TCS Daily

Stop Blaming China

By Christopher Lingle - February 23, 2006 12:00 AM

BALI, INDONESIA -- While China preoccupies the minds of most Western politicians and businessmen, their expressed concerns are mostly misguided. Instead of worrying about its bellicose intransigence towards Taiwan or stealthy attempts to displace the US and weaken Japan's influence in Asia, people blame China for economic conditions not of its making.

On the one hand, many political leaders and some economists blame Beijing's reluctance to allow its currency to appreciate against the dollar for the low interest rates in the US. On the other hand, many dread that if China and other countries unwind their dollar positions that the value of the American currency could collapse, causing a recession.

Blaming China for global imbalances may pay political dividends for American and European politicians, but it is based upon deeply flawed economic analysis. As it turns out, the real villains behind global macroeconomic imbalances are US central bankers and many of their cohorts in the rest of the world.

First, let's consider the arguments mounted by China Bashers. Their logic goes something like this: When Chinese authorities buy dollars derived from exports or capital inflows and hold US Treasuries, their prices remain high while their yields are kept low. In turn, the relatively-low yields on US Treasuries leads to lower mortgage rates in America than if the Chinese were not buying them. This contributes both to a buoyant US housing market and higher overall economic activity.

But this argument suggests something even more onerous. If Beijing reduced its indirect support of the dollar by allowing the Yuan to appreciate, rising US interests rates could burst the US housing bubble and trigger a recession. Or so the saga goes.

This keeps the never-ending bogeyman of a Yellow Peril alive with seemingly-plausible economic logic. But the above arguments ignore how interest rates are determined in the real world. Once the true nature of interest-rate determination is understood, China Bashers lose a key weapon in their arsenal.

Understanding the nature of interest rates begins with a basic understanding of the supply and demand for saving and borrowing. Let's start with savers that put money aside by giving up some benefits that could have been derived from acquiring something in the present. Saving removes the opportunity to employ funds in exchange for current access to goods and services, so the saver must receive a premium in exchange for the saved funds.

This is because a basic principal of exchange is that people give up things they currently have for things they value more. In a monetized market economy, the sacrifice of present consumption occurs when there is sufficient compensation in the form of interest payments.

The choice to postpone consumption means that an individual prefers the anticipated satisfaction from later consumption to the satisfaction from immediate consumption. In assigning higher valuations to the present consumption versus future consumption based on the cost incurred in saving, individuals express a positive time preference.

A positive time preference means that individual and business save only when returns on the saved funds exceed the cost of saving. This means that the perceived benefits from future consumption are expected to exceed benefits from present consumption.

This same positive time preference is at work when it comes to decisions about borrowing. Those seeking to borrow funds will be willing to pay a premium to gain access funds now rather than later.

As such, individual time preferences are basis of the supply and demand for saving and borrowing that determines interest rates. As such, it is bogus to claim that Beijing's exchange rate policy influences US interest rates.

Now, let's use this time preference perspective to explain the structure of yields on dollar-denominated assets. The time preference of individuals is communicated through the supply and demand for money but can be disrupted by excessive money supply growth.

An inflated money supply puts downward pressure on interest rates while a fall in excess money leads to upward pressure on rates. Pumping too much money into the financial system affects interest rates since the first individuals receiving the new money temporarily feel wealthier.

Initially, there will be greater willingness to invest and lend real savings that lowers the demand for money by lenders and investors. As the increased supply of money combined with a declining demand for money leads, an excess supply of money boosts the prices of assets higher while lowering their yields.

Now let's see what happens after China exports more to the US. Most of the increased dollars will be mopped up by China's central bank that will invest them in US Treasuries. With the amount of excess dollars unchanged for a given supply of money, there can be no overall effect on US interest rates.

If China sold its holdings of US Treasuries, their yields would rise initially. But the dollars obtained from liquidating US bonds will flow elsewhere. If other dollar-denominated assets are purchased, their prices will rise and their yields fall. Therefore, a sell-off by China of US Treasuries cannot affect dollar interest rates.

The key factor determining the excess rate of growth of money is monetary policy. The momentum of growth in excess money and liquidity is behind the US housing bubble and various global economic imbalances and not Beijing's exchange rate policy.

And so it is that if the US economy falls into a recession when the housing bubble bursts, the Fed and other central banks should be blamed rather than China.

Christopher Lingle is Senior Fellow at the Centre for Civil Society in New Delhi and Visiting Professor of Economics at Universidad Francisco Marroquin in Guatemala.


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