America’s Chinese disease (not quite what you think)

Fed chairman are expected to speak in code, so that reading their remarks is a bit like watching the famous scene in Annie Hall where the conversation between the lovers is subtitled with what they’re really saying. So when Ben Bernanke says this:

Another set of lessons that Asian economies took from the crisis of the 1990s may be more problematic. Because strong export markets helped Asia recover from that crisis, and because many countries in the region were badly hurt by sharp reversals in capital flows, the crisis strengthened Asia’s commitment to export-led growth, backed up with large current account surpluses and mounting foreign exchange reserves. In many respects, that model has served Asia well, contributing to the rapid growth rates in the region over the past decade. In fact, it bears repeating that evidence from the world over shows trade openness to be an important source of economic growth. However, too great a reliance on external demand can also pose problems. In particular, trade surpluses achieved through policies that artificially enhance incentives for domestic saving and the production of export goods distort the mix of domestic industries and the allocation of resources, resulting in an economy that is less able to meet the needs of its own citizens in the longer term.

the subtitle reads


But does the United States dare put pressure on the Chinese to do that? People constantly say that we can’t risk it — that we’re dependent on China to keep buying our debt. Yet this is all wrong under current circumstances.

How do I know it’s all wrong? Here’s one way to think about the issue that I haven’t seen anyone else put forth (if they have, I’ll be happy to give credit.)

Right now, we’re in a situation in which conventional monetary policy is hard up against the zero lower bound; rules of thumb that track past Fed behavior suggest that the short-term interest rate should be -5% or lower. To partially make up for its lack of traction, the Fed is engaged in massive “quantitative easing” — a misleading term, but I guess we’re stuck with it. What it basically means is that the Fed is selling Treasury bills or their equivalent (interest-paying excess bank reserves are essentially the same thing), while buying other assets, expanding its balance sheet enormously in the process.

What kinds of other assets? Mortgage-backed securities; securities backed by credit-card debt; longer-term government debt; etc..

One type of asset the Fed has not been buying is foreign short-term securities. But that’s not because such purchases would be ineffective. On the contrary, selling domestic short-term debt and buying its foreign-currency counterpart is the essence of a sterilized foreign-exchange-market intervention, which is a time-honored way of gaining a competitive advantage and helping your economy expand.

And some countries have, in fact, made foreign-currency purchases a part of their quantitative easing strategy — Switzerland in particular. The only reason the Fed isn’t doing this is that we’re a big player, and can’t be seen to be pursuing a beggar-thy-neighbor strategy.

But now ask the question: what would the effect be if China decided to sell a chunk of its Treasury bill holdings and put them in other currencies? The answer is that China would, in effect, be engaging in quantitative easing on behalf of the Fed. The Chinese would be doing us a favor! (And doing the Europeans and Japanese a lot of harm.)

Conversely, by continuing to buy dollars, the Chinese are in effect undermining part of the Fed’s efforts — they’re conducting quantitative diseasing, I guess you could say, hence the title of this post.

The point is that right now the United States has nothing to fear from Chinese threats to diversify out of the dollar. On the contrary, if the Chinese do decide to start selling dollars, Tim Geithner and Ben Bernanke should send them a nice thank-you note.

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Wise points professor – time permitting, could you please de-brief on some of your observations in Seoul and perhaps the panel with Taleb ? Were the attendees inscrutable or talkative ?

That kind of favor, deserves more than just a thank-you note.

But Paul, don’t you know that inflation is a fate worse then death?

You scare me.

– not because I didnt laff heartily on your ” quantitative diseasing ” (now THATS a funny bit of freakonomical contrarianism if there ever was one!) Luv the idea of us all benefiting from our profligate,promiscous, supersized consumerism.

What scares me is

The real SOURCE problem here is the institutions, pension funds, college endowments, governments etc who bought and continue to buy worthless derivatives and paper junk which enables this enormous leveraging.

If they stopped buying it, the whole thing would unwind.

And you tell me this govt is focusing on the junk!

Isn’t this more of a situation where a little rain is good and a big rain has a flash flood risk?

“Fed chairman are expected to speak in code, ”

Why? Did they do that before Greenspan?

Are tactics/strategies suitable for a ticker tape technology still suitable and optimal in a 24×7 Internet era?

Who benefits from this intentional lack of transparency, and who is hurt?

But what about all the conservatives who will throw a hissy fit over the relative decline of the dollar?

Thank you Dr. Krugman for this post. I think that both
level of consumption and industrial employment will have to be rebalanced between China and US in coming years.
We need to see revaluation of Yuan and its implications from all possible angles.


What we need is that the Chinese start buying US made products and services at an “additional” rate of $150 Billion per year….


That would put the US at a slight surplus mode, help the dollar and increase the value of the USD dominated securities held by China….

This is a win-win solution when the US economy needs exports most.

All this is correct, but it’s short-term thinking.

A major dive of the dollar would hurt the Chinese investments in Treasuries to the point, where they would publicly declare it a misinvestment.

Once the US is seen publicly as an unsafe destination for foreign funds, it will live with this stigma forever after.

The dominant role of the dollar would be over, the financial industry would lose foreign customers and the government’s lending costs would rise. Long term and irreversible.

In marketing they call that the power of the brand.

Predictably, Kudlow is braying to-nite about the demise of the dollar (says that’s why he’s wearing a black tie – which is just as blue as the set background), then bemoans Bernanke not mentioning the dollar even once in his speech today, then accuses the Obama administration of treating the U.S. like ‘just another C+ country’ in the world, then says Bernanke is just creating another speculative bubble.

Next up is the author of the Barron’s piece.

Hmmmm – if Kudlow’s getting red in the face, things must be looking up for us economically !

Dr Krugman, this is head spinning stuff.. can you write more on this topic please? Why does a stronger dollar not hurt the USA as much as a stronger currency hurts other countries? This is a very complicated balance it looks like. If China diversifies out of the dollar, we would pay more for gasoline and other imported goods right? Since America imports so much from China, how can a weak dollar be considered good unless we know precisely at what point the US economy will start producing things that we buy from China today?

(Please ignore the other post with a typo)

Great analysis once again!

Interesting, but on sterilized intervention… My take is that (portfolio effects duly acknowledged), sterilized intervention is generally believed to be ineffectual to actually change the path of the currency.

If I recall correctly (it has been some time and I do not have that great paper at hand), your model of currency crisis assumed a Central Bank doing sterilized intervention (under fixed rates, I know, but the ineffectiveness generalizes to floating rates as well) and eventually leading to the collapse of the currency.

That said, I agree with your view on China. Should they dump USTs, Tim and Ben should throw a party.

So will the Chinese “ever” be paid back by the US?
They know they will not, but they don’t really care.
What matters is that exports to the US helped them build a robust production base and that they are going to keep.
Or are they?
The majority of companies I think have R/D departments outside China and off-course sell outside China.
China is just a middle-man in the process, and that could change, maybe bringing Africa to the modern map.

US gave Chinese factories and in return they give the US products for free. It may not be a fully balanced deal but it is not that bad. I mean, if they start consuming they may get to keep some of the products for themselves.

I like. This is good piece founded on solid economics. I have not come across this argument before, and I’m yet again amazed by your ability to breakdown issues in simple terms. The only question in my mind now is: how will this play out in the real world where market reactions are not as straight forward as mental constructs.

Let’s see.


This doesn’t follow at all.

China would just be just passing the requirement to buy dollars sourced from the US current account deficit to somebody else within the foreign sector.

That’s got nothing to do directly with Fed quantitative easing. It’s just letting the foreign value of the dollar find a (presumably) more natural level.

While it is true that the Chinese selling T-bills is having the same easing effect as the Fed selling the dollar, the main difference is that in the former, the Fed gets nothing while in the latter, the Fed gets money to finance our spending. The fear of the Chinese diversification is less about the actual easing but is more about the implication of a less appetite for dollars and T-bills. Ben Bernanke would be terrified if the Chinese stop buying T-notes all together. What Ben wants is that the Chinese reevaluate their Yuan (and thus make the dollar cheaper) and yet they keep buying our T-bill (and hence, Tim Geithner implicitly assure the Chinese a stronger dollar).

I guess that means that China has been engaged in quantitative tightening of the US dollar up until now.

True, but is it not essential that China recycles the dollars it accumulates in the form of T bill or bond purchases? If not, how do we fund the trillion dollar deficits now and in the future?

The other thing that I don’t understand is this. The US in the past year has a saving rate in excess of 5 percent. That means the saving amounted last year to about more than 700 billion, and more likely more than a trillion. Doesn’t that mean that we pretty much financed more than 2/3 of last year’s federal deficit?

I’m soo not an economist. Can someone explain why Chinese selling UStreasuries would hurt Japan?

Apologies for sounding dumb but not being trained in economics, I am missing some links in your argument Dr. Krugman. I look at the situation as a three-country model (say) A – for America, C – for China and E – for Europe. Right now, the Fed is trying to put a lot of $ bills in the hands of Americans. The Chinese, by buying T-bills are sucking the $ bills away and putting it back in the Fed’s vaults (if I read the argument right). If C tried to diversify its foreign currency holdings, it would be putting lots of $ bills in the hands of E pushing the Euro’s value up which would hurt their exports. So far I follow. But how does this help A? The fact is that C is a net exporter and therefore it is debatable whether a weaker $ will cause C to start buying more goods from A or anyone else for that matter. The folks in C are habitual savers and it is hard to see a stronger local currency change that very much. At the same time, I don’t see why E should buy more from A. They can buy low-end goods from C and they make the high-end themselves. So where is the need for goods from A? The mix of exportables and their relative demand also have a role to play I think. If neither E nor C want goods made in A (for whatever reason), then whether the $ bills are lying in the Fed’s vaults or the ECB’s vaults ought not to make any difference. However, if there is some country that wants a lot of American goods then may be this flow of $ will somehow manifest itself in higher exports for A. But will it be enough to wipe out the big deficits already accumulated?

A’s best hope is to stimulate domestic demand such that it substitutes imports. Perhaps investing in TGV-type train systems between D.C., NY, Philly, Boston, etc. is one such avenue. It will create jobs – which is what the govt. wants. It may result in de-congesting the big cities (hopefully) pushing rents down which in turn would be good for inflation – this is something the Fed wants. It may also result in lower consumption of oil – which could reduce the import bill a great deal, and last but not least – it may improve productivity by reducing the time spent commuting. All in all, Keynes was right – well thought out public works programs do work.

China would not be doing the US a favor at all by selling a portion of its treasury holdings, because this would make future bond auctions by the Treasury department more difficult. We have an enormous deficit to finance- if China puts its UST holdings on the market, the supply of Treasury bonds goes up, their price goes down, and the yield the Treasury will have to offer will be much higher. This is crazy. The US has everything to fear from China diversifying out of the dollar.

It’s good to see more of the dots (finally) getting connected here. Could one even say that the whole recent boom and subsequent bust was due to undervalued Chinese currency?