The Chinese Connection

Stories about the new Treasury report condemning China’s currency
policy probably had most readers going, "Huh?" Frankly, this is an
issue that confuses professional economists, too. But let me try to
explain what’s going on.

Over the last few years
China, for its own reasons, has acted as an enabler both of U.S. fiscal
irresponsibility and of a return to Nasdaq-style speculative mania,
this time in the housing market. Now the U.S. government is finally
admitting that there’s a problem – but it’s asserting that the problem
is China’s, not ours.

And there’s no sign that anyone in the
administration has faced up to an unpleasant reality: the U.S. economy
has become dependent on low-interest loans from China and other foreign
governments, and it’s likely to have major problems when those loans
are no longer forthcoming.

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

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.

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.

So why is
the U.S. government complaining? The Treasury report says nothing at
all about how China’s currency policy affects the United States – all
it offers on the domestic side is the usual sycophantic praise for
administration policy. Instead, it focuses on the disadvantages of
Chinese policy for the Chinese themselves. Since when is that a major
U.S. concern?

In reality, of course, the administration doesn’t
care about the Chinese economy. It’s complaining about the yuan because
of political pressure from U.S. manufacturers, which are angry about
those Chinese trade surpluses. So it’s all politics. And that’s the
problem: when policy decisions are made on purely political grounds,
nobody thinks through their real-world consequences.

what I think will happen if and when China changes its currency policy,
and those cheap loans are no longer available. U.S. interest rates will
rise; the housing bubble will probably burst; construction employment
and consumer spending will both fall; falling home prices may lead to a
wave of bankruptcies. And we’ll suddenly wonder why anyone thought
financing the budget deficit was easy.

In other words, we’ve
developed an addiction to Chinese dollar purchases, and will suffer
painful withdrawal symptoms when they come to an end.

I’m not
saying we should try to maintain the status quo. Addictions must be
broken, and the sooner the better. After all, one of these days China
will stop buying dollars of its own accord. And the housing bubble will
eventually burst whatever we do. Besides, in the long run, ending our
dependence on foreign dollar purchases will give us a healthier
economy. In particular, a rise in the yuan and other Asian currencies
will eventually make U.S. manufacturing, which has lost three million
jobs since 2000, more competitive.

But the negative effects of
a change in Chinese currency policy will probably be immediate, while
the positive effects may take years to materialize. And as far as I can
tell, nobody in a position of power is thinking about how we’ll deal
with the consequences if China actually gives in to U.S. demands, and
lets the yuan rise.