Money Wars: Beating up on Beijing? (Part 2)

Chinese banknotesJohn Isbister, the author of Promises Not Kept: Poverty and the Betrayal of Third World Development (Kumarian Press, 2006), responded to Conn Hallinan’s essay in an email which we reproduce here.

The United States is blowing hot and cold on this issue at the same time, for an additional reason beyond those that Conn cites.

The U.S. federal government is running a huge deficit. Where does it get the funds to finance that deficit? From borrowing, or selling bonds. Who buys the bonds? There are two possibilities — U.S. residents or foreigners.

If U.S. residents buy them, this reduces the funds available for domestic private investment, which in turn hurts economic growth. As it turns out, however, U.S. investors are not much buying these bonds. Foreigners are buying them. But not just any foreigners. In fact, almost no foreigners.

If you look at U.S.-dollar-denominated assets as an investment, they are pretty crummy. Because of the huge foreign trade deficit, the only direction the U.S. dollar has to go is down. Would you buy an asset where downside movement was likely, and upside movement extremely unlikely? That’s right, you wouldn’t.

It turns out that virtually the only foreigners buying U.S. bonds are the central banks of China and Japan, maybe a bit from South Korea. Why are they doing it? Not because they think the value of the dollar is going to appreciate and they will make a killing. Rather, by selling their currency, and buying U.S. currency, they keep the value of their own currency relatively low, and the value of the U.S. currency relatively high. This in turn, as you explain, helps their exports, which in turn are one of the drivers of their economic growth.

Suppose this system stopped. Suppose the United States still runs a big government deficit, but the Chinese refuse to finance it. There are several possibilities, but the most likely, in my view, is that the current account deficit would be brought into balance by a huge decline in the value of the U.S. dollar. This would give us massive stagflation, 1970s style — and worse. Foreign goods, including investment goods, would be much more expensive. This would reduce real economic activity in the United States, while leading at the same time to massive inflation.

In other words, the United States can talk all it wants about how irresponsible the Chinese are in manipulating their currency. But if the Chinese ever stopped doing it, at the same time that the United States is running a big deficit, the U.S. economy would explode. Right now, the Chinese are saving our bacon — no one else is willing to do it.

Incidentally, this whole issue was and I think still is a matter of controversy in many university economics departments. Some of the more right-wing members think there is no problem, that the Chinese are essentially trapped. They have to keep propping the dollar up, not only to keep their exports growing, but also to maintain the value of their dollar-denominated assets. Many other economists think the opposite, that at some point the Chinese are going to stop throwing good money after bad, and will allow the exchange rate to adjust. And this, in turn will have the catastrophically bad effects on the US economy
that I just described.

John Isbister is the Dean of Humanities and Social Sciences at Laurentian University in Sudbury, Ontario, Canada.