May 26, 2005

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China's dollar policy and a dose of reality

Or don't believe everything you read in the New York Times (like you needed me to tell you that).

With apologies to Billmon.

Paul Krugman, I've two people and some facts for you to meet.

From J.K. Galbraith's The Affluent Society, Chapter 2 (The Concept of the Conventional Wisdom):

"We associate truth with convenience, with what most closely accords with self-interest and personal well-being or promise best to avoid awkward effort or unwelcome dislocation of life. We also find high acceptable what contributes most to self-esteem. [Economic and social behaviours] are complex, and to comprehend their character is mentally tiring. Therefore we adhere, as though to a raft, to those ideas which represent our understanding."
Just setting the stage. Conventional wisdom is often created by experts who can make "facts" fit prejudices. It becomes widely accepted because in this age of specialisation who has the time, the wherewithal and the patience to do the research to challenge a theory that seemingly fits the facts. Especially if it has the imprimatur of the New York Times to boot.

Via TPD and Saru, Paul Krugman expounding the conventional wisdom of China's dollar purchases:

Here’s how the U.S.-China economic relationship currently works:

Money is pouring into China, both because of its rapidly rising trade surplus and because of investments by Western and Japanese companies. Normally, this inflow of funds would be self-correcting: both China’s trade surplus and the foreign investment pouring in would push up the value of the yuan, China’s currency, making China’s exports less competitive and shrinking its trade surplus.

But the Chinese government, unwilling to let that happen, has kept the yuan down by shipping the incoming funds right back out again, buying huge quantities of dollar assets – about $200 billion worth in 2004, and possibly as much as $300 billion worth this year. This is economically perverse: China, a poor country where capital is still scarce by Western standards, is lending vast sums at low interest rates to the United States.

Yet the U.S. has become dependent on this perverse behavior. Dollar purchases by China and other foreign governments have temporarily insulated the U.S. economy from the effects of huge budget deficits. This money flowing in from abroad has kept U.S. interest rates low despite the enormous government borrowing required to cover the budget deficit.

Low interest rates, in turn, have been crucial to America’s housing boom. And soaring house prices don’t just create construction jobs; they also support consumer spending because many homeowners have converted rising house values into cash by refinancing their mortgages.

Now Mr Kurgman, meet Jake van der Kamp and the facts. I will repost from my Blame Japan entry:
Yes, these pundits from New York do not come to us one at a time. If we had barter trade - goods exports from China to the US against hot air exports at $1 per breath from the US to China - it would be the US that runs a big trade surplus with China, not the other way round.

Mr Krugman's point is the obvious one about how the balance of payments must balance. All those US dollars that China takes in from its big trade surplus must be invested somewhere outside of China. They are not invested in China because, if they were, China would not have a trade surplus.

And it is easy to see where that money is going, he argues. It is going into purchases of US government debt. Without this inflow to alleviate the pressure of a huge fiscal deficit, US interest rates would already be sharply up and they soon will be if China can no longer generate a big trade surplus.

Mr Krugman, do me a favour. Look at the second chart [at this link]. It shows that the big buyer of US government debt paper in recent years has been Japan, not China. Your own government's figures show that China's net purchases of Treasury bills, bonds and notes since that warmonger in the White House took office in 2001 amounts to less than 5 per cent of his blow-out in federal debt securities.

It was Japan that almost single-handedly took care of his growing fiscal deficit for more than two years until the end of last year.

But notice also that Japan has now grown tired of the game. It is buying no more. It wants out. If you now start to feel those painful withdrawal symptoms, Mr Krugman, look a little east of China for the reason.

I report. You decide.

posted by Simon on 05.26.05 at 02:56 PM in the


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Krugman won the Clark Medal, so you’ve got to assume he’s a competent economist even if you don’t like his politics. I’ve heard him mention the Bank of Japan several times, but that column you quote was written just recently, now that Japan has stopped buying.

In 2004 China’s reserves increased by more than Japan’s. The way the Chinese buy is not transparent, so the US figures don’t tell you the whole story. They buy through intermediaries in London, and they buy debt already held outside the States.

They have a huge current account surplus. If they aren’t buying dollars, what are they buying?

posted by: Harry Hutton on 05.29.05 at 04:18 PM [permalink]

My problem is Krugman's allowed politics to get in the way of the facts. The ways the Chenese buy are as transparent as the Japanese - all of these holdings are closely tracked by the Federal Reserve because all Central banks hold accounts with the Fed to hold their Treasury and Agency securities.

It's not that I doubt Chena has played some role - it's that Japan has played an even larger one, yet is not the target of any protectionist pressures. As I said, the Yen is tightly capped as well, just not officially.

BTW - Japan hasn't stopped buying. They've scaled back their purchases, but they've not stopped. If the Yen starts strengthening again, watch their purchases skyrocket.

posted by: Simon on 05.30.05 at 10:18 AM [permalink]

Great post. I hadn't seen the data for Treasuries presented in that way before. And you're right about the Japanese playing a huge role in keeping the dollar up and interest rates down. But I think we should make a distinction between dollar purchase and treasury purchases. One big differentiation between Japan and China is that the Japanese exchange rate is (ostensibly) floating. The BOJ has not intervened in the FX market since March of last year, which would probably explain the drop in their purchases of treasuries, as indicated in the graph you posted (b/c of less dollars to buy them with). If there is upward pressure on the RMB, then China has to purchase dollars to hold the peg. They may not dump those dollars into Treasuries, but they are sure buying like crazy. I don't have any data on hand, but if you can get a look at Chinese holdings of FX, you will quickly see what I'm talking about. What effect that might have on U.S. interest rates is something I'm not qualified to answer.

posted by: Saru on 06.11.05 at 04:23 AM [permalink]

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