The China currency debate

March 24, 2010Jon Brooks Comments Off

Normally, the only time I am interested in currency policy is when I look into my wallet and wonder where mine went. But here’s an interesting series of posts on what to do about the artificially low rate of China’s renminbi, which the country keeps pegged to the rate of the U.S. dollar. By keeping the renminbi’s exchange rate against the dollar low, the cheap cost of Chinese goods is maintained, making it harder for U.S. manufacturers to compete.

A common view is that the U.S. can’t tick off China by pressing them on this issue, because China finances so much U.S. debt, which, in case you haven’t heard, the country has run up a lot of. Recently, New York Times columnist (and Nobel economics prize winner) Paul Krugman wrote an op-ed called Taking on China. Krugman argues that we have nothing to lose in confronting our No. 1 banker over its harmful weak-currency policy.

It’s a policy that seriously damages the rest of the world. Most of the world’s large economies are stuck in a liquidity trap — deeply depressed, but unable to generate a recovery by cutting interest rates because the relevant rates are already near zero. China, by engineering an unwarranted trade surplus, is in effect imposing an anti-stimulus on these economies, which they can’t offset….So how should we respond? First of all, the U.S. Treasury Department must stop fudging and obfuscating… If Treasury does find Chinese currency manipulation, then what? Here, we have to get past a common misunderstanding: the view that the Chinese have us over a barrel, because we don’t dare provoke China into dumping its dollar assets.

What would happen if China tried to sell a large share of its U.S. assets? Would interest rates soar? Short-term U.S. interest rates wouldn’t change: they’re being kept near zero by the Fed, which won’t raise rates until the unemployment rate comes down. Long-term rates might rise slightly, but they’re mainly determined by market expectations of future short-term rates. Also, the Fed could offset any interest-rate impact of a Chinese pullback by expanding its own purchases of long-term bonds. It’s true that if China dumped its U.S. assets the value of the dollar would fall against other major currencies, such as the euro. But that would be a good thing for the United States, since it would make our goods more competitive and reduce our trade deficit. On the other hand, it would be a bad thing for China, which would suffer large losses on its dollar holdings. In short, right now America has China over a barrel, not the other way around.

In response, economist Scott Sumner, whose research is in monetary economics, writes on his blog TheMoneyIllusion that going after China misses the point of our current economic predicament.

…we don’t have the more expansionary monetary policy (Ed. note: to reduce unemployment) that Krugman and I would both prefer. So what’s wrong with going after China as a sort of second best policy? Here’s why it rubs me the wrong way.

First we are told that we must make all sorts of interventions in our financial system, and bail out GM and AIG, because otherwise we’ll have a depression. Or we need to run up trillion dollar deficits. When I suggest the real problem is not (mostly) subprime loans, but rather bad monetary policy that caused NGDP to fall at the fastest rate since 1938, people constantly throw up their hands and say “there’s nothing we can do about those stubborn central bankers.” So we have to adopt suboptimal financial system bailouts, auto bailouts, and massive deficits that will hurt our efficiency down the road, all because monetary policy isn’t doing its job. It like when you are at the zero bound all the laws of economics go out the window. We can justify all sorts of bailouts… And we have to have big deficits because we’re told Bernanke won’t consider a 3% inflation target. And now we are being told we must risk a trade war…

We simply have to stop treating the symptoms of the problem and attack the root cause. It is the central bank’s job to keep NGDP growth at a slow but steady rate. If they don’t do their job I just don’t see how we can keep fixing the problem with all these second best policies, whether they are fiscal stimulus, bank bailouts, or threats of protectionism.

Sumner goes on to say that Americans have yet to absorb the reality of China’s massive size, and thus, the disproportionate effect on the rest of the world that its policies have. He also says the West still treats Asian countries with inappropriate condescension:

China is a very, very, big country. We all read about its 1.4 billion population, but I don’t know if that has really sunk in. It’s roughly the population of North and South America, and Western Europe, combined. The policies China adopts will have a bigger effect than the same policies pursued in smaller countries. We need to get used to the fact that we are living next to an elephant. That shouldn’t be so hard; the Canadians have been doing that for decades…

I get very frustrated when I read Western commentators talk about China as if they are addressing a naughty schoolboy. It’s not that they aren’t naughty at times, the problem is that there seems to be no awareness that it not “our world” anymore. These Asian countries shouldn’t be treated as children. We used to treat Japan the same way. The Economist recently pointed out that in 18 of the last 20 centuries more than half the world’s GDP was in Asia. And in a few more decades they will regain a majority of world GDP. Each year the world economy will look a little more like the typical Asian economy. Maybe it’s time we stopped lecturing them about saving too much, and ask ourselves whether we are saving too little.

Then there’s Peter Schiff, a libertarian economist who gained some measure of fame for predicting the financial crisis, and who is running for the Senate from Connecticut (and who also was in my high school class, though he hasn’t yet listed that on his resume.) He has this to say:

Why Paul Krugman Should Lose His Nobel Prize

In his latest weekly New York Times column, Nobel Prize-winning economist Paul Krugman put forward arguments that were so nonsensical that the award committee should ask for its medal back.

Recent rhetoric from Washington has put the economic relationship between the U.S. and China squarely on the front burner, and Krugman is demanding that we crank up the flame…. asserting that the U.S. risks little by playing hardball, and that China has more to lose. He asserts that a Chinese decision to end its purchases of U.S. Treasury debt would make only a marginal impact on long-term interest rates….

According to Krugman, our secret weapon of economic invincibility is the Fed’s ability to print dollars endlessly. If China were to foolishly decide to attack us by selling our debt, the Fed could simply step in and buy the excess with newly printed greenbacks. (In other words, Krugman sees no difference between funding the debt and monetizing it.) For Krugman, China would gain little from such an attack, but would lose the ability to export to its best customer and suffer severe losses in the value of its dollar holdings. Krugman’s worldview is reassuring – but it has absolutely nothing to do with reality.

There is a huge difference between selling your debt to another and “selling” it to yourself. When China buys our debt, it uses its own savings. In order to purchase a trillion dollars of U.S. Treasuries, the Fed would have to expand our money supply by a corresponding amount. Even Krugman acknowledges that this would cause the dollar to lose value; however, he feels that a weaker dollar is good for America and bad for China.

Krugman does not believe that a tanking dollar will translate into higher interest rates or higher consumer prices at home. No matter how many dollars the Fed creates, or how much value those dollars lose relative to other currencies, he is confident that as long as unemployment remains high, rates will stay low and inflation will remain under control. This is absurd.

If the dollar were to nosedive, the Fed would normally look to protect the currency by raising interest rates, thereby increasing foreign demand for the currency. But with an economy currently on crutches, the Fed will ignore a weakening dollar and continue to try to boost employment with near-zero rates.

But keeping the Fed Funds rate low only holds rates down for U.S. government debt. If the dollar weakens substantially, other rates offered to other borrowers will rise as investors demand greater returns to compensate for inflation. To keep rates low for homeowners, credit card borrowers, corporations, municipalities, and state governments, the Fed would be forced to buy, or guarantee, all forms of dollar-denominated debt. The Fed would become the lender of only resort.

Once the Fed shows that its commitment to low rates is limitless (the value of the dollar be damned), private creditors will quit the game. Even average Americans would hit the Fed’s bid. It would be a race for the exits, with no one wanting to be left holding a bag of worthless paper dollars.

Most economists, Krugman included, see cheap money as a panacea for all ills. And while it’s true that a falling dollar, by lowering the real value of U.S. wages, would help make U.S. goods more competitive, it would also lead to skyrocketing consumer prices, rapidly rising interest rates, and a collapse in American living standards. Make no mistake: this is the end game of Krugman’s “get tough on China” policy.

This apocalyptic scenario can only be avoided if Washington jealously guards the status quo, avoiding confrontation with China at all costs. Yet, even that is an outcome that no one can rationally expect. Given exploding U.S. government deficits and the inability of U.S. citizens and corporations to repair their balance sheets, the United States faces financing needs that even China’s gargantuan savings stockpile will be unable to cover.

Krugman is right about one thing – China’s currency peg is destabilizing the global economy and must end. But he fails utterly to understand the implications for the U.S. and China. If China were to reverse its role in the U.S. Treasury market, both economies would be destabilized in the short-term. But in the medium- and long-term, China would clearly emerge as the winner…

So there you have it. If you’ve actually read this entire post, you deserve a picture of a puppy.

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