China and the liquidity trap
I liked this David Leonhardt article about the China-US economic relationship. But I do have a problem with this passage:
The most obviously worrisome part of the situation today is that the Chinese could decide that they no longer want to buy Treasury bonds. The U.S. government’s recent spending for bank bailouts and stimulus may be necessary to get the economy moving again, but it also raises the specter of eventual inflation, which would damage the value of Treasuries. If the Chinese are unnerved by this, they could instead use their cash to buy the bonds of other countries, which would cause interest rates here to jump, prolonging the recession.
Um, no. Right now we’re in a liquidity trap, which, as I explained in an earlier post, means that we have an incipient excess supply of savings even at a zero interest rate. (By the way, I’ve had a chance to see the transcript of the PEN/ NY Review event, and I don’t think I was misrepresenting Niall Ferguson’s position.)
In this situation, America has too large a supply of desired savings. If the Chinese spend more and save less, that’s a good thing from our point of view. To put it another way, we’re facing a global paradox of thrift, and everyone wishes everyone else would save less.
Or to put it a third way, the argument that a reduction in China’s dollar purchases would be contractionary for America because it would drive up interest rates is equivalent to the argument that fiscal expansion is contractionary for the same reason — and equivalently wrong.
But what if China doesn’t spend more, but just reallocates its reserves from dollars to, say, euros? The answer is, that’s also good for us: a weaker dollar will help our exports, at Europe’s expense.
One of the things I tried to tell the Chinese was precisely that the old co-dependence no longer exists. For now, at least, their dollar purchases are an unalloyed bad thing from America’s point of view."