Saturday, June 26, 2010

What Do We Want?

. Saturday, June 26, 2010

Some commenters on my most recent post questioning the logic of Krugman's "Make War, Not Peace" attitude towards China raised some good points that I'd like to address. Ultimately, though, I think that Krugman and those who are sympathetic to him are just not sure about what they want to get out of a confrontation with China over its exchange rates. I'll explain what I mean as I go.

First, Wise Bass and Anonymous questioned the importance of China for funding U.S. deficit spending. Wise Bass was correct to point out a (slight) error in my post, which is that I said that China was the largest purchaser of U.S. debt. This is not strictly true (anymore) if you include the Federal Reserve or all private buyers as a single group. Clearly, however, China is a very large purchaser of U.S. debt, as Krugman is quick to point out ("$1 billion a day"). In fact, if China wasn't an important buyer of U.S. debt, Krugman's point becomes even more wrong, because a change in Chinese policy would then have little effect on the U.S. But I think Krugman is right about this much, so if China exited the market for U.S. Treasuries it would certainly have a noticeable effect on interest rates.

Or would it? Commenter Adam thinks it may not:

It might actually be a good time to lean on China to absorb some of the re balancing costs that its current account surplus pushes exclusively to the US.

Capital is fleeing Europe at a massive rate, and there's no reason to think that the US is going to have a failed auction any time soon. China is the single largest holder of US debt, and a few years ago it really was buying a majority of new US issuance. But it is only a marginal player now. A Chinese strike on new issuance would have a small, short term effect on US interest rates, but the resulting "flight to safety" should ensure that it's a very small and very short lived.

So the PBoC could dump its holdings, but then the PBoC's technical insolvency (it earns about 1% on its reserves, but once the RMB appreciates, it will earn negative returns) will become a liquidity crisis. The ministry of finance would have to step in to recapitalize the central bank, which is something the central bankers dread more than anything else right now as we go into the 2012 political cycle.

The other option is a trade war, which nobody can win from but the US would loose a lot less than China. The deficit country might be forced to pay higher prices, get some inflation (not a problem right now for US), and consume less. But the surplus country takes a demand a supply hit, and growth will slow much more in China than in the US.

It's not perfect, but it's a reasonable card to threaten right now because there's a realistic chance that the US can take the hit. China needs to step up and correct its twin surpluses much more quickly than they have shown any interest in doing. Krugman is mostly right on this, IMHO.

There are a few parts to this, but before I jump in I'd like to point out that while Adam's advice makes some sense on its own, it is answering a different question than the one Krugman is asking. Adam is answering the question "How can we get China to pay for its share of a (needed) global macro re-alignment?" Krugman is asking the question "How can we make fiscal stimulus in the U.S. more effective right now?" Adam's answer would not help reduce American unemployment in the short run; it would likely exacerbate it, for reasons I'll get into in a bit. But then again, so would Krugman's.

First, I'm not sure that China's current account surplus shifts all of the costs of global macro re-alignment onto the U.S., for the basic reason that China's persistent current account surplus indicates that global macro re-alignment isn't happening. It is probably true that persistent imbalances have damaged the U.S. economy over the past decade, and it may be true that they will continue to damage the U.S. over the next decade. (Although the economists' favorite question -- "Compared to what?" -- is certainly applicable here.) Not all of this can be blamed on China, however, and taking a "we broke it, you fix it" attitude towards a still very poor country would be heartless as well as combative.

More to the point: in terms of fighting the current recession using a Keynesian framework, how could picking a fight with China help in the short run? In other words, Krugman is hoping for a situation in which China suffers lower growth and the U.S. incurs higher inflation and greater borrowing costs, because he thinks that will make U.S. fiscal stimulus more effective. Are we sure that would be good for either economy? Are we sure that a large RMB appreciation -- which would benefit U.S. exporters but hurt U.S. importers and consumers -- would really stimulate the U.S. economy? What makes us so sure that the gains to exporters and non-tradable producers will out-weigh the costs to importers and consumers? What makes us so sure that this gain will be larger than the loss from an interest rate increase that must occur when a larger supplier of funds exits a market? These are the questions that Krugman and his supporters should be answering.

The presence of a large current account deficit would seemingly indicate the opposite, because more of the American economy currently depends on imports than exports. The job losses the U.S. has recently seen have been largely in non-tradable sectors like construction, less-tradable services like finance, and less-skilled labor in retail and services. Those aren't going to come back if the RMB appreciates 10% against the dollar. Let's also remember that economic recoveries are often encouraged by more trade, even if these run up imbalances, rather than less. That is certainly one lesson to take from the interwar and Bretton Woods periods.

If the goal is to shrink the current account deficit, we can do that easily enough by importing fewer goods, thus making ourselves poorer. If the goal is to spur employment in exporting sectors, we can pursue beggar-thy-neighbor policies to make that happen. But if the goal is to raise our standards of living and boost overall employment, then cutting off imports seems completely counter-productive.

Second, suppose that what I just wrote was irrelevant. In other words, suppose short-run economic recovery was not our policy goal. Then Adam's advice starts to become a bit more logical. If we were ever going to strike at China to reshape our medium run outlook, now might be the time to do it. The world's demand for highly liquid, AAA assets is very high, and the U.S. remains in a very unique position to provide them. I still disagree that China is a "marginal player" in those markets now, and that argument violates the most basic assumption in Krugman's logic (which Adam says he agrees with), but picking a fight when the U.S. is strongest (i.e. less reliant on Chinese funds) might still make sense if the goal is to punish China.

That is, it might make sense if American political constituencies were interested in sacrificing employment and standards of living for the pleasure of knocking China down a few pegs, or scoring some short run relative gains, or correcting the trade imbalance for its own sake. It might even make sense if the American leadership was interested in any of those things. But neither is true. The American polity wants a quick economic turnaround, and the leadership wants a China that is integrated into the global economy, and more willing to take a responsible role in maintaining security and stability in Asia over the medium to long run. Neither of those things are likely to happen under the scenario that Krugman (or Adam) outlines.

The point I was trying to make in my previous post is that Krugman has confused his purposes. Confronting the Chinese right now along the lines Krugman wants might increase American relative power (or might not), but it will not help spur an economic recovery in the short run, which he has made clear is his ultimate goal. Nor will it help maintain order in the global political economy, which should be the ultimate goal of policymakers. It's a convoluted policy, with no clear goals and no reasonable expectations.


Adam said...

OK, I confess that I hadn't read Krugman's column before commenting on the last post. My bad.

However, the point I was trying to make in my last comment (though I admit that I totally did not make it very well) is that the world is facing a major demand problem in restarting global growth. Europe's debt problems have effectively taken it off the table as a possible driver of domestic demand. Ex Germany, the EU has run a current account deficit that will now have to correct. It would be awesome if Germany would do the right thing and force it's current account surplus to shrink in response, but since it's monetary policy is the same as the PIGs, it would have to happen through fiscal policy. That seems politically impossible right now.

This leaves the US and EM countries (really, just China) to absorb the cost of this shift by increasing their own domestic demand. The USD has strengthened against the EUR to help this shift happen, and the CNY was along for the ride. But the US economy is not in a position to boost domestic demand dramatically. In fact household consumption probably needs to stop growing for a few years to get the savings imbalance back into a sustainable position.

So some additional CNY appreciation would be very nice to have right now for the global economy. The new "flexible" policy of the PBoC hopefully leads to that, but so far it hasn't amounted to that much.

It's in the US and the world's interest to force down the Chinese savings rate if we are going to have any real chance of sustained global demand growth. The US cannot absorb the demand shock from the EU's credit crisis on its own, and China needs to help. A back of the envelope estimate would require about 4 percentage points in additional domestic demand from China for every 1 that the EU forgoes. This requires a much stronger RMB to achieve, I think. A trade war is not a particularly good way to go about this, as you correctly point out, but in my opinion the US is in a unique position right now to credibly threaten to use that card if the Chinese do not make the adjustment on their own. (I admit that it is very, very hard to force households to spend. Then again, China could transfer ownership of its SOEs to households or at least force them to pay massive dividends to the government that would go into social spending. And a stronger RMB would be necessary to ensure that this new demand pulls in imports from abroad rather than just a shift that saw Chinese firms sell into their home market) Beyond that, I really hope the US never needs to use that card.

What Do We Want?




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