“World Bank Chief Economist Justin Yifu Lin staked out a strong position against forcing China to let its currency appreciate as a way to rebalance the world economy.

“’Currency appreciation in China won’t help this imbalance and can deter the global recovery,’ he said in a lecture Monday at Hong Kong University.

“In an interview after the lecture, he said other countries shouldn’t intervene to keep their currencies cheap to boost their export sectors, calling it the ‘equivalent of protectionism.’”

You can read the rest at Real Time Economics. No, it doesn’t make more sense — except possibly as an expression of China’s policy.

By James Kwak

President Obama leaves next week for a high profile trip that includes meetings with other “Asia-Pacific” countries (in the APEC forum) and a visit to China.  The President has had considerable diplomatic success on the economic front to date, including at the G20 summit in April and – to a lesser degree – at the follow-up September summit in Pittsburgh.

But the issues facing him now in Asia are particularly difficult, primarily because of China’s exchange rate policy.  China essentially pegs its currency (known as the yuan or renminbi) against the US dollar, which means that it rises and – most recently – falls in tandem with the greenback.

Many countries operate de facto pegs of this nature, but China is problematic for three reasons: it is a large economy (10 percent of world GDP, if we adjust for purchasing power), it runs a big current account surplus (exporting more to the world than it buys from the world, in the range of 6-12 percent of the Chinese economy), and it consistently has a bilateral surplus with the US that is galling to many on both sides of the aisle on Capitol Hill (and their constituents).

The political backlash is not without foundation – jobs have moved and continue to move to China in part because Beijing’s exchange rate policy gives Chinese exporters an unfair trade advantage.  This has long been recognized and China committed as long ago as 2003 to address this issue, but the Bush administration was unable to achieve any lasting success on this front – despite repeated head-to-head talks at the Cabinet Secretary level. 

The Chinese currency remains at least 20 percent undervalued according to the Peterson Institute for International Economics (disclosure: I have a part-time position at the Institute but don’t work on this calculation); quietly, US officials do not disagree with such numbers.  As a result, China continues to accumulate foreign exchange reserves at a dramatic rate – it reached $2 trillion earlier this year and will like have $3 trillion around the middle of 2010 (i.e., equivalent to 20 percent of US GDP; a huge number).

The Bush administration, quite reasonably, tried to give the job of handling China’s exchange rate to the International Monetary Fund – beefing up its long-established mandate in this area.  Unfortunately, the IMF has proved unable to make any significant progress, largely because it lacks the legitimacy necessary to wield any kind of stick on the issue.  The Chinese just continue to say “no”, politely, and the IMF has backed down.   

This is embarrassing for Mr. Obama, particularly as his strategy at the G20 has been to play up the importance of “global imbalances,” which implies that over the next 12 months, the focus will be on reducing both the Chinese current account surplus and the US current account deficit.

What should he say both to China and to its neighbors – who also increasingly find China’s exchange rate policy worrying, particularly as the dollar faces pressure to decline?  Mr. Obama needs to find a carrot and at least the shadow of a stick, but he really does not want to go anywhere near a trade war (remember the tit-for-tat protectionism of the Great Depression).

A compelling argument is actually hiding in plain sight.  As a result of easy monetary policy in the United States, combined with the rapid rebound of the Chinese economy, China now faces record capital inflows.  These inflows are greatly encouraged by the inevitable prospect (in the minds of investors) that the renminbi will rise in value against the dollar within the foreseeable future.  If you have access to cheap financing and implicit US government guarantees, for example as does Goldman Sachs, borrowing in dollars and investing (e.g., through private equity deals) in renminbi looks like a one-way bet.

The longer China resists appreciation and the more it protests that no one should interfere with this aspect of their sovereignty, the more the capital will pour in.  This can have beneficial aspects, in any country that is trying to grow fast, but it can also be profoundly destabilizing – Mr. Obama should talk gently about the experience of Japan in the 1980s, the US this decade, and almost all emerging markets pretty much every decade.

Talking in public about big sticks never goes down well in Asia, and the administration should deny any inclination in this direction.  But the mainstream consensus is starting to shift towards the idea that the World Trade Organization (WTO), not the IMF, should have jurisdiction over exchange rates.  The WTO has much more legitimacy – primarily because smaller and poorer countries can bring and win cases against the US and Western Europe in that forum.  It also has agreed upon and proven tools for dealing with violations of acceptable trade practices – tailored trade sanctions are permitted.

No one wants to take precipitate action in this direction, but extending the WTO’s mandate in the direction of exchange rates would take time – and presumably warrant discussion at the G20 level.  The US has great influence over the G20 agenda and Mr. Obama’s staff should hint, ever so gently, that this is where they see the process going.

By Simon Johnson

An edited version of this post previously appeared on the NYT’s Economix blog; it is used here with permission.  If you would like to reproduce the entire post, please contact the New York Times.

We’ve been at first amused but more recently alarmed at how “global imbalances” are becoming many people’s preferred explanation of the financial crisis. At first you could brush it off this way: “global imbalances (read: ‘blame China’) . . .” But this explanation is going mainstream, not least because it is always more convenient for policymakers and bad actors to blame someone far away. For example, Dealbook (New York Times) kicked off a roundtable on the causes of the financial crisis this way:

“There is a conventional view developing on the financial crisis. The Federal Reserve’s policy of historically low interest rates spurred a worldwide search for higher risk and return. Concurrently, the entrenched United States trade imbalance led to a huge transfer of dollar wealth to Asian and commodity-based countries. The unwillingness of Asian economies, particularly China, to stimulate their own domestic consumption led these countries to reinvest the proceeds into the United States. This further contributed to lower American interest rates and further fueled the search for return.”

(Mortgage securitization gets mentioned, but only in the fourth paragraph!)

Simon and I took this on in our Washington Post online column this week, but I thought it was interesting enough to repost here in full, below.

***

The time is here for our nation to actually do something about the recent financial crisis — that is, do something to prevent it from happening again. But instead, many people are finding it easier to pass the buck than to, say, regulate the financial sector effectively.

The recent Group of 20 conference in Pittsburgh was replete with talk about “global imbalances,” which means — in the spirit of the “South Park” movie — “blame China!”

According to this story, the global financial crisis was caused by hardworking Chinese factory workers who committed the sin of over-saving, which created a glut of money that needed to be invested, conceptualized in a great episode of public radio’s “This American Life” as the “giant pool of money.” (Japan and the oil exporters also had large surpluses, but for political reasons, the finger generally gets pointed at China.)

This beast from the East, seeking higher yields than it could find in Treasury bonds, flooded into the housing market, pushing down interest rates and pushing up housing prices, and creating a bubble that finally collapsed, with the results we all know. (More nuanced proponents of this theory hold, in a “fair and balanced” sort of way, that over-savers in China and under-savers in the United States — and other countries, like Spain, Britain and Ireland — are equally to blame; in any case, it’s the imbalance that’s the problem.) This is a convenient story because it absolves us of any need to put our own house in order through better regulation.

Like most errors, this story contains an element of truth. In general, it is not a good thing for a country to consume more than it produces indefinitely because to pay for its excess consumption it must borrow money from the rest of the world, and that country can consume more than it produces only if some other country produces more than it consumes. In particular, the U.S.-China imbalance is due in part to the Chinese policy of keeping its the value of its currency artificially low — encouraging Americans (and other foreigners) to buy Chinese exports and discouraging its citizens from buying imported goods.

But the “blame China” story (or the “half-blame China” variant) suffers from serious problems. First, it takes two to tango. No one put a gun to the American consumer’s head and forced him to buy a new flat-screen TV or to do so by taking out more debt. (Nor are the Chinese somehow morally superior to us; one reason why they save so much more than Americans is that, with no social safety net to speak of, they have to.)

Second, the Chinese government did not lend to American home buyers directly. China bought U.S. Treasury and agency (Fannie Mae, Freddie Mac, etc.) bonds, which put more money into housing and also crowded other people’s money into housing. But the vast majority of Chinese money went into the safer bits of the U.S. financial system; the speculative money came largely from European banks. And all the actual lending decisions were made by financial intermediaries (banks, mortgage lenders, etc.), which made plenty of bad decisions along the way while regulators, from Alan Greenspan on down, looked the other way.

Third, there is no particular reason why a “giant pool of money” should produce a bubble. A savings glut should lower interest rates, which should increase the value of housing; a bubble occurs when prices go up more than dictated by fundamentals like as interest rates. If the run-up in housing prices was a direct result of over-saving in China, then housing prices should have fallen only if China stopped over-saving — which has not happened.

While Chinese over-saving was a contributing factor to the recent crisis, it was neither necessary nor sufficient. Cheap money is not bad in and of itself — all other things being equal, it’s better to have people lending to you at low rates than at high rates. The problem is what we did with the cheap money.

For the long-term health of the economy, we want that money to flow into capital investment by the business sector because that is the best thing we know of to boost long-term productivity growth. Instead, though, Tim Duy has a great chart, showing that the rate of growth of investment in equipment and software in the 2000s was far below the rate in the 1990s, even with all the cheap money of this decade.

This may seem like an obscure point, but basically it means that even with the low rates of the Greenspan Fed, and even with all that cheap money from overseas, we couldn’t get it where we needed it to go because it was being sucked up by the housing sector. And it was being sucked up by the housing sector because lenders earned fees for making loans that could not be paid back, and banks earned fees for packaging those loans into securities, and credit rating agencies earned fees for stamping “AAA” on those securities, and all sorts of financial institutions — including those same banks — loaded up on these securities because they offered high yield and low capital requirements. In short, we had a dysfunctional financial system that failed at its most fundamental job — allocating capital to where it benefits the economy the most.

Encouraging productive investment by businesses and preventing the next bubble go hand in hand — both require fixing the financial system. Blaming global imbalances — a consequence bereft of either a subject (an actor) or a verb (an action) — is only a way of avoiding our real problems.

By Simon Johnson and James Kwak

This post was written by StatsGuy, a regular commenter here and very occasional guest contributor. We asked him to expand on the ideas he put forward in this comment on the relationships between monetary policy, international capital flows, and bank capital requirements.

Former Fed Chairman William McChesney Martin is most famous for his notorious quip that the job of the Fed is to “take away the punchbowl just as the party gets going.” It seems this has evolved into a full fledged theory of monetary management.

Unfortunately, structural problems – like trade imbalances, inadequate capital ratios, and weak financial regulation – severely constrain Fed monetary policy options by impacting currency flows and the value of the dollar. (Some specific mechanisms are listed in the previous comment.)

Why does this matter? Because it means the Fed cannot use monetary policy as effectively to keep the country going at full throttle and avoid a prolonged fall in utilization rates (unemployment and idle machines).  How can it be that capacity utilization is still lower than at the bottom of the 81/82 recession and we’re ALREADY raising the bubble/inflation alarm? (Paul Krugman discusses this here, and the answer is that the output gap is itself defined against neutral inflation, not just capacity utilization.)

Here is a less semantic answer: When the Fed pumps money into the system to prevent deflation, the disincentive to holding cash/reserves is supposed to get money moving and thus restore the savings/investment equilibrium. In a sense, the goal is to decrease the incentive to use money as a store of value and therefore increase its use as a medium of exchange. Unfortunately, many conventional macroeconomists (unlike their brethren in the real-world finance schools) haven’t admitted that this monetary stimulus “leaks” out of their models (which focus on closed domestic economies without moral hazard). Where does it go?

Partly, it gets sopped up by large financial institutions with asymmetric reward functions (aka, government owns the downside) and government guarantees (Too Big To Fail) that give them cheap access to credit. Rather than forcing it into the real US economy, it flows into financial assets (some of this is good, since it’s necessary reflation, but too much creates a new bubble, and the asymmetric reward function certainly creates massive distributional inequities).

The monetary stimulus also “leaks” due to globalization of capital flows. It flows out of the country through a variety of mechanisms that traders might describe as dollar hedging (into commodities, foreign assets, and an anti-dollar carry trade). This is one of the most dominant trading features in the current market environment.

In order for the Fed to actually be able to fully use monetary policy to keep the economy humming at full throttle, we need financial regulation (to avoid new liquidity being channeled into bubbles instead of real investment), better capital asset ratios (to help moderate moral hazard and asymmetric risk), and limited expectations of future dollar devaluation (which currently result from our huge debts, and China’s continued mercantilist policies that keep the dollar propped up). This latter point is not entirely intuitive, and I might argue that the best way to avoid future expectations of devaluation is get the Renminbi/Yuan revaluation (which everyone expects, but over which there is massive uncertainty) over and done with. China, however, is not too keen on this idea.

So in these regards, Team Obama seems to “get it”. I concede that they have identified the right issues. How well they execute depends on many factors. As Professor Johnson notes, focusing on currency valuations (a very sensitive issue in China) on a highly public world stage like the G20 may not be productive.  By contrast, quietly moving a bill through Congress might be a better option.

But what happens if we fail to fix the structural issues? Well, the answer is not good. Without the right scalpels and scaffolding, the Fed will use a sledgehammer – taking away the punchbowl during booms and giving it back during busts. Except that it will almost always get the timing wrong – taking away the punchbowl too fast and give it back too late, due to poor regulation and dollar instability, and its own anti-inflation intellectual bias and obsession with its credibility.* If it tries to support a weak economy by keeping the punchbowl on the table (as in 2003-2005, when we had a “jobless recovery”) then we get a really bad bubble.

That is what a central bank staffer called “Second Best Punchbowlism” on Brad DeLong’s blog, and it is a very scary prospect indeed. Remember when the Fed kept rates tight in August and early September 2008 (arguably to fight the commodity bubble/dollar run)? And when, in the post-September 2008 crisis, the Fed continued its deflationary policies, even though it was abundantly clear to the entire world that aggregate demand was (to paraphrase Warren Buffett) falling off a cliff? The Fed didn’t bring out the heavy weapons until March of 2009, until things looked pretty bleak indeed. This is what we can look forward to if the Fed’s new paradigm becomes Second Best Punchbowlism.

It’s also important to recognize that we can’t just kill the Fed right now. We NEED monetary policy to be effective in order to implement new financial regulation (especially higher capital asset ratios) without killing the US (and world) economy by reducing the total supply of money. As we phase in higher capital asset ratios and other regulations, we must compensate by injecting liquidity to offset a decrease in velocity. This must be done in a highly coordinated fashion. Otherwise, financial regulation that aims at a long term equilibrium with a more stable overall money velocity (which I would argue is a good thing) could risk deflation in the near future (which will undoubtedly cause people to blame the administration currently in charge).

*“I’m acutely aware that the current FOMC has inherited the inflation policy credibility that was hard won by our predecessors. One thing that has impressed me since taking my position last year is the seriousness with which my colleagues approach the duty to protect that legacy. I am confident that the Federal Reserve’s institutional commitment to maintaining low and stable inflation will prevail.”

– Dennis Lockhart, President, Atlanta Fed, August 2008

By StatsGuy

The usual concern about the US-China balance of economic and political power is couched in terms of our relative international payments positions.  We’ve run a large current account deficit in recent years (imports above exports); they still have – by some measures – the largest current account surplus (exports above imports) even seen in a major country.  They accumulate foreign assets, i.e., claims on other countries, such as the US.  We issue a great deal of debt that is bought by foreigners, including China.

There are some legitimate concerns in this framing of the problem - no country can increase its net foreign debt (relative to GDP) indefinitely without facing consequences.  And the Obama administration, ever since the Geithner-Clinton flipflop on China’s exchange rate policy early in 2009, seems quite captivated by this way of thinking: Will they buy our debt? Can we control our budget deficit? What happens if China dumps its dollars?.

The reason real to worry about China, however, has very little to do with external balances, China’s dollar holdings, or even capital flows.  It’s about productivity and rent-seeking.

China mostly invests in activities that raise productivity, raising the amount of goods and services that they can produce.  This could be manufacturing or infrastructure or various kinds of services. Agriculture lags but continues to get some new investment. And of course they pour money into education.

I’m not a fan of the Chinese way of organizing their economy or their society.  They no doubt have weaknesses that will catch up with them eventually (including waves of overinvestment in some sectors), and there’s good reason to think they will be the center of a big new “Asia Century” Bubble that is just now starting to emerge.

But contrast their pattern of investment in recent years with ours.  What sector in our economy has expanded more than any other?  Where should you work if you want both the highest wages on average, potentially very big bonuses, and quasi-retirement by age 40?  Finance.

Of course, we need finance and an important part of modern economic development involves intermediating savings and investment.  The US did this well, with some bumps in the road, and built a system that worked through the 1960s or 1970s.

But finance as a share of our activities (i.e., percent of GDP) has roughly doubled in the past 40 years.  What has this really added in terms of productivity?  The ATM and the credit card were great breakthroughs, but they are old.

What has “financial innovation” brought us since the 1980s?  One answer, of course, is “hedging strategies” that lower the cost of doing business for companies large and small.  This is plausible, although not likely to be large relative to the economy - send me your favorite study on the cost of capital since 1990 (you choose the definition), and we can talk about whether this effect is significant, sustainable, or even sensible.

Because financial innovation has mostly facilitated a big increase in finance.  If a sector grows, pays more wages, and rises as a share of GDP, surely this is a good thing?  Not necessarily – if this is a rent-seeking sector.

Rent-seeking means effectively a tax extracted by one sector from the rest of the economy.  We’re used to thinking of this as something that occurs through trade restrictions and the big breakthroughs in this area came from analysis of tariffs and quotas (Anne Krueger, Jagdish Bhagwati).  If a tariff, for example, will make your life cushy, you will devote great resources to getting one established or increased – irrespective of the effects on the rest of the economy (call this strategy “let’s hammer the unprotected consumer”).

Finance is rent-seeking.  The sector has devoted great resources to tilting all playing fields in its direction.  Consumers are taken advantage of; consumer protection is vehemently opposed.  And great risks are taken, with the downside handed off to the government (and the consumers again, as taxpayers).  This downside protection allows an overexpansion of debt-financed finance – reaching the preposterous levels seen in mid-2008 and now re-emerging.

Finance in its modern American form is not productive.  It is not conducive to further sustained economic growth.  The GDP accruing from these activities is illusory – most of finance is simply a tax on what is done by more productive members of society and a diversion of talent away from genuinely productivity-enhancing activities.

The rise of China does not necessarily imply slowdown or demise for the United States. But if they specialize in making things and we specialize in finance, they will eat our lunch.

On an urgent basis, we need real consumer protection against predatory financial practices and an end to all forms of Too Big To Fail behavior – which is actually just the biggest, nastiest form of predation. 

This is our most pressing national and international strategic priority.

By Simon Johnson

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

On his China visit, Secretary Geithner is immediately on the defensive.  The language he is using on the Chinese policy of exchange rate undervaluation-through-intervention is the mildest available.  And the commitment he is making, in terms of bringing down the US deficit – which we all favor – is an extraordinary thing to put numbers on in a foreign capital.  Such commitments are of course unenforceable, but still the wording indicates – and is understood by China – great US weakness.

Not surprisingly, China seems likely to push for more.  Their main idea is that some part of their US dollar holdings be transfered to a claim on the International Monetary Fund, which would shift it from being in dollars to being in Special Drawing Rights – and therefore a claim against (a) the IMF’s whole membership, and (b) presumably, the IMF’s gold reserves.

This is a bad idea.

No one asked China to build up a huge level of reserves.  If one country wants to run a current account surplus that is big relative to the international economy, then someone else has to run a deficit – it’s a zero sum game because “reserves” are a claim on another country (preferably a strong one, with a convertible currency).  No one has ever offered a guarantee on the real value of reserves, i.e., what China now wants. 

We can agree that the US should have a higher savings rate, but if we did have more savings – or even if we ran our a current account surplus of our own – China’s desire for foreign exchange reserves would still mean undervaluation for them (as along as they can sustain the intervention) and a current account deficit for some set of countries in the rest of the world.

There is nothing wrong with wanting to have foreign exchange reserves, and sometimes these are accumulated just through the natural cycle of activity (e.g., commodity producers are well advised to build up reserves in a boom, because the prices of their exports also crash with some regularity).  But the way China has operated within the global system has not been responsible and it has not – an important point – been in conformance with the rules (as reflected most recently in the IMF’s Surveillance Decision, which is heavy on the legalese but quite clear on this point: no sustained undervaluation through intervention in the currency market is allowed).

China needs to acknowledge that it too has responsibility for the stability of the international system.  Current account surpluses feel good for surplus countries – this has been a consistent feature of the modern global payments system – but policies that sustain big surpluses are destabilizing for that system, because they imply that someone else will run a deficit and, more than likely, eventually have to bring that deficit down through costly adjustment.

What we really need is a complete reform of the IMF – or the introduction of a new international payments body - so that countries don’t feel the need to run massive surpluses to protect themselves against external shocks.

In the meantime, we need China to allow its currency to appreciate.  If they double their holdings of US dollar assets over the next couple of years (let’s say, going towards $4trn), effectively financing our budget and current account deficit, will we all end up safer or more vulnerable?

Is Mr. Geithner trying to persuade China to reflate a new version of our financial bubble?

By Simon Johnson

At his confirmation hearing in January, Tim Geithner nailed the China Question.  China prevents its exchange rate from appreciating through intervention (buying foreign currency), and this allows it to sustain a large current account surplus.  Geithner said, as plainly as you can expect from a senior official: this is not in accordance with international rules and should stop.

Not only is this sensible economics and correct on the rules, it is also good politics.  If you want to head off the considerable inclination towards protectionism in Congress, it would help greatly for the Chinese renminbi to rise in value (e.g., review the discussion at this House hearing).

But almost as soon as Geithner spoke on this issue, there was slippage.  By late February, Hillary Clinton was asking the Chinese nicely to continue holding US Treasury securities and, it now seems, punting the exchange rate issue.  Above all else, China wants to be left alone on the renminbi – variously arguing that any appreciation would jeopardize jobs, derail growth, and plunge the country into chaos.

So what should we expect from Geithner’s upcoming China trip?

Not much.

China refuses to talk politely about its exchange rate and rebuffs all sensible diplomatic initiatives on this front – they have held the IMF at bay for nearly 2 years on this exact issue.  The rhetoric is that their fiscal stimulus will bring down their current account surplus without need for significant exchange rate appreciation.  This is smokescreen.

The reality is that the administration is afraid that China will shift out of its dollar holdings, pushing up interest rates on Treasury debt and jeopardizing their Fiscal First reflation strategy. The Chinese have played up these fears by speaking obliquely on the desirability of a non-dollar international reserve currency – this is a pipedream, but you get the point.

The administration has essentially blinked in the face of Chinese growling.  This is strange for two reasons.

First, where would China move its reserve holdings?  The other reserve currencies are generally considered to be the pound, the yen, and of course the euro.  Which one would you definitely prefer to the dollar these days?

Second, any shift in the Chinese portfolio would also tend to depreciate the dollar – depending on what else is going on at that time – and this would likely push up inflation.  However, the administration might welcome some inflation right around now, reducing real debt burdens, and helping banks’ balance sheets and their operating profits.  And a depreciated dollar would raise exports, greatly facilitating our economic recovery.  It would be awkward for this to be explicit US policy, but any Chinese move would provide the administration with plausible deniability.

The standard view among the very people now running US macroeconomic policy is that the large Chinese current account surplus during the boom – and the consequent build-up of foreign exchange reserves – was destabilizing, because it helped make credit conditions looser in the US.  In fact, “don’t blame us, it was the global [Chinese, Japanese, oil producers’] savings glut” is almost a mantra among our policy elite. 

Personally, I would not overweight this element of the global credit mania – the financial services metabubble started long before China’s surplus became significant.  But I’m seriously worried about the potential protectionist backlash today, given that China is the only major country that does not play by standard international trade and finance rules.  The administration thinks it can safely postpone discussing China’s exchange rate for another, sunnier day.  I’m not so sure.

Still, not wanting to discuss difficult topics should make for an easy visit to China.

By Simon Johnson

I’m warming up for a longish Beginners-style article on government debt, which will come out next week or so. In the meantime, the New York Times has an article today about China’s diminishing demand for U.S. dollar-denominated debt. Theoretically this could make it harder for the U.S. to borrow money and thereby push up the interest rates on our debt (now at extremely low levels).

China’s voracious demand for American bonds has helped keep interest rates low for borrowers ranging from the federal government to home buyers. Reduced Chinese enthusiasm for buying American bonds will reduce this dampening effect.

However, the article doesn’t mention one compensating factor. The fall in China’s buildup of its foreign currency reserves is linked to the rise in the U.S. savings rate, which is projected to rise to as much as 6-10% (it was over 10% in the 1980s). Some of that new savings will go to pay down debt, but a lot will go into savings accounts, CDs, money market funds, and mutual funds – which means that depresses interest rates across the board. On the back of the envelope, 6% of personal income is about $600 billion a year in new domestic savings to compensate for reduced overseas investment. Whether this will be enough to compensate entirely I don’t know. But if we were all one global economy in the boom, we’re still one global economy in the bust.

We’ve gotten some comments to the effect that, for all the discussion of the financial crisis and the various bailouts, we haven’t looked hard at the underlying causes of the financial crisis and accompanying recession. The problem, as I think I’ve hinted at various times, is that any macroeconomic event of this magnitude is overdetermined, on two dimensions. First, there are just too many factors at play to identify which are the most important: in this case, we have lax underwriting, lax bond rating, skewed incentives in the financial sector, under-saving in the U.S., over-saving in other parts of the world, insufficient regulation, and so on. How many of these did it take to create the crisis? There is no good way of knowing, because the sample size (one, maybe two if you add the Great Depression) is just not big enough. Second, there is still the conceptual problem of identfying the proximate cause(s). To simplify for a moment, we had high leverage which made a liquidity crisis possible, and then we had the downturn in subprime that made it plausible, and then we had the Lehman bankruptcy that made it a reality. Which of these is the cause? Leverage, subprime, or Lehman?

In any case, we’re not going to resolve these issues. But I want to start an occasional series of posts looking at one of the root causes at a time.

Today’s topic was inspired by this week’s meetings between U.S.-China meeting in Beijing, where, according to the FT, “the US was lectured about its economic fragilities.”

Zhou Xiaochuan, governor of the Chinese central bank, urged the US to rebalance its economy. “Over-consumption and a high reliance on credit is the cause of the US financial crisis,” he said. “As the largest and most important economy in the world, the US should take the initiative to adjust its policies, raise its savings ratio appropriately and reduce its trade and fiscal deficits.”

There has been a lot of tut-tutting, here and especially abroad, about over-consumption and over-indebtedness in the U.S. According to this story, the problem is that U.S. consumers grew addicted to spending, and financed their spending through ever-increasing amounts of debt. Over-consumption fed itself, because it drove up asset prices, which enabled consumers to take on even more debt, which enabled them to spend more, and so on. But, according to this story, the assets were not actually getting more valuable – a house in the suburbs of Las Vegas is the same house it was ten years ago – and the asset price bubble and the debt mountain both had to collapse. (Note that, if you blame the U.S. consumer, then mortgage brokers, investment banks, and bond rating agencies all become mere enablers; if they hadn’t existed, the consumer would have figured out another way to rack up the debt.) The counterfactual “solution” (the historical path that would have avoided this outcome) was for the U.S. consumer to live a more sober life, consume less, and take on less debt.

I am unsatisfied with this story for two reasons. First, I don’t think it’s much of an explanation to say that people were insufficiently virtuous. People are the way they are, and you can only change them slowly, if at all. (The radical stage of the French Revolution, and the Chinese Cultural Revolution, both tried this, and failed miserably.) So maybe Americans are more like grasshoppers than ants. Maybe it’s our popular culture, or our mediocre public education system, or our irrational optimism, or something else. And maybe, at the margins, our leaders could have take a few steps to talk people down from their belief that assets only appreciate in value. But it wouldn’t have changed much.

Second – and this was supposed to be the topic of this post – it takes two to tango. If the U.S., seen as a single unit, borrowed a big pile of money, that’s because someone else lent it to us – and lent it to us cheaply. And while China isn’t the only country that lent us money, it was the major new lender of the last decade.

The U.S., as we all know, has been running a large trade deficit. The flip side of a trade deficit, leaving aside a few details, is foreign capital inflows. Again, looking at the U.S. as one big household, if we consume more than we produce, we have to pay for it somehow; we pay for it by selling assets (foreign direct investment in the U.S., foreign purchases of U.S. stocks, etc.) or borrowing money from overseas (foreign purchases of U.S. bonds).  If we are not saving enough to invest in our economy, then the investment is coming from some other country that is saving more than it needs for its economy.

So far, this may sound like ants and grasshoppers, one being more virtuous than the other. (Although, in the current situation, both are equally responsible for the degree of economic imbalance in the world.) But it’s a little more complicated. Because while Americans were over-consuming, the Chinese government was consciously and explicitly suppressing domestic consumption. It did this by intervening on foreign currency markets to keep its currency, the renminbi, artificially low. Having a cheap currency made Chinese goods cheaper in the U.S., increasing our imports. It also reduced the purchasing power of people in China, making it harder for them to buy imported goods and reducing their standard of living. So to the extent that the U.S. over-consumed, it was aided and abetted by other countries under-consuming, China most prominently.

I don’t know the specific mechanism used to control the exchange rate, but in general the most direct means would be some combination of printing more renminbi and using it to buy U.S. dollars. In order to be able to control its currency, and as a result of keeping it low against the dollar, the Chinese government has amassed roughly $2 trillion in foreign currency reserves, which are believed to be largely in U.S. dollar-denominated assets, such as Treasury bonds and the bonds of government agencies such as Fannie Mae and Freddie Mac.

Now, China wasn’t the only country building up foreign exchange reserves, largely in dollars. Since the emerging markets crisis of 1997-98, the conventional wisdom has been that large currency reserves are necessary to protect yourself against an attack on your own currency, and as a result countries like Russia, South Korea, and Brazil (all victims in 1997-98) amassed hundreds of billions of dollars’ worth of reserves on their own.

All of the U.S. dollar reserves held by all of these countries were effectively loans to the U.S. Treasury bonds were loans to our government; agency bonds were loans to our housing sector. This large appetite for U.S. bonds pushed up prices and pushed down yields, lowering interest rates and thereby fueling the U.S. bubble. Even though the money didn’t go directly into subprime lending, it lowered the costs for all the investors who were investing in subprime. so at the same time that irrational beliefs about asset prices were driving those prices up, the increased availability of money looking for things to buy also drove prices up. Looking at it counterfactually, if there had not been so much global demand for U.S. assets, it’s unlikely that even the once-divine Alan Greenspan could have kept 30-year mortgage rates as low as they were, since the only lever he had control over, the Fed funds target rate, is an overnight rate. And if mortgage rates hadn’t been so low, the bubble couldn’t have been as big.

Which brings us back to the present. Does China really want us to mend our ways, “raise [our] savings ratio appropriately and reduce [our] trade and fiscal deficits,” or do they just enjoy hearing themselves say it? If the U.S. does start saving and reduces its trade deficit, the impact on China’s export-led economy could be devastating. On paper, China could switch toward promoting domestic consumption, thereby reducing its reliance on exports, but at a minimum this is likely to cause significant internal dislocation for a period of years. In any case, they are likely to get what the wish for: the U.S. savings rate is likely to increase significantly simply due to the rush of panic that many Americans have felt for the last two months, and the trade deficit is likely to improve both due to a reduction in consumption and due to the fall in commodity prices.  Countries that want someone else to do their consumption for them may have to start looking elsewhere.

So, the global economy is falling apart, but not in the way people expected. Under the de facto arrangement sometimes known as “Bretton Woods II,” emerging market countries pegged (officially or unofficially) their currencies to developed world currencies at artificially low rates, having the effect of promoting exports and discouraging consumption by emerging market countries and promoting consumption and discouraging exports in developed countries. Of course, the classic example of this was China and the U.S. The U.S. trade deficit and Chinese trade surplus created a surplus of dollars in China, which were invested in U.S. Treasuries and agency bonds, keeping interest rates low and indirectly financing the U.S. housing bubble and consumption binge of the last decade (and, therefore, growth in Chinese exports).

The general fear was that U.S. indebtedness would lead China to diversify away from U.S. assets, causing the dollar to fall and U.S. interest rates to rise, hurting the U.S. economy and making it harder to finance the national debt. This may yet happen someday. But instead of demand for Treasuries collapsing, it’s been demand for every other type of asset that has fallen. Treasury yields have collapsed and the dollar has appreciated about 20%. Still, despite this increased purchasing power, the fall in U.S. (and global) consumption is having a severe impact on growth of the Chinese economy. Even though the Chinese government has signaled that it will do everything in its power to keep growth above 8% per year (down from 11-12% in the past few years), the slowdown has severely constrained the ability of the urban manufacturing sector to absorb internal migration from the countryside, and there are signs of a reverse migration that is aggravating the problem of rural poverty in China. Although China may seem to have all the cards – high economic growth, large foreign currency reserves – it could yet turn out to be a major loser of the global economic crisis.

This is of course just a brief introduction. For more I recommend Brad Setser, among others: some of his posts are here, here, and here.

Other countries can only drool with envy. China today announced a $586 billion stimulus package – that’s 17% of 2007 GDP. Spread through the end of 2010, it’s still more than 7% of GDP per year. By comparison, the US stimulus package earlier this year was just over 1% of GDP, and after causing a small uptick in spending in Q2 it vanished into the sea of bad news; our recent proposal was for 3% of GDP, and that was at the higher end of the range.

Of course, the stakes for China are very high. GDP growth ranged between 11 and 12% in 2006 and 2007, but the IMF recently cut its estimate for 2009 to 8.5% (down from the 9.3% estimate just a month ago), and according to the New York Times article the annualized rate for this quarter could be as low as 5.8%. While these are growth rates that the developed world hasn’t seen for decades, the huge population migration from countryside to city requires high growth simply to keep unemployment in check. So the Chinese government brought out the heavy economic artillery.

The current crisis has proven, if it needed any proof, that even China is susceptible to the fortunes of the global economy. If it can lead to greater participation by China in the global financial system, including institutions like the IMF, that would be one positive outcome.

OK, that may be a bit of a stretch. But there’s little doubt that the global recession will take its toll on China’s double-digit growth rates.

One (emailed) response to our recent Washington Post op-ed criticized us for overlooking the role of China (although we did discuss China in the following Forbes article). In particular, the reader said, “it is my opinion that China holds all of the cards and I believe they will likely play some of them early in the next U.S. administration” – this because of China’s role in financing the U.S. deficits by investing in Treasuries. This may be true in the long run, although of course China cannot try to damage the U.S. economy without also crippling its own export-dependent economy. More immediately, though, China is facing an old-fashioned slowdown of its own.

All Things Considered did a story this past week on the impact of the global slowdown on Chinese exporters. One figure jumped out at me: 80% of the toy factories in Guangdong province have closed.

Also, the Baltic Dry Index, a measure of bulk cargo shipping costs and hence of global demand for heavy stuff (largely commodities) has fallen off a cliff this year (see the second chart in that post) – one reason why the Shanghai Composite Index is down more than 60% this year.

China is a place I won’t claim to understand. But as we all know, the Chinese government relies on an unsteady equilibrium in which it uses economic growth to legitimize the political system and convince the growing middle classes not to question the political order. Tocqueville’s observation (which I alluded to in my previous post) about the tendency of political strife to arise not out of prolonged abject misery, but when increasing expectations are dashed, could turn out to be particularly appropriate for China.

Update: Thanks to Randy for his comment (below). I fixed the error regarding the Baltic Dry Index.

Update: The Economist has a post with almost the same title as this post – but no question mark.