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Paul Krugman Needs to Buy Paul Krugman's Textbooks

By Tim Worstall - June 21, 2005 12:00 AM

We Brits were privileged with a flying visit by arguably "the most brilliant [...] most controversial economist of our generation" recently. Yes, that would be Paul Krugman and his views were outlined in the Sunday Telegraph [1]:

        Sensing my surprise, Krugman lays out his argument. "China exports lots of goods and 
        foreign companies are investing heavily there, so it's running a huge trade surplus. But 
        rather than keep all that money, Beijing is using it, overwhelmingly, to buy US government 
        Treasury bills.

        Krugman then spells out the jaw--dropping extent of China's T-bill purchases: $200bn in 
        2004 and possibly as much as $300bn this year. Beijing, he says, is "bankrolling 
        America's huge budget deficit", now almost 5 per cent of national income, to the tune of 
        $1bn per day.

        "At some point," he says, excited by the power of his logic, "China could well decide to 
        stop this. If so, the dollar falls sharply, US interest rates rise and our housing bubble bursts."

        A pause. "Quite simply," he concludes, "that would stop the American economy, 
        the locomotive for the whole world, in its tracks. So, in this weird way, China is now the 
        financial nexus keeping the global recovery going."

It's obviously extremely foolhardy for a half educated type like myself to go up against the most brilliant economist of our generation but there's one or two little things there that don't seem to make sense to me. "But rather than keep all that money"....I'm sorry, what is being suggested? That the cash be put beneath the mattress? That the Chinese authorities, after they have exchanged the dollars for renminbi, simply fill room after room with green pieces of paper? Or, in this modern world, simply leave the money as bits and bytes upon their own computers?

To do so would make the imports effectively free as far as the US economy is concerned. Imagine, all those computers and t-shirts come over to the US and all that has to go back the other way is ink and paper! Great bargain if you can negotiate it, Paul, but I don't think that's really the way it works. No, those dollars will be spent or invested somewhere and will eventually flow back to the US and become a claim on US goods or assets. So, something of a pity but that does seem to be the way that the international economy works. As, indeed, the standard textbook on the subject, written by one P. Krugman, tells us.

The part of his thesis -- that if China stops buying US Treasuries then the price of such Treasuries will fall (assuming no other changes) -- is obviously true. That will indeed lead to a rise in (long term) US interest rates and so on, just as described. But the question isn't whether it is true that such things will happen, it is whether it is trivially true that such things will happen. Just how important is it that the Chinese keep spending $200 or $300 billion a year on buying up the debt? Will their ceasing to do so cause a crisis or will it be lost in the noise of the system? The answer to that requires looking at some actual numbers, the numbers that the US Treasury helpfully releases each month. [2]

We can read these numbers a number (sorry) of different ways. If we wished to emphasize how dangerous the situation is we would look at the net purchases by foreign governments of the US government debt. $200 billion and change each year, so we quite clearly have a problem. You see that's $200 billion a year and the Chinese buy $200 billion a year and if they stop then no one will and Aarrrgh! The sky is falling and we're all doomed I tell you! Doomed!

There is another way to look at this, you will not be surprised to hear. Even when we are talking about those semi-literate in the subject, like myself, the number of opinions on an economic matter is always n+ at least 1 where n is the number of economists. We don't actually care very much whether the Chinese government comes along and buys those lovely bonds at all. We do care that someone comes along, of course, but the identity of that who is immaterial to us.

So instead of comparing the gross Chinese purchases (that $200 billion) with the net position of foreign governments (that $200 billion and change) why don't we look at the gross purchases by those ChiComs who have such a grip on our economy and the gross purchases of all foreigners? We'll assume that the Chinese figures were the same, some $200 billion each year and then we see that gross purchases by all those not privileged to be Americans were $14 and $15 trillion in 2003 and 2004. Yes, we seem to be stating that for disaster to happen we only need a change in 1/70th or 1/75th of the market...or that 1.3% of the market drives prices.

While everything that happens in economics happens at the margin I don't think that that is really all that likely a story now is it? Sure, the absence of $200 billion in a $15 trillion market will have some effect on prices but it isn't all that likely to be very large. Especially, as above, the Chinese can really only do one of two things. Spend or invest it elsewhere, in which case the dollars will come back to the US to be spent on something, quite possibly Treasuries, or stick it in a big big room and do nothing with it in which case the US just bought its imports for the cost of the paper and ink.

Quite why the Good Professor wants us to think in the first manner I'm really not sure. There must be a reason he emphasizes how terrible could be the results but I don't think that he even believes it himself, for he is, as we know, a better international economist than that.

There is one further point to be made which leads to a question. If, as we are told, foreign governments who buy $17 to $25 billion a month's worth (that $200 to $300 billion a year) of Treasuries stopping doing so is such a problem, then how do we deal with, in our numbers on foreign purchases, line 10 for March 2005? The number showing that there were net sales of $15 billion in that month? While not exactly the same number it is close enough for us to expect the effect to be similar, is it not? So, err, it's already happened, hasn't it? Hmmmh.

So we're left with that question for the Professor. Sir, why hasn't the sky already fallen?

Tim Worstall is a TCS contributing writer living in Europe. Find more of his writing here.






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