect those for whom continued work poses a serious burden. It is also incumbent on private employers to design ways to make workplaces friendlier to an aging workforce.

The challenge of adjusting Social Security in the face of unevenly distributed increases in longevity, growing income inequality, and the prospective shortfall in Social Security financing is real. The issues are difficult. But solutions are unlikely to emerge from confusion about the way Social Security operates and the actual effects of proposed changes to the program. And it will not be advanced by proposals that would bring to Social Security the failed Vietnam War strategy of destroying a village in order to save it.