Fear The New Krugman
by Brady Willett
March 18, 2010
Such explosive growth in debt can't go on forever, and it won't. Yet our current leaders and their apologists insist that the problem will magically solve itself. Paul Krugman ~ November 4, 2003
The U.S. borrows and spends beyond its means and almost everyone realizes that tough policy choices must be made to avert disaster. However, rather than confront the imbalances that have resulted from U.S. profligacy by ending U.S. profligacy, there is the growing threat that policy makers are in search of ‘magical’ alternatives. One such alternative is trying to force China to stop ‘manipulating’ its currency.
While the Yuan ‘manipulation’ theme is not new, the contrast of little or no growth in America versus supergrowth in China has sparked renewed interest. Highlighting this interest was a recent letter from 130 Members of Congress to the Treasury demanding that China revalue the Yuan or risk tariffs and a popular commentary from Paul Krugman entitled ‘Taking On China’. In Krugman’s article some fantastic speculations are made about what might happen if the U.S. enacts a 25% surcharge on Chinese goods:
“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 short, right now America has China over a barrel, not the other way around. (bolds added)
So we have no reason to fear China. But what should we do?”
Apparently Krugman assumes – a la the not too hot and not too cold doctrine - that if China starts dumping U.S. assets the U.S. dollar would fall enough to seriously hurt China but not enough to hurt U.S. interests. But what if instead of a controllable ‘fall’ the dollar crashes in response to China dumping U.S. assets? Krugman continues:
“What you have to ask is, 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.”
As Krugman explores the outcome(s) to China dumping U.S. assets further it is impossible to not acquire a sense of unease. Think about it: Krugman tells us (incorrectly) that interest rates are efficiently set by ‘market expectations’ and in the next line he claims that the Fed can set long-term interest rates to whatever level it wants. Which is it Krugman?
Rather than continue to attack Krugman with my words, why not do so with his own? Keep in mind when reading the quotes below that since 2003 the U.S. has grown more dependent on foreign capital, China has become the largest holder of U.S. debt, and the projected fiscal deficits for the U.S. have grown significantly larger.
“…the U.S. currently has very little leverage over China. Mr. Bush needs China's help to deal with North Korea -- another crisis that was allowed to fester while the administration focused on Iraq. Furthermore, purchases of Treasury bills by China's central bank are one of the main ways the U.S. finances its trade deficit.
Nobody is quite sure what would happen if the Chinese suddenly switched to, say, euros -- a two-point jump in mortgage rates? -- but it's not an experiment anyone wants to try.” The China Syndrome - September 5, 2003
Why did Krugman speculate about a 2-point jump in mortgage rates only 7-years ago while arguing that there would be no impact from a major Chinese reserve switch today?
“…we've developed an addiction to Chinese dollar purchases, and will suffer painful withdrawal symptoms when they come to an end.” The Chinese Connection - March 20, 2005
Anyone care to speculate why Krugman now advocates a pain-free withdrawal from the U.S.’s addiction to Chinese dollar purchases?
“…there's no sign that anyone in the administration has faced up to an unpleasant reality: the U.S. economy has become dependent on low-interest loans from China and other foreign governments, and it's likely to have major problems when those loans are no longer forthcoming.” The Chinese Connection - March 20, 2005
Again, why ‘major problems’ when China stops lending the U.S. money yesterday but no problems observed today?
Ignoring the contradictions, Krugman currently believes the following: the U.S. can attack China for manipulating its currency because the only blowback would be an advantageous (to the U.S.) devaluation of the U.S. dollar. Krugman also believes that even if China were to ‘dump’ its holdings long-term interest rates wouldn’t rise because the Fed wouldn’t allow this to happen.
Even if you agree with Krugman, it is obvious that this issue is not about currency prices and interest rates alone. An excellent summary of the U.S./China theme from Brookings recently explored this idea:
“But can China make a big difference to U.S. interest rates ...? The answer lies not in the absolute amounts of financing that China brings to the table, but in how its actions could serve as a trigger around which nervous market sentiments could coalesce.”
What are some of the actions and their impact on market sentiment Brookings may be talking about? Consider a hypothetical: In response to the U.S.’s 25% surcharge China dumps Treasury Securities, enacts retaliatory tariffs against the U.S., invests $100 billion in Iran, and occupies Taiwan. As global stock prices crash and the Fed expands its Treasury purchase program by trillions, reports of a panicked move out of paper currencies and into precious metals abound. Thanks a lot new Krugman!
Embellishment aside, while focusing policy based upon the premise that the U.S. financial markets and U.S. dollar are too important to fail can, arguably, be beneficial to the U.S., this may only be the case if the policies adopted do not directly endanger the U.S.’s ability to borrow money at attractive rates of interest longer-term. In other words, before undertaking a risky protectionist experiment the U.S. would be well served to try and get its financial house in order (the Krugman of old would probably concur). The U.S. would also be well served to remember that there is ample reason to fear China so long as the U.S. is in pursuit of novel schemes to intentionally ‘manipulate’ the dollar lower…
© 2010 Brady Willett