While the dust settles on the U.S.’s mid-term elections leaving the Republicans in control of the House of Representatives, questions abound about where the country’s international trade and economic policies go from here. As it stands, the U.S. is squarely “at a disadvantage” with countries like China, argues economist Clyde Prestowitz, a former trade negotiator and author of, The Betrayal of American Prosperity: Free Market Delusions, America’s Decline and How We Must Compete in the Post-Dollar Era. Wharton management professor Stephen J. Kobrin and Knowledge at Wharton spoke with Prestowitz about the election results and beyond, about whether China’s development is a threat or an opportunity for the U.S., how policy makers around the world are undermining the country’s economic leadership, and what options President Obama has to take global economies off the path of what Prestowitz calls “mutually assured destruction.”

The following are edited excerpts from the conversation.

Stephen J. Kobrin: In your book, The Betrayal of American Prosperity, you argue that American prosperity from the start of the republic was due to a great deal of business and government cooperation.

Clyde Prestowitz: That’s exactly right. We have a myth in the U.S. that America’s wealth was built by rugged individuals and entrepreneurs. While that’s partly true, it’s also the case that from about 1800 until about 1950, American economic policy, business policy and foreign trade policy resembled pretty much that of China today. There was enormous government intervention and support for things like the telegraph and the transcontinental railroad. [Electronics company] RCA was 50% owned by the U.S. Navy from about 1919 until the mid-1930s. We got rich as a result of intense government-business cooperation.

Kobrin: How do you think the U.S.’s mid-term election results will affect the possibility of some sort of government-business cooperation in future industrial policy?

Prestowitz: [The Tea Party’s antigovernment platform is] really kind of a romantic, nostalgic longing for a mythological past that never was. The result of [the Republican gains in Congress] will not really be better business, even though the Tea Party and the Republicans are presented as the party of business. In fact, they’re not. Or, put a different way, they hate regulation. Of course, they want tax cuts. So that is helpful in some ways to business. But what the mainstream of American business really needs is a global currency regime that doesn’t put American exports at a disadvantage. Right now, the dollar is managed by Asian countries so that it is overvalued, and that is a disadvantage to U.S. industry.

U.S. industry needs close cooperation with government in research and development and the development of high technology and clean energy, and that will suffer a setback. I really feel that we’re on a track right now that’s likely to make the U.S. less competitive, rather than more competitive.

Kobrin: The U.S. has argued for decades that if countries open their markets and adopt capitalism, they will develop. China, in its own particular way, has and is now the second-largest economy in the world. Do you see China’s development as an opportunity for the U.S.? Do you see it as a threat? How do you think we should deal with it?

Prestowitz: It’s both an opportunity and a threat. The problem is more that U.S. policy makers and intelligentsia very badly misunderstand China. Because we misunderstand China, we adopt the wrong policies. That results in China being viewed as something of a threat. I hate to use the word threat because I don’t believe China is going to invade the United States, and it’s not like the old Soviet Union. What I do think is that China’s path of development is one that can undermine U.S. capabilities unless the U.S. has the proper policies.

The mantra in the U.S. ever since the late 1990s has been that globalization will make everybody rich. By being rich, they will all become democratic. By being democratic, they will all be peaceful. Well, globalization is working in a somewhat different way. China is getting rich — and India is getting rich. But China’s not getting democratic. We’ve seen in the recent case of China embargoing the export of rare earths that it’s a kind of a mercantilist economy. The economy is being run for strategic purposes in ways that we didn’t anticipate.

Second, the U.S. view has been that globalization is win-win. Trade is always win-win. It’s not. The rare earth example again shows that trade can be a zero-sum game. President Obama was in China in November and had a press conference with President Hu Jintao, and in the course of the conference, Obama said we had agreed to assist China in developing its own commercial airliner. I paused when I heard that because I thought, “We have a big trade deficit with China. Commercial aircraft are one of the few things we make that we can sell to them. Why are we going to help them develop their own?” It’s because we don’t understand that this kind of trade can be a competitive issue. We’re just not facing it properly.

Knowledge at Wharton: How does China’s export-led strategy today compare with Japan’s during the 1980s? Given the role that China is playing in financing the U.S. global trade deficit, what options does the U.S. have in responding to China’s rapid growth?

Prestowitz: China’s export-led growth model is a variant of the Japanese model. It’s very similar. Japan pioneered the model. The tigers — South Korea, Taiwan, Singapore — adopted their own versions of it. Now we have the last tiger — or maybe the first dragon — but it’s a variant of the same thing.

The model is to suppress domestic consumption to focus on achieving high savings, channeling the savings into export industries, achieving economies of scale by focusing on exports and even subsidizing exports. You remember in the 1980s, how Japan ran enormous trade surpluses? It still does. We think of China as financing the U.S. deficit and it does. But so does Japan. The result, of course, is we get into a kind of ‘mad’ situation — mutually assured destruction — where China, Japan and to some extent Germany and the oil-producing countries are holding huge dollar reserves.

On the one hand, you could say, “Wow, that’s a real threat. If they sold their dollars, the U.S. would be sunk.” The problem is that they don’t have any real place to sell their dollars. The U.S. actually has a lot of good options. President Obama himself, without going to Congress or the G20 [group of 20 major developed and developing nations], can engineer a revaluation of the currency. For example, there’s one product that is only made in America, which everybody in the world wants — it’s U.S. Treasuries. We could impose a tax on foreign [purchases] of U.S. Treasuries. That would effectively change the currency rates.

Brazil, Thailand, Switzerland and a couple of other countries are already imposing limited capital controls. We could make similar moves. The U.S. President could take action against imports being subsidized by currency manipulation to countervail those subsidies. That again would rebalance the currency.

A really important issue that is rarely discussed is investment incentives. A country like Singapore, Ireland, France or China will approach a global company and say, “Why don’t you move your production to my country? If you do, I’ll give you free land and infrastructure and you’ll only pay half price for utilities. And by the way, you won’t pay any taxes for 20 years. If you need a capital grant of US$1 billion or US$2 billion, we could arrange that.”

What’s interesting about that kind of offer is that you could take a company like Intel, which can be completely competitive as a low-cost U.S.-based producer — and when you add that capital subsidy, it’s advantageous on an overall cost basis to move production to Singapore, China or wherever. We don’t match that in the U.S. Some of our states offer bond issues or tax abatement at a state level to attract investment. But the states are playing with peanuts, and they’re broke anyway. At a federal level, we don’t match the investment incentives. As a result, if you look at the way the global economy works, virtually all incentives — whether taxes, investment incentives or currency valuations — encourage the movement of production of tradable goods and services out of the U.S.

We’ve been seeing that now for 30 years. We’ve accumulated huge international debt and a chronic trade deficit, which is a drag on growth and employment and needs to be reduced.

Knowledge at Wharton: Why doesn’t the U.S. match the incentives?

Prestowitz: The argument has been made by our leading economists and has been accepted by our policy makers that that’s picking winners and losers and anti-free trade, free market, Adam Smith and David Ricardo. In fact, many of our economists argue that the incentives offered abroad are just gifts to American consumers and we should be happy about that. I remember some time ago when I was in the Reagan administration, Herb Stein, the late and great, who was then chairman of the Council of Economic Advisers, said to me, “Clyde, don’t worry, they — meaning Japan in those days — will make Toyotas and we’ll sell them poetry.” There’s just no sense that the structure of the economy is important.

Knowledge at Wharton: Given your background in trade negotiations, what do you think of the way the U.S. has handled China’s policy of valuing the yuan. Is the Chinese equivalent of the 1980s Plaza Accord with Japan possible today?

Prestowitz: I would give both the Bush and Obama administrations a C- for their handling of the currency issue. No, a Plaza deal with China is not possible. It was possible with Japan. I was one of those who helped negotiate the deal [for Japan to revalue the yen against the dollar]. It was possible with Japan because Japan was a client state of the U.S. We provided Japan’s security umbrella and we, as a result of the Second World War and the occupation of Japan, had turned Japan into a client state. We had great leverage with Japan that we do not have with China.

The mistake both in Japan and China is that we approached them in an accusatory manner, with a sense of, “You guys are cheating. You guys are really bad guys. You need to stop. And if you don’t stop, we’re going to declare you a currency manipulator, which is just about the worst thing in the world. We might have to take you to the IMF, which is a wet noodle, and to the WTO, which is two wet noodles.” What we do is make them angry and more resistant to changing or negotiating some reasonable deal with us.

The premise of our approach to China is that they subscribe to a free market, capitalist, free trade regime for the global economy just like us. The truth is they don’t. We are what I call a simplistic Ricardian economy in terms of international trade. We’re laissez-faire. We don’t believe in picking winners and losers. The Chinese believe in picking winners and losers. They believe in accumulating a trade surplus. They’re playing football; we’re playing baseball.

We accuse them of being unfair. In a way, they’re not being unfair. They’re playing football fair and square. They don’t clip and they don’t go off sides. But football is a rougher game than baseball. They’ve got pads and helmets on and we don’t. So we tend to get beaten up. Then we get mad because we think they’re cheating. But they’re just playing a different game. We haven’t responded to the different game. If you look at the recent proposals that Treasury Secretary [Timothy] Geithner has made in the G20 meetings, he’s shifted dramatically. It began by urging China to revalue its currency and stop being a nasty trade or currency manipulator. It has now progressed to, “Let’s set some kind of a target for trade surpluses and deficits as a percentage of GDP.”

Think about this. Here’s the Secretary of the Treasury of the United States, the champion of global free trade, saying, “Let’s set targets.” That is managed trade. I suggested something like that in the late 1980s and early 1990s, and I was cast into nether darkness as a benighted protectionist and xenophobe. Now, Geithner’s coming around to managed trade. The moment he said that he abandoned — and he doesn’t realize it — the U.S. doctrine of the last 40 or 50 years. He’s on the right track, and what we should do is not try to force the Chinese to do what they don’t want to do.

A much better approach [for Obama] is to go to the Chinese and say, “I understand, Prime Minister Wen, President Hu. We understand that you guys are doing what you think is best for the Chinese economy. I know you’ve got to create jobs and clean up the environment, and I know you’re doing what you think is best for the Chinese economy and God bless you, I hope you succeed. If I can help you in some reasonable way, I will. But I want you to understand that I need to create jobs, too. In fact, if you just look at the election results of [November 2], you will understand I really need to create jobs or I might not be here in a couple of years. I need to take the steps necessary to create jobs in the U.S. I’m always willing to talk if there are issues, or you have concerns about what we’re doing. I’m always willing to negotiate. But I am going to take the measures necessary to revitalize the U.S. economy.”

Knowledge at Wharton: Does it make sense for the yuan to be a reserve currency like the dollar and the euro?

Prestowitz: It cannot be a reserve currency until China has open capital markets. It will take some time before China has an open capital market. Open capital markets make it much more difficult for governments to control and guide their economies. It’s not impossible. Singapore does it and Japan and other countries have industrial policies. I don’t think the yuan is going to be a reserve currency for a while.

The Chinese are making bilateral deals with countries like Russia and Brazil. They did it with Turkey also. They say they’re going to conduct their bilateral trade in the two national currencies. I’m not sure how exactly that’s going to work. China is buying a lot of things such as commodities from Brazil, but I guess Brazil’s buying a lot of stuff from China. Maybe there’s enough bilateral currency flow that they can do it. You could easily see how they would have difficulty doing that. If Brazil winds up with a lot of yuan, what are they going to do with that? We’ll see. It’s an interesting development.

The role of the dollar as the global currency undercuts America’s competitiveness. The dollar is going to have to decline and eventually it is not going to be the world’s currency. Rather than resisting that to the last moment, the U.S. would be wise to lead the evolution of a new global currency system, to embrace the proposals made by [Premier] Wen Jiabao to use the IMF’s special drawing rights or create a basket of currencies that would become the international currency.

Kobrin: You’ve talked about China as being capitalist but not democratic. Is authoritarian capitalism sustainable over the long run? We’ve always believed — idealistically or mythically — that capitalism leads to democracy.

Prestowitz: We’ve always believed that capitalism leads to democracy. We believe that because we want to believe it. I’m not sure that it does. In fact, you could make a good argument that authoritarian capitalism is more effective than democratic capitalism. Think of two examples. Singapore is very effective as a capitalist economy, but it’s a lite-authoritarian regime, not oppressive, but not a democracy. It’s been very successful. It’s only 3.5 million people. On the other hand, think of Venice. Venice was a great world economy and empire for hundreds of years, and kind of like Singapore, had a lite-authoritarian system.

China today is, of course, much less authoritarian than it was 20 years ago. There has been a degree of liberalization and democratization. But it’s hard to see China as a real democracy for a long time. Obviously, it’s being very effective economically…. Maybe it’s not right to look at this as democracy versus authoritarianism, but more in terms of stability and the environment for planning and investment.

What troubles me is that in the United States today, the environment is somewhat hostile. The political system right now in the U.S. is exacerbating rather than ameliorating the hostility.

Knowledge at Wharton: The export-led strategies of Japan, China and to some extent Germany have been based on suppressing domestic consumption and catering to overseas markets, especially the U.S. Now that American consumers are struggling with high levels of debt and may be de-leveraging, the U.S. will find it difficult to increase imports endlessly. Will the export-led strategies continue to work or will these countries be forced to develop their own domestic markets?

Prestowitz: That’s the $64-trillion question. That’s what the leaders in the G20 are all struggling with. They talk about rebalancing and it’s one of these situations in which at some level everyone agrees that there needs to be a rebalancing. The global economists agree with that. Now, you have the global policy makers also agreeing about it at some intellectual level. But it means that surplus countries — Germany, Japan, China, Korea — need to consume more, export less, invest less. Deficit countries — the U.S. and U.K. — need to consume less, produce more of what they consume, export more of what they produce. That sounds simple. But look at what has happened in the last year or so.

The U.S. authorities went to the Germans prior to the last G20 meeting and they said, “You need to reduce your surplus, export less, consume more.” The Germans scratched their heads and said, “You guys don’t get it, do you? We’re Germans. We don’t do that. We save. We invest. We export. Get lost.” Then we went to China and we pretty much said the same thing. The Chinese are a little more polite than the Germans and said, “We’ll agree to decouple our yuan from the dollar.” And we cheered. But, of course, the Chinese didn’t really mean it…. They let the yuan float up about .02% or something.

Let’s take another example. Look at Japan, because I was involved with Japan for a long time. I remember in 1984, I was in the room when then Prime Minster [Yasuhiro] Nakasone pledged to President Reagan that Japan would become an importing super power. We’re 26 years down the road and Japan still has a huge trade surplus.

We economists and G20 leaders talk about rebalancing. But what is not recognized is that China, Japan and Korea are countries organized economically to export and they’re organized politically to export. The United States is organized to consume, economically and politically.

When you say, “Rebalance,” what you’re really saying is, “Tear up your political and economic structure, and do it all over again.” That’s not easy to do. That’s where the G20 is. That’s what Tim Geithner is struggling with when he says, “Set some targets.” None of us knows how this will come out, but the chances for a crisis and upheaval are pretty good.