Noah Millman asks about QE2
Specifically he asks four questions:
1. If the Chinese intend to let their currency float, and if the general assumption that a free-floating Yuan would appreciate significantly against the dollar, they should probably unload their Treasury holdings first, to avoid taking a big loss. Certainly, they should stop buying more of them. But America is producing debt at a prodigious rate. If what QE2 accomplishes is mostly to convince the Chinese to stop subsidizing low interest rates in America, leaving the Fed to basically pick up the slack, how is that going to improve the American economy? Wouldn’t we just wind up with higher inflation and higher nominal interest rates – i.e., stagflation?
There is a lot going on here, but let’s assume that China stops subsidizing low interest rates in the United States by refusing to buy Treasuries. Perhaps China even attempts to dump its Treasuries on the market.
Now, I think this is highly unlikely because the result would likely be devastating to China, but should it choose to do so we would see a collapse in the value of the dollar, at least vs. the yuan. With such a big move it’s hard to tell exactly how all the net exchange rates would work out. Yields on U.S. debt would be soaring, which would encourage lots of other investors around the world to buy and raise the value of the dollar vs. other currencies. However, the dollar would be very unstable, which would encourage them to sell and lower the value of the dollar vs. other currencies.
In any case the price of Chinese goods in the United States would soar, and the price of American goods in China would collapse. That would encourage a complete reversal in trade patterns. The United States would become a massive exporter to China. Indeed, that is what it means for a nation to repay a debt. It begins to export goods to the country it owes money to.
The direct effect would be stimulative for the U.S. economy as net exports would rise dramatically. The rapid increase in uncertainty, not least because this action indicates that the regime in China is insane, would not be good for growth.
2. The reserve army of the unemployed in China is numbered in the hundreds of millions. . . That problem is really the only thing China’s economic managers think about. Trade may not be terribly important to America’s economy all things considered, but it is enormously important to China’s economy. . . . [W]hat do you think China will do to respond if America makes it clear we’re acting without regard to their interests? Doesn’t it make sense that their first response would be not to show up for the next Treasury auction? And wouldn’t that be a problem?
No. Refusing to buy Treasuries at all will collapse Chinese exports and exacerbate the problem that, in your own words, is the only thing they care about. Again, one of the major effects of China dumping U.S. debt would be to convince the world that China’s leaders are unstable.
3. Higher inflation expectations should reduce demand for money and increase demand both for depreciating goods (consumer goods) and for goods that retain value in an inflationary environment (commodities). . . . If easier money means the marginal investment dollar goes to a commodity-based economy like Chile’s, that creates real problems for Chile without particularly helping stimulate demand in the United States.
Commodity price increases are a concern. The question is whether they are supported by underlying growth expectations or simply a liquidity bubble. If it’s underlying growth, then, yes, the commodity increases will slow growth, but that is because lack of commodities is a genuine constraint on global growth. If it’s a liquidity bubble, then that’s a more serious issue, and it goes beyond what I can discuss here. At the end of the day, though, it’s a risk management issue: how likely do you think a liquidity bubble is, what are the costs and how could it be managed.
4. The “big bang” danger lurking behind any proposal for a seriously expansionary monetary policy is the risk of a dollar crisis. . . . [M]any of the more radical proposals for monetary stimulus have a flavor of “we need to convince people that we’re being irresponsible – that we actually want to trash the currency, so that they don’t just wait for us to withdraw the liquidity we’ve created but actually go out and buy stuff.” And it seems to me that anything that actually convinced the market that the Fed was going to be irresponsible in money generation would surely also convince the market that dollar should no longer be the preferred reserve currency. Right? So, again, you aim for lower real rates and wind up with higher – much higher – nominal rates.
So here is a question of magnitudes. A sudden shift away from the dollar as reserve currency is theoretically possible. Though you have to ask: Shift to what? The euro? The yen? The pound? Do any of those seem plausible?
Saying that we want a “commitment to be irresponsible” by restoring the long run path of prices that the market expected in 2007 is entirely different than suggesting that we are going to inflate with no end in sight.
It’s important to realize how conservative central bankers naturally are. What the inflationistas are arguing now is that the Fed should commit to being just radical enough to undue previously unexpected declines in inflation.
I have been arguing that 2 percent inflation is just dangerously low as a general matter and does not allow room to deal with shocks that we should expect to experience over the next 50 years. However, the Fed need not address that now. It simply has to make up for the low inflation we are currently experiencing.
Karl Smith is an assistant professor of economics and government at the University of North Carolina and a blogger at ModeledBehavior.com..
| November 9, 2010; 3:52 PM ET
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