Threats to global economic recovery

U.S. and emerging market economies are the two driving forces in this recovery. One of the biggest concerns a while back was that the Fed withdraws its monetary supports too soon. Looks like the Fed has been methodical and moves in measured pace. Markets appear to have confidence in Bernanke's Fed.

Similarly, since China's enormous stimulus succeeded in pulling the country out of the potential slump caused by rapidly shrinking global demand, another of the biggest concerns was that China ends its stimulus policy too soon. That concern has mostly gone, as inflation is heating up in China and excessive bank lending has caused economists and observers to speculate about the Chinese bubble.

Both countries have been adjusting and rebalancing. We need to trade more, not less. U.S. needs to export more, so does China. Current debates however are so narrowly focused on the Chinese Yuan, the currency itself, that a potential break-out of a trade war has emerged as the biggest threat to the global recovery.

Paul Krugman represents an increasingly confrontational stance that the U.S. Congress and the Administration may come to adopt. Referring to China's long-disputed currency-peg policy, he stated that

And it’s a policy that seriously damages the rest of the world. Most of the world’s large economies are stuck in a liquidity trap — deeply depressed, but unable to generate a recovery by cutting interest rates because the relevant rates are already near zero. China, by engineering an unwarranted trade surplus, is in effect imposing an anti-stimulus on these economies, which they can’t offset.

All of a sudden, China has become the central culprit for the developed world's economic problem, in particular its inability to stimulate its way out of the recession. I have a feeling that ultra-Keynesian economists like Krugman have run out of ideas, and a convenient way to get some growth is to push China to abolish its long-standing currency policy. And he goes about it in a way quite like how George W Bush went into war with Iraq: we have strong evidence that Hussein was posessing WMD, therefore we must invade, because nothing else would work.

That's very dangerous.

Paul Krugman won his Nobel for his New Trade theory, which tries to explain the trade flows among conntries that do not seem to have distinct comparative advantages. This thoery that examines the implications of economies of scale and monopolistic competitions sometimes yield very different policy implication from the traditional trade theory. We don't really know if that work has colored his views on trade issues with China. If it does, it's unfortunate.

For over the last 30 years or so, China's trade with U.S. was mostly about taking advantage of its vast labor force outside of the cities. This allowed the exporting sector to thrive on razor-thin profit margin, producing goods that ordinary Chinese could not afford or not willing to consume. Most of the margin is made by U.S. multi-nationals. And it came with an enormous costs on the environment. I think the classic comparative advantage argument still applies in this case. If so, the more trade the better. Protectionism can only lead to a worse outcome for all countries.

China ran a trade surplus because the Chinese people consumed less than they produced. U.S. ran a trade deficit because Americans consumed more than they produced. Currency peg has little to do with these results. Many developing countries have their currencies pegged to the US dollar to have an anchor for pricing.

It is in China's interest over the long run to have its currency fully convertible. China will do so only when it thinks it's ready for the change. Just as "shock therapy" would not work 20 or 30 years ago, a currency shock therapy will not work this time. The most likely scenario is as the global economies recover, China will revalue its currency gradually in many steps.

After more than 30 years of development, China is probably ready to float its currency. Some experts (e.g. Goldman Sachs Group's O'Neill ) already think the currency is no longer very under-valued.

Krugman went on to argue that U.S. should not fear China's dumping its 2 trillions plus holding in US Treasuries. Because if China does that, the yield will increase, thereby lowering the value of the holding. In a sense, Krugman thinks that U.S. holds China in hostage because China was stupid enough to lend so much to the U.S. And it's time to take advantgae of that. This is somewhat of a pirate's logic, it seems. Just unbelievable.

China has already been trying to diversify its holding away from the treasuries. It will continue to do so. U.S. will not find it so easy to finance its deficit when China moves substantially away. If interest rates rise suddently, it will hurt U.S. a lot more than it will hurt China. China's holding is the price that it chooses to pay to run the trade game. The holding itself is not been pledged for anything critical.

If long term interest rates rise just 2%, it will put an enormous pressure on the housing market. That'll kill the U.S. recovery. The Fed can always step in to buy up the debt. That will certainly send the US Dollar into a tailspin. Gold price will shoot off the roof in that case. So a logical place for China to park their reserve is gold. What China loses in their US Treasury holding, they can make it up from the gold holding. The loss will be even more limited due to the Fed purchase. If you take this scenario to extreme, that China dumps almost all its UST holding and moves to gold and other forms of precious metal, or oil. The Fed will be forced to step in, blowing up its balance sheet by another 2 trillions or so. That seems like a recipe for another financial crisis. Inflationary expectation will be ignited.

Krugman went so far as to suggest slapping 25% tariff on all Chines imports to the U.S. He meant to use it as a temporary measure to force China's hands. That's a scary thought. This is no blackboard exercise. U.S. consumers will see many everyday items suddently have a price jump. Many factories in China will be forced to close. Trade flow will experience an enormous jolt. For what? If China decides to retaliate, by imposing higher hurddles on U.S. exports, what will U.S. get? Will the world obtain the 1.5% growth that Mr.Krugman imagines it would if only China stops pegging its currency?  I think the world will likely get the opposite: a trade war will send the global economy into a double-dip recession and possibly a world-wide stagflation.