Paul Krugman finally answers a rhetorical question he posed in September of 2003. Way back then he was bashing Bush for Iraq (natch) and for going hat in hand to China to talk to them about their undervalued currency. His Nobel Prize for international trade was still in the future, so on the gloomy prospects of a currency confrontation between China and the US the extent of his "analysis" was this:
But [President Bush, by way of Treasury Secretary Snow] got no satisfaction. A quick look at the situation reveals one reason why: the U.S. currently has very little leverage over China. Mr. Bush needs China's help to deal with North Korea — another crisis that was allowed to fester while the administration focused on Iraq. Furthermore, purchases of Treasury bills by China's central bank are one of the main ways the U.S. finances its trade deficit.
Nobody is quite sure what would happen if the Chinese suddenly switched to, say, euros — a two-point jump in mortgage rates? — but it's not an experiment anyone wants to try.
That was during the 2003 recession and recovery when the Fed was keeping the Fed Funds rate below 2%.
But the years have passed, as has the Bush Administration, and now Paul Krugman has joined the world in decrying the undervalued Chinese currency. And he has answers on the economic front!
Tensions are rising over Chinese economic policy, and rightly so: China’s policy of keeping its currency, the renminbi, undervalued has become a significant drag on global economic recovery. Something must be done.
If Treasury does find Chinese currency manipulation, then what? Here, we have to get past a common misunderstanding: the view that the Chinese have us over a barrel, because we don’t dare provoke China into dumping its dollar assets.
What you have to ask is, What would happen if China tried to sell a large share of its U.S. assets? Would interest rates soar? Short-term U.S. interest rates wouldn’t change: they’re being kept near zero by the Fed, which won’t raise rates until the unemployment rate comes down. Long-term rates might rise slightly, but they’re mainly determined by market expectations of future short-term rates. Also, the Fed could offset any interest-rate impact of a Chinese pullback by expanding its own purchases of long-term bonds.
It’s true that if China dumped its U.S. assets the value of the dollar would fall against other major currencies, such as the euro. But that would be a good thing for the United States, since it would make our goods more competitive and reduce our trade deficit. On the other hand, it would be a bad thing for China, which would suffer large losses on its dollar holdings. In short, right now America has China over a barrel, not the other way around.
Hmm, some of those points were obvious even to me back in 2003. As to debunking the "common misunderstanding" that China has us over a barrel, one wonders why that was less obvious back when Bush was raising the issue. One might also wonder whether Krugman was contributing to that misunderstanding with his "Nobody is quite sure what would happen if the Chinese suddenly switched to, say, euros" fog-burst. And while we are wondering, we might ask when it was that Team Obama solved the North Korean problem that featured so prominently in Krugman's 2003 rhetorical sally.
So many questions. No doubt some will be cleared up by a Krugman column in 2017.
MORE: Dan Drezner decries Krugman's bellicose unilateralism and manages to limit his "I told you so-ism" to much less than seven years.