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The Dangers of Financial Jujitsu

March 17, 2010
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Paul Krugman unleashes a broadside on Chinese exchange rate policies, calling out the Treasury Department to attack the yuan/RMB’s peg to the dollar. While some commentators believe China has the stronger bargaining position on the economy, Krugman rejects this argument.

What you have to ask is, What would happen if China tried to sell a large share of its U.S. assets? Would interest rates soar? Short-term U.S. interest rates wouldn’t change: they’re being kept near zero by the Fed, which won’t raise rates until the unemployment rate comes down. Long-term rates might rise slightly, but they’re mainly determined by market expectations of future short-term rates. Also, the Fed could offset any interest-rate impact of a Chinese pullback by expanding its own purchases of long-term bonds.

It’s true that if China dumped its U.S. assets the value of the dollar would fall against other major currencies, such as the euro. But that would be a good thing for the United States, since it would make our goods more competitive and reduce our trade deficit. On the other hand, it would be a bad thing for China, which would suffer large losses on its dollar holdings. In short, right now America has China over a barrel, not the other way around.

Krugman and others believe the US can use the momentum of China’s economic engagement with the United States against it as leverage in the currency dispute. But suppose China nevertheless refuses to depart from its weak RMB policy? Krugman reiterates the older call for a 25% tariff on Chinese goods until they see the light. Now, the economics of his whole argument for making this case are more shaky than they might appear at first. China has already allowed the yuan to appreciate several times at our behest.

If Krugman is right, or at least, if policymakers believe Krugman is right, then we are opening the door for much more than pressure on “currency manipulation.” Krugman’s essential argument is that China has an excessive current account surplus, which is preventing global recovery. However, many East Asian countries have current account surpluses, many due to a high savings rate. Of course the Chinese government is intervening through holding large amounts of foreign exchange, but perhaps China is learning from our mistakes. China has seen how low-savings European and American countries have put themselves deep into debt paying for their comfortable lifestyles and social safety nets, and China will have the challenge of constructing and paying for those along with financing its military. China has strong interests in choosing its economic strategy. They are interests uncongenial to ours, but salient nonetheless.

Krugman complains of China’s blatantly mercantile strategy, but what he proposes is nothing more than naked mercantilism in response. He is confident our blatantly mercantile policy will have no real unintended consequences. I am not so sure. I am no economist, but I am fairly confident China will do more than just play along to Krugman’s script. Yes, within the means of normal economic policymaking, that might be China’s fate. But China knows better than to follow our rules. China will not permit international humiliation that will diminish its prosperity, and the trade war that ensues, even if Krugman is right about the economics, will spill over. It will galvanize the already growing Chinese nationalist opposition to the United States. In a time where a majority of Chinese believe a Cold War is inevitable, pursuing a mercantile power struggle with China will undoubtedly trigger bigger problems. Chinese cooperation on Iran, North Korea, the environment, human rights or internet freedom will disappear, to the extent it already has.

China feels entitled to rise, and believes that they are doing a world a favor by making it a “peaceful rise.” Now, that has always been somewhat propagandistic and Chinese militarism and nationalism have always been possible. But China recognizes a peaceful rise is preferable to armed confrontations with the militarily dominant West. China does not want to stoke hatred towards the West or lose the peaceful economic avenue of ascendance that might engender violent nationalism and war. But beginning a trade war with China might unravel all that. After all, if American policymakers really believe we “have China over a barrel,” why not push for concessions on other issues? Increasingly, American policymakers will appear not to have a problem with China’s means, but its end of becoming a true world power. The Chinese government, whether to force the US to back down or to cope with internal discontent about the economy, will begin pursuing more confrontational, nationalistic policies. Krugman may be confident about the economics, but no policymaker who must concern himself about the broader issues of US-China relations and world politics should share his confidence or assertiveness.

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