Secretary Geithner’s China Strategy: A Viewer’s Guide

On Monday and Tuesday of this week, Treasury Secretary Geithner – and Secretary of State Clinton – meet with a high-level Chinese delegation.  (Could someone please update the Treasury’s schedule of events? At 7am on Monday it still shows last week’s agenda; update, 9am, this is now fixed – thanks).

According to official previews (i.e., the apparent contents of background briefings given to wire services), the economic topics are China’s concerns about the value of the dollar (i.e., their investments in the U.S.) and the amount of debt that the U.S. will issue this year.

This is absurd.

China decided to accumulate over $2trn worth of reserves, most of which they are presumed to hold in dollars.  No one compelled, suggested, or was even particularly pleased by their massive current account surplus (peaked at 11% of GDP in 2007, but still projected at 9.5% of GDP for 2009).  We can argue about whether this surplus – arguably the largest on modern record for a major country – was intentional or the result of various policy accidents. 

Irrespective of underlying cause, any country that runs such a current account surplus is implicitly taking a great deal of currency risk – China was in effect deciding to take the biggest ever official long-dollar position.  The idea that the US government should spend time reassuring them is somewhere between quaint and not good strategy.

If China decides to now shift out of dollars, what would happen?  Remember that the US left the world of fixed exchange rates and associated rigidities a long time ago – back in the early 1970s.  The dollar would surely depreciate and inflation would likely rise.  But who cares?

A weaker dollar would help our exports.  It’s not honorable for the issuer of a reserve currency to talk down its own exchange rate (hence the Rubinesque “strong dollar” rhetorical trap), but if a third party leads a big sell-off, what can we do about it?

Treasury’s concern is not really the value of the dollar – particularly as they would like a bit of inflation at this point; again, if it’s China’s fault that the real value of our debts falls, that might play (or spin) well in Peoria.  Instead, Treasury’s concern is the large amount of debt that they/we are trying to issue.

If China is worried about the future value of our debt in renminbi, then Treasury will have to pay higher long term interest rates.  But, as Treasury and the White House have been emphasizing, what really matters for our long-term fiscal solvency is bringing Medicare and associated costs under control.  Any strategy that relies instead on indefinitely low long-term interest rates is illusory – and any investor who thinks we will be like Japan in this regard is in for some disappointment.

The real issue for discussion this week should be China’s current account surplus and the pressing actions needed to bring this under control.  The US should put on the table the possibility of more assertively taking China to the World Trade Organization over its fundamentally undervalued exchange rate and associated trade policies (Arvind Subramanian’s idea).  The exchange rate dimension should have been dealt with by the IMF, but unfortunately that organization has (again) ducked its responsibilities on this issue.

The Treasury apparently thinks it should be deferential and on the defensive vis-a-vis China.  This is not only bad economics, this is bad geopolitical strategy.

By Simon Johnson

57 responses to “Secretary Geithner’s China Strategy: A Viewer’s Guide

  1. Has anyone actually analyzed whether the US would benefit from stronger renminbi? The cost of imports from China may rise significantly and the volume of exports to China may not grow all that much. On top of this, stronger renminbi will increase China’s demand for oil and other commodities (again bad for the US trade balance).

    So given the current structure of imports and exports, and very limited opportunities for import substitution in the US, the ride along the J-curve may turn out to be a very unpleasant experience.

  2. E. Barandiaran

    Simon,
    Two points. First, your understanding of your government’s policy makes me wonder if you know what is going on. You say “But, as Treasury and the White House have been emphasizing, what really matters for our long-term fiscal solvency is bringing Medicare and associated costs under control.” You can read the latest R. Samuelson’s column to inform yourself about your government’s position.
    Second, your understanding of China’s strategy makes me wonder if you know what this strategy has been for the last 15 years and how badly the Treasury needs China to continue buying its bonds (I’m talking about flows not the stock). FYI, China has been investing abroad a significant share of its state banks’ domestic deposits to diversity the portfolio of these banks (if in 1994 China had opened up their banking system to private banks, the exchange rate would have been much higher than 8.28 per US$). Even today China cannot invest at home all the flow of domestic savings without increasing the risk of a banking crisis. What China has to do is to diversify its investment abroad and to do it by changing the composition of the flow of this investment (something they have already doing in several ways) while acknowledging that there is little they can do with the stock of their investment in US bonds, except to urge the US government to reverse its unsustainable fiscal deficits (and I’m sure the Chinese know that this reversal will not come from the already failed health insurante/care reform).

  3. donthelibertariandemocrat

    China has had a clear policy about this issue:

    “Remarks of Deputy Governor Wu Xiaoling on the International Seminar on the Tenth Anniversary of Asian Financial Crisis

    June 21, 2007

    “(3) China promised that the RMB would not depreciate. Being a highly responsible country, the Chinese government made the decision of no depreciation of the RMB with an aim of safeguarding regional stability and promoting development, which played a pivotal role in maintaining economic and financial stability of the Asian countries and the world at large, as well as Asian countries’ economic recovery and regaining of rapid growth in later years.”

    No one has told me yet if this is what happened, but it’s a pretty clear statement of policy. I’m not saying that China isn’t responsible for its investments,and that they aren’t looking out for their interests, but you can’t say that they don’t have a clear view on devaluation. I’d be interested in what people think about the view put forward by them.

  4. E. Barandiaran

    Because of her high positions in the People’s Bank of China since 1994, Ms. Wu Xiaoling knows very well the China’s strategy that I outlined in my previous post. I’m sorry but I don’t have time to give a detailed explanation of China’s banking, monetary and exchange rate policies in the past 15 years, but think the problem in terms of a huge flow of domestic savings mobilized through state banks that until 1994 had been lending these savings to state enterprises with no accountability. Since they wanted to continue with state ownership of banks the only way to reduce the probability of a financial collapse was to diversify by investing abroad and they started to do this after the reforms of 1994. Of course, the investment has been done through the People’s Bank China (the Central Bank) and this is why for most Western economists (including Simon) this investment amounts to accumulation of international reserves.

  5. “The Treasury apparently thinks it should be deferential and on the defensive vis-a-vis China. This is not only bad economics, this is bad geopolitical strategy”

    Mutual Stockholm Syndrome amd Mutual Assured Destruction doesn’t make for a good relationship

  6. This is one of the sharpest posts to date, and absolutely 100% correct. Yet for some reason, Geithner and Bernanke etc. behave as if we are negotiating from a position of weakness.

    China incurred its own problems by exclusive depending on a strategy of export-led growth. The US is primarily at fault for believe our own free-trade conceipts, and becoming enamoured of its most-favored-nation keep-domestic-wages-low use-imports-to-suppress-domestic-environmental-regulation approach to the economy. We facilitated Chinese expansionism, but this may very well hurt China in the long term.

    There’s an old joke about banks. If you owe the bank a million, you’re in trouble. If you owe the bank a billion, they’re in trouble.

    We owe the Chinese bank 2 trillion, give or take. China has a huge dilemma. If everyone thinks they’re going to leave the dollar, their investment sinks before they can spend it. If that happens, the value of their exports decline (they earn dollars that buy less on the world markets), the value of specific assets in factories for US-targeted production declines, and their economy has some large distortions to reckon with (even beyond the loss in savings).

    China’s strategy is now clear – talk up the dollar to everyone else, while slowly shifting out of dollar-backed reserves. Also, try to get the US to commit to a strong-dollar strategy (high interest rates, low fiscal spending) even if that kills the US economy but allows China to keep its dollars whole. (If the US caves on this, the resulting unemployment rate will cost Obama the election in 2012.)

    But where does China go from the Dollar? China is pursuing multiple options:

    1) Special Drawing Rights (e.g. a form of international “tunneling” which converts devalued dollars to a claim against the entire world via the IMF)

    http://www.economist.com/displayStory.cfm?story_id=13988512

    2) Shifting trading partners into yuan/renmibi to settle trade, essentially creating a Chinese currency block (which Russia really loves, since it’s anti-US).

    http://www.forexblog.org/2009/04/chinese-yuan-vies-for-reserve-status.html

    This would help sustain Chinese growth by creating demand for Chinese currency (rather than just chinese products).

    3) Buy commodities and foreign companies. This is being officially encouraged, and _financed_ by the Chinese official policy of “going out”. In other words, convert Dollars to hard assets before people stop taking dollars.

    (John Mauldin, via Zero Hedge)

    http://zerohedge.blogspot.com/2009/07/some-weekend-thoughts-by-john-mauldin.html

    So long as China is still trying to exit dollars, it will support the dollar. At some point, there is a very real possibility of a run.

    And here’s the kicker: ANTICIPATION of a run will heighten interest rates above the optimal Taylor rate for economic recovery. In the medium to long run, the US might be better off devaluing the dollar and just getting it over with, so that interest rates are not pricing in a future bought of US depreciation (and hence inflation). The costs, I suppose, would be an international financial shock that the world can scarcely tolerate unless we have strong coordination through an agency like the IMF (but, alas, the ECB doesn’t want to play ball).

    The US, however, is trying to delay this as long as possible, and in the process we are probably sacrificing our children’s economic future.

    If the US holds to a strong-dollar strategy to placate China (and keep short term inflation low while sacrificing our long-term future), then this will constitute a vastly larger bailout than TARP.

    As to the moral message it sends, let me summarize:

    “The US consumer was a poor investment. For our benefit as well as yours, please don’t loan us so much money in the future.”

  7. What are the risks of shooting war, as opposed to trade war? Are there places where China is likely to express its displeasure in a direct way?

  8. Well, China is trying to shift out of dollars. Look at the deals they are making with Brazil and Russia and others away from using the Dollar as an exchange. Plus they are taking a lot of the dollar currencies they hold and using them to buy up other assets from gold, mining companies, and other corporations around the globe.

  9. Time for that single global currency we’ve been flirting with? Has anyone treated this subject comprehensively and even-handedly in a paper or book recently? Would love to hear Mr. Barandiaran’s thoughts if he can come back later to discuss. The only thing I’ve heard anyone say decisively on this topic was “it wouldn’t be fair to developing countries,” but without an explanation.

  10. Robert Mundell still seems to be one of the people to ask. According to wikipedia, he was named “Cavaliere di Gran Croce del Reale Ordine del Merito sotto il Titolo di San Ludovico by Principe Don Carlo Ugo di Borbone Parma,” and he’s been on Letterman 5-6 times.

    “His first appearance was in October 2002[2] where he gave The Top 10 List on “Ways My Life has Changed Since Winning the Nobel Prize.” In March of 2004[3] he told “You might be a redneck” jokes followed in May of 2004[4] with “Yo Mama” jokes. In September of 2004[5] he appeared again, this time to read excerpts from Paris Hilton’s memoir at random moments throughout the show. In November of 2005[6] he told a series of Rodney Dangerfield’s jokes. On February 7, 2006[7] he read Grammy Award nominated song lyrics, the night before CBS aired the 48th Grammy Awards.”

  11. The risks of a traditional shooting war in the next 5-10 years are low. The costs of that war to China would be severe. The dislocation/hoarding/disinvestment that would result from even a credible threat of such a war are unbelievably huge.

    Beyond 5-10 years, who knows. US military superiority will persist probably through 20 years if you believe Pentagon projections… The most modern weapon systems take years to produce, and then you need enough of them to make a difference. Consider the life cycle of the F-22, the F-35, etc… New systems, almost exclusively drones, are where the competition will be – and it will take two decades for China to effectively compete there.

    Military power projection is also a qualitatively different thing than local defense. You need bases. You need high seas fleets.

    But that’s a traditional war, and future wars may be fought along different dimensions (e.g. hacking).

    But there’s always the risk that the US might elect another cowboy id1ot savant into office, and start our own “preemptive” war.

  12. “this is why for most Western economists (including Simon) this investment amounts to accumulation of international reserves”

    Which it DE FACTO is, because the Chinese government maintains strict currency controls in order to keep their currency undervalued versus the dollar. In other words, having an institution be “private” is meaningless if all of its transactions are governed by the state.

  13. The US doesn’t want China to _depreciate_ its currency.

    The Chinese pledge to not depreciate is utterly meaningless when its running such huge surplus. It’s like the wealthiest man in the world saying “I give you my solemn pledge not to go broke”.

    I rather suspect the Chinese pledge not to depreciate is relevant to local trading partners by encouraging them to hold Chinese currency as a store of wealth (e.g. displace the dollar). If local trading partners think it’s a one-way bet (securitized by China’s foreign currency reserves), this gives them incentive to do just this.

    Having external countries “buy” chinese currency (by selling them goods/services) and then hold it is a great thing for China (if they don’t abuse that privilege, like the US did) – it keeps inflation low even as they stimulate their economy.

    I can’t fault China for pursuing it’s current strategy – it’s perfectly reasonable. They were foolish to keep subsidizing exports to the US long after we became a credit risk. The US, however, would be foolish not to use legal mechanisms at its disposal (e.g. monetary policy) to avoid long term debt-slavery.

  14. E. Barandiaran

    I don’t know how familiar you are with the term “international reserves” but to extend to the People’s Bank of China the idea of central banking that underlies both the IMF’s policies and statistics and Western textbooks on monetary economics has been a source of misunderstanding of China’s strategy. This type of extension reminds me of the misunderstandings that follow Peron’s imposition of 100% reserve requirements on all forms of Argentina’s bank deposits in 1949. It is difficult to apply the concepts of manuals and textbooks to situations that differ significantly from the underlying ideas.
    Your point about China’s currency controls ASSUMES that the intention is to keep the currency undervalued. They keep currency controls for a number of reasons but perhaps the most important one is to rationing foreign exchange in accordance with their “priorities”, and most likely one priority has been the diversification of the state banks’ portfolios.
    With respect to your last sentence, let me remind you that for decades (1930 to 1970) the international monetary system was based mainly on exchange rates and often on exchange controls, and in Western countries private banks were still considered private.

  15. For “Treasury Department” read Tim Geithner. He is deferential toward anyone with money or power. That is why he is such a perfect representative for the president himself. Obama won’t even take a stand on important specifics (Where does Obama stand TODAY on a public healthplan option?) of his own healthcare reform initiatives.
    When you elect amateurs, you get amateur shows.

  16. If there’s a run on the dollar, will we have inflation or hyperinflation?

    Inflation seems OK but hyperinflation sounds scary.

  17. What % of US manufacturing capacity rests on Chinese soil? How about US food production?

    All of this US manufacturing capacity & food production can be shut down without firing a shot if there is a war. What effect would this have on our ability to wage a conventional war with China? Any contingencies? Probably not.

  18. Should we place a “war tax” on all the fat cats making those hugh profits from cheap Chinese labor to provide for contingencies?

  19. bungalowbill

    S.J. : “A weaker dollar would help our exports.”

    And what is it exactly that the US would export?

    Last time I checked the US were manufacturing no consumer goods at all. Do the factories even exist here to make say laptops or clothes on a massive scale? How long would it take to build such factories in the US? Even if such factories were built would American workers be willing to work and live like Chinese workers? I’d rather be unemployed.

    I’m guessing that the exports S.J. talks about are more like raw materials, agricultural products or software. Not great sources of employment for the average American.

  20. E. Barandiaran

    Uncle Billy vs. Mont Pelerin
    Thanks for your interest in my thoughts. Rather than a single global currency, the problem right now is the abandonment of fixed exchange rates by smaill countries (indeed, despite constitutional objections, I think it’s much more likely that you have a Californian dollar than a single global currency). The few remaining countries that before the crisis relied on fixed exchange rates to avoid unnecessary currency risk have been pushed to move to flexible rates. The experience of small countries with flexible rates is not as good as most economists argue, however.

  21. I don’t mean a direct confrontation. But proxy wars, perhaps in Africa, perhaps over resources, on the Cold War models, seem plausible.

  22. “They keep currency controls for a number of reasons but perhaps the most important one is to rationing foreign exchange in accordance with their “priorities”, and most likely one priority has been the diversification of the state banks’ portfolios.”

    With all due respect (and in defense of Western textbooks), rationing foreign currency to control internal development priorities is the EXACT DEFINITION of using currency controls to keep your currency undervalued. The effect is suppressing domestic consumption and “non-strategic” investment, which is exactly the purpose of mercantilistic currency undervaluation.

    You are making a semantic argument with no substantive basis.

    Furthermore, you are arguing that China’s currency undervaluation is not intentional, but rather is an unfortunate side effect of how it coordinates its internal economy.

    First, why should we believe this? (You are arguing about intentions, not outcomes.) Second, why does this matter (unless you are implying that China does not have the capacity to manage its economy any other way, even if it had the will).

  23. “This surplus… was intentional or the result of various policy accidents”.

    Or was it a result of a politico-economical consensus? Bretton Woods v2.0?

    The US being ‘unhappy’ with China’s ‘currency manipulation’ is the same sort of rhetoric posturing as the infamous “strong dollar” doublespeak. If the problem was Chinese manipulation, the US would’ve done smth else rather than happily keep recycling this money into debt issuance for 25 years.

    However, with this Ponzi economics being over, kaputt, playing the war of nerves with the Chinese over ‘the value of dollar’ is likely to benefit no one. There’s no precedent of a nation successfully pulling off a ‘slow’ devaluation while issuing an enormous amount of debt. Sooner or later, as more auctions fail, monetization will take a life of its own. It’s a long painful road to ruin.

    Remember it took Zimbabwe 8 years to come all the way from monetization to hyperinflation. They are not as foolish there as most people think, they knew what’s going to happen in the end, but once you take this road, there’s no ‘exit strategy’.

    And some people in Zimabawe got VERY reach through the ‘insider’ trading opportunities which emerged along the way.

    I can’t help saying this – GS execs will be all too happy as the US stubbornly turns itself into 3rd world nation!

    We’ll all be lucky if the US Gov’t had the guts to pull off an FDR-style ‘overnight’ devaluation, although that might look a bit confusing in a world where all currencies are fiat (I mean, how do you measure the ‘right’ degree of devaluation?)

  24. I assure you, the Pentagon has exhaustively planned for contingencies, and wargamed this to death. That’s the points of the Strategic Petroleum Reserve (90 day supply at current rate, which doesn’t even account for reduced civilian consumption or commandeering local supplies), and maintaining “critical” industries in the US.

    US is a net food exporter in a big way.

    BUT WHO CARES? Going to war would be about the dumbest thing one could possibly imagine. If the US and China can’t settle this peacefully (one way or another), we’re hosed beyond belief.

  25. No.

    But we should put a labor/environmental parity charge on those goods to compensate for “competitive advantage” created by regulatory weakness.

  26. It depends.

    In most situations with hyperinflation (Argentina, Weimar Germany) the key driver has been external debt obligations that have been nominally fixed in a foreign currency. Thus, monetization of debt does not reduce external debt (or the rate of debt payments), but creates accelerating inflation as expectations respond.

    The US doesn’t have huge non-dollar govt debt. It also has reasonably robust exports (we just import way too much).

    So the primary threat of hyperinflation comes from commodities which (purportedly) have an inelastic domestic demand curve – that is, oil and a few others. In that sense, oil imports are like a debt or tax payment. This is why a real energy policy is desperately required (but is going nowhere right now because gas prices dipped – Congress is so shortsighted).

    The secondary threat is from imports that are critical components in larger systems (aka, chinese manufactured components in systems that are assembled in the US and sold in the US – we are surprisingly seeing this right now in the steel industry).

    The question is what percentage of non-commodity US imports could the country survive without while it developed local sources of production… I don’t know the answer to that one.

    The US would be better off with a single discontinuous inflation event that was large enough to eliminate the risk of future devaluation for the foreseeable future. BUT, for this to be credible we need to bring our fiscal deficit into order.

    Until we fix our fiscal crisis (of which healthcare is the biggest component) and our energy policy, we will remain dependant on other countries.

    The ideal policy response right now is fiscal constraint, tax increases, aggressive monetary policy, and competent trade/energy/health policies.

    However, the opposition party in the US has engaged the obstructionist engines. It may be that the US political system is simply outdated.

  27. I believe freedom of expression is important. Freedom of expression of course means freedom of speech and freedom to write the things you feel. In China that’s not allowed. I could tell you more than one story about that.

    In China if you say things which could take away from the “harmony” of society you can get into big trouble. What statements or actions take away from the “harmony” of society??? Only Hu JinTao and the Standing Committee knows for sure.

    So China is a fun place for young people. You can see here, at the NYT link.

    http://www.nytimes.com/2009/07/27/world/asia/27china.html?_r=1&scp=1&sq=China%20students%20july%2027&st=cse

  28. “It may be that the US political system is simply outdated”-SG

    BINGO!

  29. Or for that matter, Central and South America.

  30. “And what is it exactly that the US would export?”

    Weapons. We corvids eat tonight!

  31. E. Barandiaran

    StatsGuy,
    I know that it’s hard to understand how the Chinese system works. Remember the government wants to keep ownership of the state banks and these banks have been able to mobilize a huge amount of deposits. In 1994-96 they became aware of how bad the loan portfolios of these banks were. In addition, during those years it became clear to the Chinese government how much they needed foreign direct investment to gain access to modern technology so they facilitated many joint ventures with state enterprises. Since then, an increasing part of the he large PRIVATE SAVINGS mobilized by the state banks has been invested abroad (I don’t have the data because I stop working on China ten years ago).
    The foreign exchange system was based on a fixed nominal rate because of the greater stability in relative prices (what economists usually call the real exchange rate) that a country with such a huge savings can afford (in Latin America we cannot afford it because of low savings). The Asian crisis strengthened this view: the government could not control the flow of private savings into the state banks and they
    were afraid of banking crisis. Foreign exchange controls were not to undervalue the currency but, in my view, to ensure first that enough private savings were invested abroad and second that SOME state enteprises could get foreign exchange at a “lower” price (most likely, the negative effect of this policy was offset by letting other state enterprises to enter into joint ventures with foreign companies). Now if you want to argue that the exchange rate was/is undervalued, you have to tell me which policies you change in your alternative scenario (you cannot change just one policy).

  32. The same Pentagon that planned for the aftermath of Desert Storm, shock & awe, etc.? A conventional war with China would be over in 90 days? The Iraq war was not dumb?

  33. E. Barandiaran

    StatsGuy,
    Sorry, don’t take this personally, but I’m Argentinian and I know the economic history of my country well, in particular the history of all the crises since 1951. In Argentina, hyperinflation started in July 1982 (just after the Malvinas War) when the government attempted to bail out private enterprises from their banking debts and a “small” mistake was made–banks lose all their time deposits in a few days because the government prohibited the payment of interest on deposits at less than 90 days (at that time almost 100% of time deposits were at less than 30 days). To pay these deposits the government printed money and the average inflation rate jumped to around 50% per month for a few months in late 1982. Subsequent episodes of hyperinflation until March 1991 were largely the result of fiscal deficits that cannot longer be financed by market loans of any type. Hyperinflation was not a problem related to the country foreign debt (although some people will argue that between February 1981 and July 1982 most of private sector’s foreign debt was nationalized and the government had problems to service the debt, but this nationalizatiion only aggravated the difficulties to finance the fiscal deficit after the first hyperinflation).
    In the US, hyperinflation is possible either because there is a sudden large decline in the demand for US currency (remember that this demand is large outside the US) or because the prospect of large US fiscal deficits for a long period of time forces the Fed to continue or resume its expasionary policies of the past 10 months.

  34. The primary snag of an FDR style devaluation would be an enormous oil-shock ($200-$300 bbl) that would quickly kill all our oil-based agriculture and transport systems stone dead.

    This would necessitate a government takeover of most of the remaining infrastructure of this country, likely for efficiency/waste reasons.

    A big oil shock would also benefit net producers, and countries who have managed to buy up a lot of supply.

  35. Patrice Ayme

    China’s real agenda is simply what it says it is: strength. Strength is not just absolute, but also relative. It goes through weakening its greatest potential adversary, the USA.

    So China is trying to get the USA to obsess about everything, but its real problems: its de-industrialization, and its falling off the edge of knowledge and wisdom.

    Patrice Ayme

    http://patriceayme.wordpress.com/

  36. The strategic petroleum reserve is like my $5k slush fund. Good for emergencies, but spitting in the wind as far as a really big problem is concerned.

  37. Respectfully (since I don’t live in Argentina) I’m going to disagree with you.

    What you are describing caused _inflation_.

    The _hyper_ inflation was triggered by debt denominated in other currencies.

    Here is the debt/exports picture of Argentina in the 80s:

    Demand for Argentina’s currency was collapsing (the Falkland’s War, as you note), largely as a function of failure to sustain debt payments with exports and loss of confidence of foreign investors. In spite of this, Argentina’s central bank linked rates on debt payments to the dollar, including most internal payments. Perhaps this was designed to encourage investment? It had the effect of driving up interest rates massively as the peso tanked against the dollar. Vast numbers of businesses went defunct, loans got written off in huge numbers.

    Among those who REALLY got killed were those who owed debt in foreign currency (especially large private employers). Without exports to earn that foreign currency (not to mention the time lag, and the demand deposit issue you raise above), this created a massive spike in demand for dollars to pay back debt (right when Reagan embarked on the Strong Dollar policy, which only added insult to injury).

    Meanwhile, the central bank extended special guarantees to cronies (effectively subsizing the exchange rate for politically connected people – great example of tunnelling) and kept an overvalued Peso (even while private investment was fleeing the country) while racking up 30 billion in debt to private banks in the US and France (denominated in non-Peso currency).

    So you can blame lots of things (certainly the fiscal deficits motivated the foreign borrowing), but the thing that put the stake in Argentina’s heart was non-Peso debt that it could not repay and linking internal interest rates to an external currency. (the root cause of the creation of this debt, of course, was largely political)

    The US is not there yet – and until we start (privately or publicly) borrowing in foreign currencies to sustain our deficits I’m not so worried about _hyper_ inflation. I do think we could see a run on the dollar at any time, which is why I think commodities and critical imports are the bigger issue. And I am somewhat concerned about the de-anchoring potential of TIPS (but they are a small portion of govt debt).

  38. More importantly (since we still have a huge trade deficit), a weaker dollar would curtail imports. The remaining fragments of U.S. industry could start making (or make more) of the things we now import.

  39. E. Barandiaran

    Sorry, but you totally wrong about what happened in the first episode of hyperinflation, starting in July 1982. It was a typical episode of a huge increase in the supply of currency–in this case to pay for the time deposits that were taken out the banking system because of what I said in my previous post. The episode was called in Spanish “la licuación de los pasivos” because the beneficiaries were the debtors of the banking system and “el caballazo” because the plan was implemented by Domingo Cavallo, then President of the Central Bank (in March 1981 as Minister of Finance he established “la convertibilidad”). After this first episode the government could not finance its deficits in credit markets until the 1990s and was not able to reduce the deficits; the only source of funds to finance the deficit was the Central Bank and the government imposed price controls to reduce the inflationary impact but sooner or later they had to remove the controls and prices exploded (this is why Alfonsin had to give up the presidency in July 1989 rather than in December–Menem assumed the presidency in July 1989 that he won in an election that took place in May 1989 but should have taken place in October 1989–this is what happens when your government has deficits and the only source to finance them is the central bank).
    You may need a quick course in Argentina’s economic history to learn what could happen in your country.

  40. E. Barandiaran

    Correction: “la convertibilidad” was established in March 1991.

  41. Precisely.

  42. Oh goodie. Now that a developing country wants the chinese currency to appreciate, we are ‘allowed’ to advocate for that with the WTO and elsewhere. If it’s ‘just’ the USA and especially American workers who are hurt, well of course we have to stand aside and allow the Chinese to work their will on us.

  43. Lavrenti Beria

    “The risks of a traditional shooting war in the next 5-10 years are low.”

    With all respect to you personally, if the United States continues with its efforts to encircle Iran and Russia with hostile NATO forces and, through one AIPAC Stephin Fetchit or other, ratchet up the war threats over Iran’s assertions of its rights to nuclear power, China, whose interests in Iranian energy are rather considerable, will move more palpably toward the creation of a formal anti-American bloc. Remember, now, American foreign policy isn’t being conducted by Americans who see themselves as in any way free to pursue purely American interests, but rather by those under the watchful eye and coercive threats of the Israel Lobby. So before you can say Avigdor Leiberman, you just might find yourself in yet another proxy war, this time with real adversaries. I’d say that’s almost certainly going to happen inside of five years what with the beholdenness of the Obama/Biden/Clinton entourage to these foreign interests. If it were up to Biden, we’d launch an attack on Russia from Georgia and another on Iran from Afghanistan, Iraq and the Persian Gulf today. China is not likely to stand idly by while the United States takes on an increasingly ominous military presence in all too many of the worlds’ hot spots. We have the Korean experience with which to refer.

  44. Pak is right. The USA is as much responsible for the mess as China is – Treasury Secretary O’Neill tried to get the world to be less dependent on exports to the USA (and to end USA dependence on foreign capital) in 2001. Nothing happened. Nothing happened because a sufficient number of influential Americans believed
    a) they could democratize China by helping it to prosperity (see the debate about Most Favored Nation Trading Status)
    b) Americans deserved all the investment the Chinese could provide and
    c) it would never end

    The American “strategy” has unravelled, badly. If you think the Chinese are worried, think again.

  45. With due respect don’t agree. In 2008 as the oil price went up to $147, the transportation sector didn’t go broke, except for low-cost airlines, whose business model can’t work when fuel costs take too big a share of the ticket’s price.

    Agricultural commodity prices will actually shoot up much more than oil prices as they are usually the first ones to respond to currency depreciation. If you remember, US farmers were doing quite well in early 2008. The ones who’ll suffer will be those 3rd world nations which are dependent on food imports.

    Then, the US is a not-so-small oil producer and has sizable oil inventories. The US transporters can pass on the increased fuel costs to the final consumer faster and with less pain than what will happen in Europe, Japan and China who’ll suffer most from the ‘oil price shock’ as the US$ will depreciate much less against currencies than commodities, which are stil traded in US$.

    I think it’s clear from the above analysis that after the devaluation is done, very few powers in the world would be willing to rock the boat, but instead will have to work out damage control measures.

    When the Chinese or Russians talk of a new international reserve currency, or regional reserve currencies, or trade in Yuans, I don’t think they really mean it. All fiat currencies are basically a sort of ‘US$ derivatives’ at this time in history, they aren’t going anywhere if the US$ leaves the scene. When you have no gold standard – which is not coming back – any new reserve currency regime will take many years to be agreed on, and we’ll need extensive written regulations on a global scale to prevent currency manipulation and ‘currency wars’.

    So why they are talking what they are talking is that they are buying time to protect assets and control damage – at the expense of anyone else. You might notice that Russians are actually shouting louder than the Chinese about ‘regional reserve currencies’. That’s not a sign of strength or vision. It’s merely a reflection of their panicky mood as they will remain heavy net US$ assets sellers in years ahead, trying to finance their enormous (and enormously non-productive) budget deficits.

    But I personally think the powers that be in the US will fear to go the FDR way because they are delusional enough to expect the consumer to ‘recover’ soon, and thus think such overnight devaluation will do too much damage as salaries will respond much slower than living cost. However these brave deflation fighters will be disappointed. The credit crisis is still with us, deflation is a wicked enemy, and it’s coming back soon because it took them too long to win their first battle; small/medium businesses which provide so much employment are too deep underwater already.

    And as they respond with more ‘stimulus’, the game they are playing wil become increasingly dangerous because they can’t support the bond market and the US$ at the same time. The US$ will have to drop dead because if interest rate volatility is allowed to set in, it will kill the interest rate swap (IRS) market. IRS’ form the bulk of the US banking cartel’s derivartive exposure. We’ll then all be amazed how we could get scared to death by smth as insignificant as the MBS market collpase in ’08..

  46. Mr Johnson says: “If China decides to now shift out of dollars, what would happen?………………..The dollar would surely depreciate and inflation would likely rise. But who cares?” I AM SURPRISED TO HEAR SUCH REASONING FROM MR. JOHNSON.
    The US cares, Mr Johnson. Because a dollar tsunami will take place, the whole world will start dumping their USDs, they will stop investing in US assets (then who will finance the US deficit and debt?) prices of imported goods and services will rise, as well as those of their US competitors, inflation will gallop driving interest rates much higher, hurting the real economy and the country’s competitiveness etc etc etc

  47. An outdated–and unresponsive–US political system is the primary culprit in this drama. Chomsky even makes the case for the US being a ‘failed state’.
    Our deference to the short-term goals of our financial and business elites is costing us dearly.
    Meanwhile, the 8 engineers who constitute China’s politburo are free to make (and follow!) long-range programs that increasingly advantage their country.
    In short, the US appears unable to make and follow long-range plans (whether financial, or infrastructural). That is the real disaster which has been waiting to happen…until now.

  48. Re the Chinese/USdollar reserves difficulties,

    We could denominate our US Treasury bonds sold to Chinese investors in Chinese currency (renmimbi).

    This would eliminate Chinese concerns re reserve value protection whilst enabling US borrowings to continue as required for trade balancing.

    Does this give any party a problem?

  49. China doesn’t have any Muslim allies, thanks to their treatment of the Uighurs. Likewise, it’s not likely that Russia will make any strong alliance with China–they have divergent interests and a history of conflict. I can’t imagine a US attack on Russia–the US can’t afford it, the NATO allies won’t go for it, the US military is tied up in Iraq for several years to come, & Obama doesn’t like war as a diplomatic strategy. Not gonna happen that way.

    And yet the trade conflict between the USA and China–really, between China and the rest of the world–is so great that it seems likely to lead to war somewhere.

  50. Thank you for so kindly educating me…

    But your conclusions – that the US is like Argentina, and what happened there is likely to happen here, is faulty. The missing element is foreign-denominated debt, and until the US starts selling T-Bills in Euros, I’m not going to worry about HYPER inflation (e.g. 50%+ inflation PER MONTH).

    You state that Argentina entered hyperinflation because it lost access to international financing…

    Argentina lost access to foreign currency debt markets because it DEFAULTED ON ITS FOREIGN-CURRENCY DENOMINATED DEBT in 1982…

    Here’s a nice summary, and you can google a hundred others. You can argue that the 89 hyperinflation was mostly domestic, but the trigger events – 82 – started due to the currency markets and non-peso debt.

    http://iadb.org/res/laresnetwork/files/pr250finaldraft.pdf

    On specific points:

    1) The time deposits you were referring to were denominated in dollars, or actually held in dollars, and were forcibly converted _because_ the central bank needed to acquire foreign currency. Why?

    2) Because the peso was artificially pegged to the dollar, and was substantially overvalued for a decade. The forced conversion constituted an effective “taking” of money from time-depositors to generate foreign currency (largely to cover foreign currency obligations).

    3) The 1977-82 period is frequently referred to as the beginning of the DEBT crisis – Argentina deregulated its finance industry (sound familiar?), cut tariffs to lower import prices (sound familiar?), and ran deficits to finance its dollar/peso peg. It largely financed this deficit through FOREIGN BANK DEBT in non-peso currency, precisely because the deficit was not to support domestic production but rather to support the subsidized acquisition of foreign currency (by both private and public Argentinian actors).

    4) The beginning of the large deficits was 77/78, hyperinflation didn’t begin till summer of 82. Almost all inflation begins because of government financing deficits with new money – I never contested this – but the HYPER inflation started because of a need to finance its dollar obligations and an inability to sustain these obligations through domestic sources.

    And THAT is the foreign currency debt trap. If debt is denominated only in local currency, then inflation is somewhat self-limiting. Inflation jumps, existing debt is largely devalued, and interest rates spike… The government cannot get access to financing (no one trusts it not to print money), until it offers some real commitment to not inflate (either that, or it uses martial law).

    So it turns to foreign currency lenders… (since it can’t inflate foreign currency), but this commits it to acquiring foreign currency at any price to repay the debt. But in 1982, ARGENTINA DEFAULTED because it could not raise enough foreign currency to cover existing debt payments. And that de-anchored everything.

  51. Is it possible that all of the comments have been written by economists who misunderstand political reality? To begin, China is a monolith, not a collection of fast talking politicians trying to get personally rich. It continues accumulating Treasury paper only because it has no other way to acquire western technology. It needs a lever. Our elected idiots have been providing the lever since at least 1995. They got low interest rates for their corporate pals, who used the money for consumer usury here at home and cleaned up. Problem. The consumer rates got so sky high our consumers can no longer pay. Now what? The politicians bailed out our banks with free money; china continues buying Treasury bonds since its purposes have not changed. Our politicians recognize that unless china soon begins buying more of our drek, soon nobody will be willing to accumlate dollar assets. So we send china Hillary Clinton, our economic expert, to talk tough to china? We are lucky that chinese are inveterately polite. They will not tell Hillary to stuff it; they will smile and nod and say maybe and keep on keeping on and when the time comes that china no longer needs our technology it will dump those Treasury bonds and interest rates will revert to historic levels which, if anyone is interested, prevailed as recently as 1981.

  52. So you appear to be arguing that China is using extensive currency controls which have the ‘side-effect’ of keeping the Renmibi/Yuan substantially undervalued (relative to a free market rate), but this is entirely ‘incidental’?

    And you expect us to believe that?

    You write:

    “They keep currency controls for a number of reasons but perhaps the most important one is to rationing foreign exchange in accordance with their “priorities””

    You mean, China wanted to suppress domestic consumption in order to enforce investment in “priority” industries (which had state-chartered semi-monopolies)?

    Hmm, where have we heard that before?

    http://en.wikipedia.org/wiki/Mercantilism

  53. A bit off topic but…

    When I was growing up China, like the USSR, was considered an anti-democratic evil communist regime bent on a “conspiracy to sap and impurify all of our precious bodily fluids”. They were considered the evil to end all evils and via the “domino theory” would consume our nation if we didn’t vigilantly protect against them.

    Now despite the fact that as far as I can tell little has changed in their governing style, they are a “preferential trade partner”.

    So, what did change? Did they suddenly become a bastion of human rights? No. Did they suddenly allow freedom of press? No. Did they suddenly embrace democracy in any of its forms? No. Did they disavow communism and repent their evil ways? Not even close.

    What did they do then???

    They opened up to capitalism.

    So what does that really say about the whole “red scare” we grew up with? What does it say about the dangers of communism?

    It says it was all about money. It was all about property rights and government control of business. Once China allowed privatization, all was good again.

    So much for the “evils” of communism.

    And that of course is why Chavez is evil and Hu Jintao’s name doesn’t even come up. Chavez is for deprivatization and Hu is allowing privitization.

    In short, it never was about freedom, or democracy, or human rights. It was about the profits of major American corporations, and China if anything today has only accelerated them. Chavez could massacre a 100,000 people tomorrow and be our best friend if only he would re-privatize Venezuela’s oil fields.

    But they know how to manipulate us and in an Orwellian way those things that actually would benefit us are seen as bad and those things that hurt us are seen as good.

    In any case, I don’t see China as evil, though certainly they do evil things (we as well), however I think it brings truth to the lie we grew up with. It wasn’t about communism (though I’m not saying it shouldn’t have been), it was about money.

  54. Lavrenti Beria

    “I can’t imagine a US attack on Russia–the US can’t afford it, the NATO allies won’t go for it, the US military is tied up in Iraq for several years to come, & Obama doesn’t like war as a diplomatic strategy.”

    Ah, yes, the perfect time to insert one of Josef Stalin’s brilliancies into the mix it would seem. Reflect on this remark and relate it to the reality of Obama’s recent “peace offensive” if you will:

    “If any foreign minister begins to defend to the death a “peace conference,” you can be sure his government has already placed its orders for new battleships and airplanes” … J. Stalin

    Time to remove the rose colored glasses, perhaps?

  55. Hard to argue with any of this. Don’t think my generation quite understood that Vietnam was about the opportunity to make textiles with $1 per day labor. What do you suppose Afghanistan and Iraq are about? Clue: what would oil at $8 per barrel mean to energy lenders and energy plutocrats?

  56. Excellent post, thank you.

    Question: why is US trying to postpone what appears to be inevitable? Stalling while trying to figure out options? Normal politics: stay afloat? Something else?

    What is their option B? What are the mid-game scenarios?

  57. Just re-read the main post. Most excellent statement.