Ape Man

If you follow Brad Setser, you know that he is very concerned about China’s policy of artificially lowering the value of the Yuan so as to subsidize their export sector. He has extensively argued that China’s policy poses grave dangers to the economic health of the US, China, and the world at large. He uses every chance he can get to argue that China should change its policy and that the US and the rest of the world should pressure China to do so.

As regular readers know, I am broadly sympathetic to his argument. But I think he puts too much of the blame on China. He should really turn his attention towards The Federal Reserves and start directing some of his ire towards them.

Don’t get me wrong. I want the Chinese to stop subsidizing its export sector by artificially lowering the value of Yuan just as badly as Mr. Setser. And as some of my previous posts have demonstrated, I can’t conceal my contempt for China’s irrational economic policy.

But I think that Mr. Setser puts too much stress on the artificially low value of the Yuan. To my mind, the real problem is that US interest rates are artificially low.

Of course, these two problems are not really separate. China cannot keep the Yuan artificially low without subsidizing US interest rates. And US interest rates would not be so low if China and others were not trying to keep their currencies artificially low against the dollar. Mr. Setser himself articulates this in his latest post by saying….

A lot of folks are sitting on capital gains that stem in no small part from low interest rates — low rates that stem at least in part from this huge flow. A lot of people in New York make their money selling debt — usually packaged in complicated ways — to folks who sold their Treasuries or Agencies to the PBoC. Private equity firms might not be the kings of Wall Street in the absence of the huge surge in central bank demand for debt, and the resulting easy availability of liquidity.

The longer emerging markets continue to subsidize the issuance of dollar denominated debt, the more deeply this subsidy will start to be woven into the fabric of the US economy — and into the structure of the US financial sector. There no longer is much of a constituency for adjustment — at least as far as I can tell — in the US financial sector.

But if cheap money is distorting US economy as the above quote seems to argue, isn’t that an argument for making money more expensive?

Moreover, if US interest rates were higher, won’t China stop subsidizing the US? After all, China is only trying to make sure that the dollar stays strong relative to Yuan. Higher interest rates should cause the dollar to stay strong against the Yuan without any outside help, right?

One might protest that we should not raise interest rates to suit China’s needs, but that objection holds no water if you follow Mr. Setser’s logic in the quote above. After all, Mr. Setser argues that in the absence of China’s (and others) reserve accumulation, interest rates would already be higher than they are now. Thus, a rate rise would only be bringing rates to their natural level. So it seems to me that anyone who believes that China’s reserve accumulation is detrimental to US long term economic health should also believe that the Fed should raise rates.

In short, if you accept Mr. Setser’s argument that artificially low interest rates are distorting the economy, then you believe that interest rates are going to have to rise sooner or later. So why not force the issue before more damage can be done?

Of course, there are objections that could be made to this line of argument. Perhaps the most powerful objection would center on the difficulty in determining what the “natural” interest rates should be. Just because someone is convinced that China is artificially holding down interest rates does not mean that they feel confident that they know what the “natural” interest rate should be.

But the Fed never knows what the “right” interest rate is. That does not stop them from trying to carry out their duty to fight inflation and maintain the soundness of the financial system. If you truly believed that the Chinese subsidies represent such a threat, why shouldn’t the Fed take corrective action?

Besides, most of those who worry about China support either trade restrictions or capital controls to deal with the “threat.” But if either of those things were successful at dealing with the “threat,” they would cause interest rates to rise. Plus, those “solutions” run the risk of distorting the US economy in ways that are equally bad as the damage done by China’s cheap money.

I don’t really expect anyone to accept the above argument. I am not entirely sure I accept it myself. But I can’t help but feel that Mr. Setser is trying to save himself some metal work by making the current mess all China’s fault with the poor old US sitting by helplessly. The current mess is as much in the US interests as it is in China’s. That is the real reason the US is “just sitting by.”

I think that this is true even in the US manufacturing sector. True, a high dollar/low Yuan makes it harder to export. But cheap credit makes it easier to sell domestically. If it were not for China, General Motors would have gone bankrupt already.

If we don’t have the guts pay the price necessary to bring this thing to a head now, how can we blame China for their lack of guts?

Basically, I have a problem with the idea that China is imposing something on the rest of the world and it bothers me when people I respect put forward that idea. For example, in the comments to this excellent post, Macro Man says….

Under the current regime, however, China’s “right” to set its own exchange rate entails an obligation on the part of foreign countries to accept the exchange rate (and, increasingly, yield curve slope) that China gives it. I and a lot of financial participants have a problem with this, but it tends to get glossed over amidst all the protectionist rhetoric coming out of the US and, to a smaller degree, Europe.

I just don’t buy this. When America ceases to want cheap money, then I will believe that China is obligating people to accept its exchange rate. But until then I will continue to hold both countries equally culpable.

This entry was posted on Tuesday, July 10th, 2007 at 8:08 pm and is filed under Economics, Uncategorized. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.