Economic Primer

Krugman provides lesson one:

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.

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

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...

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.

Ouch. Makes me wonder if I should hold off on trying to buy my first house--and worried about whether I'll have a job if/when I finally manage to gather together the spider's web of financial info/entanglements required.

But as for the macro-level consequences of Bush's present policy, that is to say, the put-it-on-the-credit-card plan, well, I believe Krugman is pointing out that eventually the bill comes due, despite Dick Cheney's assertion that "deficits don't matter." At that point, the US might well see itself subject to an IMF style "austerity plan" that will almost certainly leave large numbers of people howling.