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In his
latest weekly New York Times column, Nobel Prize-winning economist
Paul Krugman put forward arguments that were so nonsensical that the award
committee should ask for its medal back.
Recent rhetoric from Washington has put the economic relationship between the
U.S. and China squarely on the front burner, and Krugman is demanding that we
crank up the flame. This week 130 members of Congress sent a letter to
Treasury Secretary Timothy Geithner demanding that the Obama administration
designate China as a "currency manipulator". Following that, a
bipartisan group of senators introduced a bill that looks to force the Obama
administration's hand. For its own part, Beijing invites criticism by
continuing to deny its utterly obvious currency agenda.
As these tensions escalate, most economists urge Washington to tread lightly
because of the negative fallout for America if China were to begin selling
its enormous cache of U.S. Treasury bonds. Krugman pushes back,
asserting that the U.S. risks little by playing hardball, and that China has
more to lose. He asserts that a Chinese decision to end its purchases of U.S.
Treasury debt would make only a marginal impact on long-term interest rates.
Did you hear that Stockholm?
According to Krugman, our secret weapon of economic invincibility is the
Fed's ability to print dollars endlessly. If China were to foolishly
decide to attack us by selling our debt, the Fed could simply step in and buy
the excess with newly printed greenbacks. (In other words, Krugman sees no
difference between funding the debt and monetizing it. See my
latest video blog on
the subject.). For Krugman, China would gain little from such an attack,
but would lose the ability to export to its best customer and suffer severe
losses in the value of its dollar holdings. Krugman's worldview is reassuring
- but it has absolutely nothing to do with reality.
There is a huge difference between selling your debt to another and
"selling" it to yourself. When China buys our debt, it uses its own
savings. In order to purchase a trillion dollars of U.S. Treasuries, the Fed
would have to expand our money supply by a corresponding amount. Even
Krugman acknowledges that this would cause the dollar to lose value; however,
he feels that a weaker dollar is good for America and bad for China.
Krugman does not believe that a tanking dollar will translate into higher
interest rates or higher consumer prices at home. No matter how many dollars
the Fed creates, or how much value those dollars lose relative to other
currencies, he is confident that as long as unemployment remains high, rates
will stay low and inflation will remain under control. This is absurd.
If the dollar were to nosedive, the Fed would normally look to protect the
currency by raising interest rates, thereby increasing foreign demand for the
currency. But with an economy currently on crutches, the Fed will ignore a
weakening dollar and continue to try to boost employment with near-zero
rates.
But keeping the Fed Funds rate low only holds rates down for U.S. government
debt. If the dollar weakens substantially, other rates offered to other
borrowers will rise as investors demand greater returns to compensate for
inflation. To keep rates low for homeowners, credit card borrowers,
corporations, municipalities, and state governments, the Fed would be forced
to buy, or guarantee, all forms of dollar-denominated debt. The Fed would
become the lender of only resort.
Once the Fed shows that its commitment to low rates is limitless (the value
of the dollar be damned), private creditors will quit the game. Even average
Americans would hit the Fed's bid. It would be a race for the exits, with no
one wanting to be left holding a bag of worthless paper dollars.
Most economists, Krugman included, see cheap money as a panacea for all ills.
And while it's true that a falling dollar, by lowering the real value of U.S.
wages, would help make U.S. goods more competitive, it would also lead to
skyrocketing consumer prices, rapidly rising interest rates, and a collapse
in American living standards. Make no mistake: this is the end game of
Krugman's "get tough on China" policy.
This apocalyptic scenario can only be avoided if Washington jealously guards
the status quo, avoiding confrontation with China at all costs. Yet, even
that is an outcome that no one can rationally expect. Given exploding U.S.
government deficits and the inability of U.S. citizens and corporations to
repair their balance sheets, the United States faces financing needs that
even China's gargantuan savings stockpile will be unable to cover.
Krugman is right about one thing - China's currency peg is destabilizing the
global economy and must end. But he fails utterly to understand the
implications for the U.S. and China. If China were to reverse its role in the
U.S. Treasury market, both economies would be destabilized in the short-term.
But in the medium- and long-term, China would clearly emerge as the
winner.
Absent Treasury-bond purchases, the value of the Chinese currency would rise
sharply, causing goods prices to tumble in China. This long-delayed
increase in purchasing power for everyday Chinese will unleash pent-up demand
in what is already the largest middle class in the world. Chinese
factories would retool in order to produce goods for their own citizens to
consume. In RMB terms, commodity prices would plunge, making it easier
for China to produce all kinds of stuff, such as automobiles, while also
making it cheaper for the Chinese to buy gas. Millions will trade in bikes
for cars, and Chinese oil imports will swell.
The opposite would occur in America, where an artificial, consumer-based
economy, supported by Chinese lending, will come tumbling down. Without
the ability to import cheap goods from overseas, Americans will pay more and
get less. While gas and food become cheaper for the Chinese, they will
simultaneously become much more expensive for Americans - so too will automobiles,
consumer electronics, furniture, and just about every other product we want
or need (even those few we still make ourselves).
Washington's best option is to recognize that the current relationship is
unsustainable and to plan, as best as possible, for a more viable future. We
Americans also must be honest with ourselves and recognize that we have been
living beyond our means and that our lifestyle has been largely financed by
austerity in China. We must conceive of a plan that weans us from this dependence
without provoking China to pull the rug out from under us before we have a
firm footing. To construct a policy around Krugman's ridiculous assumption
that we benefit China more than they benefit us is to invite catastrophe on
an unimaginable scale.
For in-depth
analysis of this and other investment topics, subscribe to The Global
Investor, Peter Schiff's free newsletter. Click here for more information.
Peter D. Schiff
President/Chief Global Strategist
Euro Pacific Capital, Inc.
20271 Acacia Street, #200 Newport Beach, CA 92660
Toll-free: 888-377-3722 / Direct: 203-972-9300 Fax: 949-863-7100
www.europac.net
pschiff@europac.net
For a more in depth analysis of the tenuous
position of the American economy, the housing and mortgage markets, and U.S.
dollar denominated investments, read my new book : The Little Book of Bull Moves in Bear Markets" (Wiley,
2008).
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