China’s Empty Threat

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Dean Baker
The Guardian Unlimited
, March 30, 2009

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

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

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

In other words, if Mr. Wen was threatening to stop buying dollar denominated assets, and therefore let the yuan rise against the dollar, he is threatening to do exactly what the U.S. government has been demanding that China do. He will stop “manipulating” China’s currency – deliberately intervening in the market to keep its value from rising.

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

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

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

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

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

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

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

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


Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of Plunder and Blunder: The Rise and Fall of the Bubble Economy. He also has a blog on the American Prospect, "Beat the Press," where he discusses the media's coverage of economic issues.