Imagine being a child again, playing with your friends at the playground. Suddenly, another child, bigger and stronger than the rest, joins in. He insists on cheating and playing by rules that just apply to him. Predictably, he starts winning. You know this is unfair, but if you say something, he might beat you up. He looks pretty tough, after all. Better just to keep quiet and hope that the bully starts playing fairly.

In today’s global economy, China has become this neighborhood bully, defying established trade rules with impunity. This imposes a significant cost on the United States and presents a dangerous challenge to the free market.

Since the 1970s, most currencies have been free to fluctuate, or “float,” in response to changing economic conditions. China’s currency, the yuan, was once pegged to the dollar. Although technically it has floated since 2005, China only allows the yuan to fluctuate in a narrow, artificially low range. The People’s Bank of China maintains this position by buying about $200 billion worth of U.S. dollars per year from currency markets in order to purchase American treasury bonds. This increases the value of the dollar relative to the yuan.

Just how undervalued is the yuan? The exact answer remains something of a mystery, as most estimates typically range from 10 to 40 percent. A highly acclaimed Peterson Institute for International Economics study recently estimated that the yuan is 15 to 25 percent too low. Regardless of the exact situation, today’s exchange rate clearly does not reflect the yuan’s true value.

To date, China has built up nearly $2 trillion in U.S. currency and treasury bonds. Although this market intervention imposes a cost on the PBOC, China’s government deems it worthwhile because an undervalued yuan makes Chinese exports more competitive in the world market. This stimulates China’s export-oriented manufacturing base, creating jobs.

But this arrangement adversely impacts China’s trade partners. Currency manipulation artificially subsidizes Chinese exports, placing American manufacturers at a major disadvantage and violating World Trade Organization conventions. Furthermore, China’s endless purchase of treasury bonds depresses long-term interest rates in the United States. This diminishes domestic savings, encourages ill-advised lending, and makes it tantalizingly cheap to finance giant budget deficits. You may recognize these very factors as contributors to the current recession; they must be reversed for robust growth to occur.

This argument is not an attempt to irrationally bash China. The country’s rapid growth has lifted millions from poverty and created wealth in developed countries. But its currency manipulation has caused a damaging structural imbalance. Therefore, American government intervention is justifiable to restore the true free-market equilibrium.

U.S. law already requires the treasury to report currency manipulators to Congress, but the treasury has failed at this duty—it has not cited a single instance of currency manipulation since 1994. This is unsurprising: The treasury is inclined to turn a blind eye to China’s actions, since low interest rates, which sustain fiscal stimulus and encourage consumer spending, are crucial for economic recovery. Frankly, it would be unwise to confront China in the midst of a major recession. But once strong economic growth resumes, Congress should instruct the U.S. Trade Representative to appeal to the WTO for arbitration. The WTO has the power to declare China’s undervaluation of the yuan an illegal subsidy. If it takes no action or China ignores its ruling, then Congress should impose trade sanctions on Chinese imports.

Although administration officials are reluctant to challenge the Chinese dragon for fear of being scorched, China is unlikely to retaliate harshly. Policymakers fear three potential scenarios. The first: China would impose new tariffs on American goods. While this would affect American producers, it would also harm Chinese citizens. China is the world’s fourth largest consumer of American goods, which would become pricier in this scenario. Another possibility: China would slowly diversify out of American assets. True, this would increase U.S. interest rates. However, waiting until after the recession to confront China lessens America’s need for these low rates. The most frightening threat: China would rapidly dump treasury bonds in an attempt to submerge the dollar’s value. But China’s dollar holdings are so vast that selling them all without incurring a huge loss would be impossible. Also, destabilizing the American economy would be deadly for China’s own export-led economy. In all three cases, China is unlikely to cut off its nose to spite its face.

John F. Kennedy ’40 said that the Chinese word for crisis is composed of two characters: one meaning danger, the other meaning opportunity. While this is not entirely factual, the metaphor sticks in this case. Despite China’s willingness to game the currency market, long-term global prosperity still rests on our ability to fully integrate China into the world economy. Ultimately, we can further this goal only when we summon the courage to stand up to the neighborhood bully.

Anthony P. Dedousis ’11 is an economics concentrator in Leverett House. His column appears on alternate Thursdays.