China's empty threat

If Wen Jiabao stops buying US debt, China's currency will rise - which is what America has wanted all along

by Dean Baker

guardian.co.uk (March 30 2009)


When China's prime minister, Wen Jiabao, expressed concern about the ability of the US government to repay its bonds, his comments prompted headlines everywhere. The newspapers were filled with gloomy warnings that China may no longer be willing to buy up US debt, which supposedly would have dire consequences for us all.

Unfortunately, too little thought was given to what these "dire consequences" might be, and who would end up suffering them. Suppose that China stops buying US government debt. That would mean that the dollar would plummet in value against the yuan. Chinese imports would suddenly become much more expensive for consumers in the United States, making domestically produced items far more competitive.

The opposite would happen in China. Goods and services made in the United States would suddenly be much cheaper. As a result, we would expect to export much more to China, and see many more Chinese come to the United States as tourists or for business purposes. The reduction in imports from China and the increase in exports would substantially improve our balance of trade.

In other words, if Wen was threatening to stop buying dollar-denominated assets and therefore let the yuan rise against the dollar, he was threatening to do exactly what the US government has been demanding that China do. He will stop "manipulating" China's currency - meaning he will stop deliberately intervening in the market to keep the yuan's value from rising.

There is an alternative interpretation of Wen's threat. Perhaps he will stop buying long-term government bonds, but continue to buy short-term debt. This will have some impact on raising long-term interest rates in the United States, but it hardly provides a basis for panic.

The reason that Wen's threat should not be serious cause for concern is that if we want to keep long-term interest rates low, we already have a mechanism: it's called the Federal Reserve Board. Just last week Federal Reserve chairman Ben Bernanke announced that he was going to buy up more than $1 trillion in long-term government or agency (Fannie Mae and Freddie Mac) bonds over the next several months. This purchase far exceeds any possible purchases of long bonds by the Chinese. If Wen pulls out of the market, Bernanke can simply increase his purchases to offset the lost demand.

Does this policy risk inflation? Actually, the Chinese purchase of Treasury bills and the Fed's buying up the long-term bonds would have the same impact on inflation. It really doesn't matter whether the Chinese government or the Fed is buying bonds to hold down the long-term interest rate - the impact on the inflation rate will be the same. Of course in a period where there are serious concerns about deflation, a modest increase in the inflation rate would be a good thing.

There is one other irony about Wen's threat that is worth noting. In 2004, Alan Greenspan began to raise short-term interest rates. He expressed surprise that long-term interest rates stayed constant or even fell slightly. He described this as a "conundrum".

There was actually nothing mysterious about the situation at all. As Greenspan was acting to raise short-term interest rates, the Chinese and other foreign central banks were intervening directly in the long-term market, buying up long-term bonds in order to keep long-term interests down. Did Greenspan fail to recognise the impact of the Chinese intervention in the same way that he managed to miss an $8 trillion housing bubble?

In short, Wen has nothing with which to threaten the United States. He is proposing to do something that Congress and the Bush and Obama administrations have all urged him to do: stop propping up the value of the dollar against the yuan.

This will lead to an adjustment process involving some pain on both sides. In China's case, the reduction in exports to the United States will require increasing the size of its domestic market, or at least finding alternative destinations for its exports. In the case of the United States, we will have to pay more for our imports, which will mean some increase in the rate of inflation and, in the short term, a modest decline in our standard of living.

But we always knew that China would not subsidise its exports to the United States forever. It would have been better for us if they had stopped a decade ago, before we developed a huge trade imbalance and developed a housing bubble-led growth path. Still, better late than never. Wen has made a promise, not a threat - and we should encourage him to follow through on it.

guardian.co.uk (c) Guardian News and Media Limited 2009

http://www.guardian.co.uk/commentisfree/cifamerica/2009/mar/30/us-economy-china-debt?commentpage=1http://www.guardian.co.uk/commentisfree/cifamerica/2009/mar/30/us-economy-china-debt?commentpage=1

QUESTIONS:

Dean Baker's comment's refer only to relations between the United States and China. But as
http://www.moneymorning.com/images2/foreigncreditors.GIF shows, various nations hold more three trillion dollars of US Treasury Bonds, denominated in US dollars. Japan holds 626 billion dollars of those bonds. All would lose severely from any significant devaluation of the US dollar vis-a-vis their own currencies.

Wouldn't those losses cripple the credibility of the US dollar and the United States' ability to make up for its paucity of saving and taxation by borrowing from foreigners?

Would those losses spark a worldwide run on the US dollar?

Bill Totten


Bill Totten http://www.ashisuto.co.jp/english/index.html