Today, the Commerce Department reported that the U.S. trade deficit in July widened to $40.3 billion. More than a quarter of the deficit -- $11.3 billion to be precise -- was with China, including a record $13.4 billion in Chinese imports. This trade imbalance has recently raised the ire of politicians who see China as an enemy of American jobs.

The focus of particular scrutiny is China's currency peg, which for the past 10 years has traded at a fixed exchange rate of 8.3 yuan (a.k.a. renminbi) for every dollar. After years where this peg functioned without complaint, suddenly it's come under fire as an "unfair scheme" by the Chinese to hold their currency at an artificially weak level and thereby promote cheap exports, which, of course, come at the expense of American goods.

Politicians, in their noble effort to "protect American jobs," are pushing strongly for China to allow its currency to float freely against the dollar. An Associated Press story yesterday reported that a group of Republican and Democratic senators would push for tariffs on Chinese imports if China doesn't take steps toward letting its currency float.

It's true that China's currency is likely undervalued relative to the dollar, and at some point China should and probably will allow its currency to float. However, American politicians are not doing any of us any favors by trying to strong-arm the Chinese with threats of tariffs. Anti-free trade policies are the real threat here.

For some real clarity on the issue of Chinese/American trade, Fools would do well to read an outstanding essay, China: Punishing Whom?, written today by Morgan Stanley economist Andy Xie. Entirely missed by politicians, but not Xie, is the fact that for each dollar of goods imported from China, "American businesses add on about four dollars in value before the goods reach the US consumers."

Xie continues:

China's exports to the U.S., according to U.S. government statistics, reached US$125 billion last year and grew by 25% in 1H03. If the trend continues, U.S. imports from China would reach US$156 billion this year. U.S. businesses would then add US$625 billion in value before the Chinese goods reach US consumers. This amount of value would be the equivalent to 5.8% of the U.S. GDP. Moreover, this portion of the U.S. GDP is probably more labor intensive than the U.S. economy as a whole. I estimate it would imply that more than 8 million American jobs are tied up with the Chinese imports.

Xie's figures point to a more general truth: Free trade economics is not a zero-sum game. All nations involved in free trade enjoy greater production and lower prices than that achievable for any one country. Again, the real threat here is not China, but politicians wielding their protectionist policies.

Before buying into the political rhetoric against China, consider Xie's conclusion:

The political rhetoric, however, could be ominous for the global economy in the long run. It could mean that the U.S. commitment to free trade is not as solid as it was. It also reminds me of what the U.S. did after the crash of 1929, when the bursting of the financial bubble led to high unemployment. The U.S. Congress eventually legislated to restrict trade to protect jobs at home. As other nations also resorted to protectionism for the same purpose, it became a negative-sum game for the global economy that caused the Great Depression.