The Greek government owes more than it can afford to pay, now or in the near future, at market interest rates.  There are two options: reduce the payments through some form of restructuring, or move the debt into the hands of people who are willing to charge below market rates for the foreseeable future.

In this decision, the International Monetary Fund has relatively little say – this is really a political decision to be made by the European Union, with discrete backing from the US and China.

While the EU leadership is surely tired of Greek politicians at this point, they also fear greatly the implications for other eurozone countries if Greece says it can’t pay or won’t pay.  The realization that spreads on Spanish government debt will rise sharply concentrates the mind wonderfully. 

And the damage would not be limited to Spain – do not underestimate the smugness with which the eurozone has completely and utterly failed to prepare for any kind of sovereign default.  The lack of loss-absorbing capital in major European banks is a first-order scandal that could bring down governments.

Fortunately for the undeserving European policy elite, the IMF has plenty of money it can lend at low rates and the Europeans have plenty of votes at the IMF.  The IMF can also access considerably more funding as needed, with the agreement of the United States – which really does not want another short-term shock to the world economy.  And funding is available from China and other emerging market countries with large stockpiles of foreign exchange reserves.

China has every interest in making sure that the euro survives and prospers as a major reserve currency – to make sure that, over a longer period of time, the US dollar will decline as the primary place in which to hold public and primary rainy day funds.

The IMF will do as it is told by its major shareholders: help to refinance Greece, effectively protecting creditors and eurozone politicians to the fullest extent possible.

An edited version of this post appeared this morning on the NYT.com’s Room for Debate; it is used here with permission.

Most accounts of the ministerial meeting last weekend of the Group of 20 — 19 nations plus the European Union that represent the world’s wealthiest economies —implied that it continued to perform sterling service – heading off currency wars, keeping explicit protectionism under control and deftly managing the process of reforming governance at the International Monetary Fund.

Post-financial crisis, middle-income countries continue to rise in economic importance, and the recent shift in global leadership from the Group of 7 (the United States, Canada, Britain, Italy, France, Germany and Japan) to the G-20 is commonly supposed to accommodate the growing claims of “emerging markets” on the world stage.

This interpretation is correct as far as it goes, but it also misses the main story, which is that emerging markets have two primary goals that are increasingly at odds with each other. These goals – to hold large stocks of American dollars and to stave off a flow of capital from abroad – add up to wanting to retain the emerging markets’ recently achieved status of collective net creditors (i.e., being owed more than they owe). Unfortunately, this contributes to the serious vulnerability of the world economy as we head into the next credit cycle.

Emerging markets want to hold onto – or increase further – the vast stock of foreign exchange reserves that they have recently accumulated through current-account surpluses. In part these assets are a buffer against future shocks, but the countries now hold much more than they would need for purely precautionary purposes – China alone acknowledges holding around $2.5 trillion, much of which is presumably in American dollars.

Increasingly, emerging markets think about using the value of these reserves (or what they could buy with them) in a broader manner. They enjoy the status and power that comes with being a net creditor to the system – rather than a net debtor, as in the past (which involved periodic crises, loans with unpleasant conditions from the International Monetary Fund and having to be deferential to the United States when times were tough and so on).

They even begin to think about forming the basis for a new monetary arrangement that is less dependent on the dollar – since the 2008 financial crisis, both the Russians and Chinese have spoken in public about this objective, and it is shared in private by most policy-makers outside Europe and the United States.

The “reserve currency” status of the dollar means just that – private and public sector investors around the world hold their rainy-day funds in dollars. Traditionally, at least, this arrangement has been seen as a major economic advantage and source of political power for the United States.

Emerging markets want to discuss moving reserves into a basket of currencies, presumably involving some Chinese renminbi, Indian rupees, Russian rubles and Brazilian reals (the four Rs), among other currencies.

But this is where tension with the second goal enters the picture. Most emerging markets – including those with the four Rs – do not want to allow their currencies to appreciate, and they are also unwilling to take other measures (like cutting fiscal spending) that would be likely to hold back appreciation in some instances (Brazil, in particular, takes this stance). Instead they are imposing capital controls to prevent inflows.

The controls are unlikely to prove fully effective, but they do slow the appreciation for now – and they also send a very clear signal: Foreign investors will be treated at a differential disadvantage when the chips are down.

Ask an Indian executive whether she is thinking about investing in Brazil and the answer is an unequivocal yes. But ask whether she or her policy-making colleague would like to hold reserves in reals and the answer is also quite frank: no, thank you.

Emerging markets will continue to save for a very rainy day (or a bright unspecified future) – in dollars. They intervene to keep their exchange rates relatively depreciated and will try to run current-account surpluses for as long as they can. This behavior pushes down long-term interest rates in the United States, relative to what those would be otherwise.

And – here’s the kicker – very low interest rates in the United States contrast sharply in the minds of yield- and risk-seeking investors with the situation in Brazil, where you are now offered 11 percent interest rates.

In other words, the global credit machine in this part of its cycle takes savings from emerging markets, runs them through the United States, and – at the margin — plows them back into emerging markets. Dollars are bought up through central bank intervention and – you guessed it – funneled back into the United States. The Institute for International Finance, which represents global banks, just revised upward its estimate of capital flows into emerging markets this year.

This is exactly the kind of issue – inherently cross-border and very political – for which a structure like the G-20 is needed. But it will do nothing about these flows for three reasons:

1. The emerging markets want to save in this fashion, thinking they can dodge the consequences.
2. The United States needs to borrow, big time. Our politicians refuse even to think about the first-order causes of our recent fiscal disaster; they would rather just continue to borrow (at least as long as interest rates remain low).
3. The big banks like this approach. Their influence is in no way diminishing, and there is nothing about their recent track record that has diminished their appeal in the eyes of policy-makers (just this week, for example, the I.M.F. appointed a senior Goldman Sachs executive to head its high-profile European Department).

Accommodating emerging markets in global governance structures is appealing; their aspirations are legitimate, and the G7 looks outmoded. The profound instability of global financial structures and the broader “doom cycle” today is not the fault of emerging markets – the blame lies squarely with the United States and Western Europe, which have consistently failed to rein in their global megabanks.  (For an 8-minute primer on the “doom cycle,” if you are not familiar with the concept, try this video.)

The argument that the global savings glut, largely from emerging markets, was a major driver of the 2008-9 crisis is tenuous at best. But there is no question of a dissonance within the current policy goals of emerging markets – and this is not helpful to financial stability moving forward.   Most likely it helps feed – or otherwise becomes central to – the next financial frenzy.  And there is nothing the G-20 can or will do about it.

An edited version of this post appeared this morning 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.

The G20 communiqué, released after the Toronto summit on Sunday, made it quite clear that most industrialized countries now have budget deficit reduction fever (see this version, with line-by-line comments by me, Marc Chandler and Arvind Subramanian).  The US resisted the pressure to cut government spending and/or raise taxes in a precipitate manner, but the sense of the meeting was clear – cut now to some extent and cut more tomorrow.

This makes some sense if you think that the global economy is in robust health and likely to grow at a rapid clip – say close to 5 percent per annum – for the foreseeable future.  With high global growth, it will matter less that governments are cutting back and unemployment will come down regardless.  Taking this into account, the IMF is actually predicting (as cited prominently by the G20) that budget “consolidation” actually raise growth over a five-year horizon.

There is no question that some weaker European countries, such as Greece, Portugal, and Ireland, had budget deficits that were out of control.  Particularly if they are to pay back all their foreign borrowing – a controversial idea that remains the conventional wisdom – these countries need some austerity.  But what about those larger countries, which remain creditworthy, such as Germany, France, the UK, and the US?  If these economies all decide to reduce their budget deficits, what will drive global growth?The answer in Toronto was obvious: China.  China is only about 6 percent of the world economy, measured using prevailing exchange rates, but it has a disproportionate influence on other emerging markets due to its seemingly insatiable demand for commodities.  It also has a relatively health fiscal balance – and its fiscal stimulus, working mostly through infrastructure investment, did a great job in terms of buffering the real economy in the face of declining world trade in 2008-09.

Now, however, the Chinese government is trying to slow the economy down – there is fear of “overheating”, which could mean inflation or rising real wages (depending on who you talk to).  Chinese economic statistics are notoriously unreliable, so reading the tea leaves is harder than for some other economies, but most of the leading indicators suggest that some sort of slowdown is now underway.

The G20 knows this, so the bet is that China will pull off a “soft-landing”, with growth staying in the region of 8-9 percent.  China’s recent exchange rate appreciation against the dollar does not help in this regard, and this is one reason why pressure for further appreciation from other governments is likely to remain muted.  Even the United States, above all, wants a robust China.

Talking to Chinese experts – I was in Beijing over the weekend – there are three major worries.

1)      There is already a great deal of wasteful investment in infrastructure.  At some level, there is a desire to clean this up and make it more sensible.  This implies slower growth.

2)      There is much discussion of “overcapacity” in the state sector.  Again, there is interest in addressing this – although it is not an easy problem.  In any case, this further lowers the incentive for state investment both directly and through various forms of subsidies to government-backed enterprises.

3)      The incentives for local government officials have been heavily weighted towards boosting GDP growth; they move up (and presumably down) the government and party hierarchy based on how they do in this dimension.  There is now a great deal of thinking that it would be better to also include other objectives, such as impact on the environment.  This makes sense – air and water quality are hot issues – but it would also imply slower growth.

China’s reported GDP numbers are likely remain robust – the reported statistics are very much part of the broader government management process.  But the economy could still slowdown in ways that would impact commodity prices – these are the key variables to watch, including for energy and metals used in industrial production (e.g., for the link to Latin America, see the NYT today).

The irony, of course, is that China is also a leading candidate to be at the epicenter of the next boom.  In a sense this is what the G20 would like, unless the boom becomes debt-based and unsustainable, as in emerging markets during the 1970s or Japan in the late 1980s.

The G20 is betting that China can keep its growth high enough to sustain the global economy while also not getting drawn into some sort of bubble – particularly one that would involve big Western banks.  Given the nature of China and the volatility of global capital flows – international investors love you without limit, until the moment they leave you – this is quite a bet.

We should also not overestimate the ability of the Chinese government to fine tune its economy.  To be sure, the authorities have done well both in terms of high average growth and in terms of managing the impact of regional and global cycles over the past 20 years.  Can they really do so well indefinitely?

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

China is the largest holder of official foreign currency reserves in the world, currently estimated to be worth around $2.4 trillion – an increase of nearly $500 billion in the course of 2009 (on the back of a current account surplus of just under $300 billion, i.e., 5.8 percent of China’s GDP, and a capital account surplus of around $100 billion).  These reserves are accumulated through arguably the largest ever sustained intervention in a foreign exchange market – i.e., through The People’s Bank of China buying dollars and selling renminbi, and thus keeping the renminbi-dollar exchange rate more depreciated than it would be otherwise. 

China is also currently the second largest holder of US Treasury Securities – at the end of December 2009, it held $755.4 billion – just behind Japan (which had $768.8 billion).

The US Treasury data almost certainly understate Chinese holdings of our government debt because they do not reveal the ultimate country of ownership when instruments are held through an intermediary in another jurisdiction.

For example, UK holdings of US debt rose during 2009 from $130.9 billion to over $300 billion, despite the fact that the UK ran a substantial current account deficit last year.  A great deal of this increase may be due to China placing off-shore dollars in London-based banks (Chinese, UK, or even US), which then buy US securities.  China may also purchase US securities through other routes. 

China is presumed by most observers to hold the majority of its incremental reserve accumulation in US Treasuries – this makes sense given that the other potential reserve currencies (euro, yen, and pound) all have serious issues – but according to the official US data, Chinese holdings peaked at $801.5 billion in May 2009 and fell by about $50 billion during the remainder of the year.  A modest fall in true Chinese Treasury holdings – given slower reserve accumulation in December and the likely desire to diversify – is not completely implausible.  But there are no indications that China is moving out of Treasuries in any large scale manner. 

While the exact amount is not knowable based on publicly available information, a reasonable working assumption would be that China owns close to $1 trillion of US Treasury securities, i.e., perhaps half of the stock of treasuries in the hands of “foreign official” owners, which was $2.374 trillion (at the end of 2009, with the important caveat that other governments may also hold Treasuries through circuitous routes) and just under 1/7 of all US government securities outstanding ($7.27 trillion, of which $3.614 trillion was held by all foreign owners, official and private, at the end of 2009).

There is a perception that China’s large dollar holdings confer upon that country some economic or political power vis-à-vis the United States and, in particular, that Chinese reserves prevent us from putting pressure on that country’s authorities to revalue (i.e., appreciate) the renminbi.  This view is incorrect and completely misunderstands the situation.

It is in the interests of both the United States and global economic prosperity that China discontinues its massive intervention in the market for renminbi.  This intervention is a breach of China’s international commitments (as a member of the International Monetary Fund) and constitutes a form of unfair trade practice.

If China were to end its intervention, the renminbi would appreciate substantially – likely in the region of 20-40 percent.  China would also stop accumulating dollars (and other foreign assets). 

The primary effect would therefore be an effective depreciation of the US dollar against the Chinese renminbi – and against all other countries’ currencies that are implicitly pegged to the renminbi (more precisely, to the dollar rate with an eye on China’s competitiveness).  On a trade-weighted basis – and in real effective terms (despite the fact that the currencies of our other major trading partners float freely) – the dollar would also likely fall in value.

Such a movement in the dollar would help expand our exports and improve our ability to compete against imports; this would aid in the process of recovery, job creation, and broader adjustment in the US economy.  Even a substantial movement in the dollar – e.g., a 20 percent depreciation in real effective terms, which is most unlikely – would have no noticeable effect on inflation and therefore would not force the Federal Reserve to increase interest rates.  The “hard landing” scenario for the dollar – feared by analysts since the traumatic experiences of the 1970s – is unlikely for the US today, given the low level of inflation expectations and the high “output gap” (reflected in measured unemployment near 10 percent and true unemployment of at least 15 percent). 

The effect on short-term US interest rates would therefore likely be minimal or nonexistent, particularly as the Federal Reserve currently aims to keep rates close to zero.  The effect on longer-term US interest rates would also be small – and could be offset by the Federal Reserve, as it currently seeks to limit all benchmark interest rates (most recently affirmed by Chairman Bernanke this week).

In fact, the current stance of monetary policy – and the low, stable level of inflation expectations in the United States – makes this an ideal moment at which to press China to revalue its currency.

In another potential scenario, there is concern that China would threaten to reduce its purchases of US government securities without allowing its currency to appreciate.  But if China continues to intervene to maintain its currency peg, it will accumulate foreign reserves – so they need to hold increasing amounts of foreign assets of some kind.  What else would the Chinese authorities buy?

1. If they buy other dollar denominated assets issued by US entities, this would push down spreads on those assets relative to Treasuries.  This would directly help private US borrowers – thus stimulating growth in the US.
2. If they directly buy dollar denominated assets issued by non-US entities, this will still reduce spreads more broadly and help US borrowers – as there is a global market for dollar assets and there is not much high grade non-US dollar debt available for sale.
3. If they buy dollar equities – which is most unlikely – this would help the stock market, household balance sheets, and firms’ access to funding (as well as helping to shift our economy from debt to more equity financing, which would a desirable move in any case.)
4. If they buy non-dollar assets, given that the Fed will keep interest rates near to zero, this will push down the value of the US dollar and help boost US growth.  Such a move would produce protests from the eurozone and Japan, but this change in currency value would be solely China’s responsibility.

If China stops buy foreign assets altogether, this would of course be equivalent to ending foreign exchange intervention.  This is exactly the policy change that we should be seeking.

In addition, there are significant potential losses – in terms of net foreign assets – for China if their authorities sell Treasuries or otherwise undermine the value of the dollar (or intentionally roil markets) with negative comments.  A depreciation of the dollar directly reduces the value of their foreign holdings and does not, under current circumstances, pose any kind of threat to the US.

There is still an open question of how best to push China to revalue the renminbi.

1. Bilateral negotiations, as championed for example by former Treasury Secretary Paulson, have achieved essentially nothing since 2002.  This is not a promising way forward.
2. The International Monetary Fund (IMF) has proved itself incapable of calling China to account.  The IMF’s much vaunted “Surveillance Decision” is a failure and the general Fund mandate of “multilateral surveillance” has (again) proved to be a paper tiger.  Working with the IMF on this issue is not worth any additional effort by the US government.
3. China is obviously a currency manipulator and should be so labeled by the US Treasury in its next report to Congress.  China’s threat to react by selling Treasuries is – as explained above – at worst a bluff and at best a way to help the US with a depreciation of the dollar.  This bluff should be called.

This, of course, raises the issue of what the US should do beyond applying labels.  Bilateral trade sanctions are never a good idea and can easily get out of hand.  Given the failure of the existing multilateral mechanisms around the IMF, the US should take up this issue at the level of the G20 – there are two summits of leaders this year and plenty of support around the world for addressing China’s exchange rate.

The most plausible proposal is to expand the mandate of the World Trade Organization – which should operate in this respect without the involvement of the IMF – in assessing exchange manipulation on the same basis as it deals with unfair trade practices (as proposed by Mattoo and Subramanian).  While full implementation for such a rearrangement of responsibilities would take some years, concrete moves in this direction would concentrate the minds of the Chinese authorities in a potentially constructive manner.

——-

The remainder of this testimony deals with our broader economic baseline.  Exchanges with Joe Gagnon were most helpful in preparing all this material.

First, there’s been a lot of talk about the “lost decade” for stocks. The S&P 500 is below where it was a decade ago. Dividend yields bring you back up to break-even (the Vanguard Total Stock Market Index Fund had average annual returns of 0.18% for the ten years through the end of November, and that’s after about 0.1% in expenses), but inflation sets you back a couple of percentage points per year. (Vanguard’s S&P 500 index fund, however, was negative over those ten years.) James Hamilton, drawing on data from Robert Shiller, has some thoughts on why the stock market did badly; the fundamentals were so-so, but the big factor was that valuations were at their historical peak at the beginning of the decade.

For me, the worrying thing about investing in stocks is not specifically the high price-earnings ratio. It’s the fact that in the 1990s, everyone started saying that stocks were the best long-term investment, because “over any thirty-year period ever stocks do better than any other asset class.” That’s not a direct quote, but I’m sure you can find hundreds that are virtually the same. There are two problems with this statement. The first is that it’s assuming the future will be like the past. But the bigger problem is this: if everyone thinks that X is the best long-term investment, then it probably isn’t, in part because enthusiasm about X will drive the price of it up. I believe people were saying roughly the opposite in the late 1970s, and look what happened in the next twenty years.

That said, I’m no investment genius, and I have a fair proportion of my money in equity index or near-index funds. But the general point is that when everyone agrees on an investment strategy, they are probably wrong.*

Second, there’s been a lot of China boosterism in the past year or so, as the Chinese economy has returned to growth and its stock market has soared. The Times had an article today on the topic. I’m far from an expert here, but wasn’t the government basically ordering state-owned banks to  lend money cheaply and without asking too many questions? Aren’t Chinese economic statistics so bad that economists use electricity consumption as a proxy for GDP? Haven’t we seen this movie before all over emerging markets around the world?

I think some of the U.S. press coverage of China reflects our pessimism about ourselves; in that sense, it reminds me of the idolization of Japan that took place in the 1980s. Of course, there are huge differences. The Chinese economy has nowhere to go but up, and with over 1.3 billion people its economy will surpass ours in gross output in my lifetime. (On a per capita basis, though, I don’t think that will happen in my daughter’s lifetime, even if there is a Chinese immersion charter school down the road here in Western Massachusetts.) But just as the United States is not on the brink of world-historical disaster, so everything is not perfect in China.

* What’s the right grammar here? I know “everyone” is singular, but are you really supposed to say “when everybody agrees on an investment strategy, he is probably wrong”?

By James Kwak

“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

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.

“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

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

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

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

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

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

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.

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.