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More Dollar Blues

There is surprisingly little written about the dollar's troubles in the US media, such that you usually need to go to to foreign papers to read about it. But Krugman takes it on this week, and makes the problem quite clear:

Money 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.

Low 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.

Here's 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.

Because the big Asian central banks have such vast dollar holdings, they're mighty concerned about what will happen when and if the dollar tanks, and thanks to Michael Duran who pointed us to an article in Forbes this week that tells of how the three Asian central banks with the largest dollar holdings -- Korea, Japan and China -- are so tweaked about the situation that they have put aside nationalistic differences and banded together to work in concert to avoid the fallout. And just yesterday, Korea announced that it will no longer be buying dollars, which the US relies upon to finance its enormous monthly trade deficit. That's big news, and drinks are on me if anyone can show me where CNN or MSNBC or (perish the though) Faux News covered the story.

The inevitable correction to Bunnypants' fiscal irresponsibility will potentially dwarf any of his disasters-to-date. Novakula's probably got his crypt loaded down with emergency stockpiles of virgin's blood so what does he care, but expect the not-so-bloodless to be feeling the pinch in the not-so-distant future.

posted by Jane Hamsher @ 5/21/2005 12:00:00 AM