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"Create long run problems akin to the "Transfer Problem". Keynes pointed out the inconsistency of expecting Germany to pay WW1 reparations to the Allies without allowing Germany to run a net export surplus. Germany = US, and reparations = debt service payments"

The difference is in the squeeze of the vise and its political consequences. We're not Britain or Germany in 1931, and, hopefully, the political actors are not as scary. Hence, there's more space and time to fashion a solution without blowing things up.

Ordinarily, my sympathies would be with China on this, not the U.S. China is still a lot poorer than the U.S. or Canada, and I don't get very upset if it uses currency manipulation to try to boost its industrial development. In the long run, I expect that this strategy will lead to more rapid industrialization, and help China catch up to the "developed" world. In normal times, I am pretty unsympathetic to cries of pain from rich countries afraid that poor countries might be gaining at their expense.

However, I do see Krugman's point that this is especially harmful to other countries in a recession, and that it hurts other poor countries which are not in a position to do the same thing.

Whenever I hear about China's $2 trillion in foreign reserves, the cynical side of me wonders if those reserves are truly held by the People's Bank of China. Maybe I'm just too paranoid.


Britain and Germany were at least two of the world's leading military, economic, and political powers in 1931. Hitler was not in power yet, so the statement that their leaders then were scarier than those in the US and China now is not so obvious. It is precisely to avoid a situation like 1930 (US Smoot-Hawley tariff directed primarily at Germany who owed US banks for the Dawes Plan) through Hitler's coming to power in 1933 that avoiding something like Krugman's idiotic proposal is strongly advisable.

A few comments:

Paul, A trade surpluses slows economic growth, as it means domestic saving exceeds domestic investment. If instead of piling up T-bonds, China used the money to buy capital goods (as South Korea did in the 1970s and 1980s) they'd grow even faster. It's a long term policy, and AD doesn't affect economic growth rates in the long run.

Nick, I don't see how this relates to the German transfer problem. These are voluntary loans made in US dollars. German debts were forced down their throats, and they were in gold terms.

I would add that this is a long term policy, so it isn't appropriate to examine it from an AD perspective. Indeed the Chinese CA surplus has actually gotten smaller during the recession. If you are trying to look at this from a cyclical perspective, it would seem that what matters is the change in the surplus. Most China critics see their surplus as a long term problem. That's one area I give Krugman credit--he understands that it isn't a problem if the rest of the world is not in recession. But I don't see where it's a problem even if they are in recession. The reason the current level of AD in Japan the US and Europe isn't higher right now is that the Fed, BOJ and ECB clearly don't want it to be higher. Indeed they have rebuffed critics who have called for higher inflation (which is exactly the same as calling for higher AD.) So what does this Western policy failure have to do with China?

"The reason the current level of AD in Japan the US and Europe isn't higher right now is that the Fed, BOJ and ECB clearly don't want it to be higher. "

huh? A CB cannot control AD so directly -- it is not like turning a knob up and down.

A CB can only lower the marginal costs of banks, hoping that this entices people to borrow more and spend more. Japan has found that when people (in aggregate) do not wish to borrow even at any rate, then CB policy is impotent at increasing aggregate demand.

Moreover, the CB is incapable of increasing inflation without seriously damaging the economy. An increase in inflation will lead to an increase in nominal interest rates and will make it difficult for businesses and over-levered households to roll-over debt, which is denominated in nominal terms and paid out of sticky nominal incomes -- and this will put even more downward pressure on demand as credit contracts further.

This is all about AD and the distributional issues, (which themselves push down aggregate demand).

Scott: Think about the gold standard world for a minute, where gold is the international reserve. If (say) China wants to accumulate gold reserves, the rest of the world faces a choice between: 1. deflation, or 2. losing gold reserves. Now replace gold with US dollars as the international reserve. If China wants to accumulate reserves, the rest of the world faces a choice between: 1. deflation, 2. losing dollar reserves, or 3 the US prints more dollars. But if the US prints more dollars, to satisfy China's increased demand for reserves, those reserves are liabilities of the US. To what extent are those loans "voluntary", if the only alternative is deflation, to give China the extra (real) reserves it wants? And even here, deflation would just increase the real value of US liabilities to China.

The solution though, is not I think the tariffs that PK advocates. It's a change in the reserve regime. For example, China must allow the Fed to buy yuan. That way China can increase reserves without deflation or without any other country losing reserves.

Scott: I understand what you're saying, but I guess I'm pretty sceptical of this sort of Solow-model thinking. People invest where it makes sense to invest, and it makes plenty of sense to invest in China now.

One part (not the most important part) of why it makes sense to invest is the low value of the Chinese currency. This makes Chinese exports more viable. People have an incentive to invest in factories to make those goods, so they invest. Sure, if the government wasn't buying so many U.S. T-bills, they would have more money to invest in factories, but if the factories wouldn't be viable because their costs are too high, the investment won't get made.

I see the Chinese currency strategy as one of a short term cost (lower standard of living than would be possible) for long term gain (rapid growth of industry due to low costs).

Nick, This same point came up in another thread, I think you are confusing bonds with currency. Only bonds create a interest-bearing liability. And only the demand for cash is deflationary. The only loans we are forced to make (in order to avoid deflation) are interest-free loans, i.e. currency.

Paul, I don't follow your response. China has a CA surplus, which means investment is China is less than saving in China. In net terms, the Chinese are investing outside of their country. So they are slowing their rate of growth as compared to countries like Korea, which ran CA deficits during their high growth period.

Scott: You seem to be saying that the Chinese authorities are very stupid to have such a policy. I don't think they are stupid at all.

I guess it boils down to whether you think that investment in a country is limited by investment funds available or by profitable investment opportunities. You think it's limited by the funds available - that buying U.S. T-bills leaves China short of funds to invest.

But think about it. How would such a shortage manifest itself? It could only be through the Chinese interest rate. Profitable companies, short of funds to expand into new opportunities, would bid up the rate. But the central bank is not going to let that happen. It is just going to print whatever money is needed to keep the interest rate at whatever level it decides on. So there can be no shortage of the sort you seem to believe in.

I think that investment is limited by the number of profitable opportunities available. At any time, there will be a certain number of opportunities available which are profitable, and that number will be influenced by two things - the interest rate and the exchange rate. If the interest rate goes down, that makes more opportunities profitable. The interest rate is controlled by the central bank. If the value of the domestic currency goes up, that will make fewer investments profitable because fewer things will be able to compete in foreign markets.

Paul, I am not claiming they are stupid. There might be very good reasons for the government to save. They have a lot of unfunded pension liabilities, for instance.

Monetary policy determines nominal interest rates, savings and investment propensities determine real interest rates.

OK. You can think about it like that. But your "investment propensity" is not just a constant or a characteristic of a population or something like that. It has to be a function of the exchange rate.

For any given combination of interest rate and inflation rate, people are going to invest more if their currency has a lower value relative to others, because it makes more investments viable.

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