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Noah Millman asks about QE2

By Karl Smith

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..

By Karl Smith  | November 9, 2010; 3:52 PM ET
 
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Comments

pentultimate paragraph: "undo" instead of "undue"

Posted by: bdballard | November 9, 2010 4:18 PM | Report abuse

pentultimate paragraph: "undo" instead of "undue"

Posted by: bdballard | November 9, 2010 4:20 PM | Report abuse

"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?"

If they resurrect SDRs then the US might have to start worrying. But the gold standard?

http://online.barrons.com/article/SB50001424052970204425904575604180968649878.html

Posted by: tuber | November 9, 2010 4:48 PM | Report abuse

There's no "bringing back" with respect to SDRs, they exist today

http://www.imf.org/external/np/exr/facts/sdr.htm

Posted by: bdballard | November 9, 2010 5:12 PM | Report abuse

The Chinese don't want their currency appreciating for the reasons mentioned by Dr. Smith. But what I've never heard explained is why the value of their US government bond portfolio is of much concern to them one way or another. What are they planning to do with this portfolio? Retire to Boca Raton? Throw a fancy wedding for their daughter?

Posted by: Jasper999 | November 9, 2010 6:16 PM | Report abuse

First a caveat. It is difficult predict what will happen in an economy when there are countervailing expectations involved. It is even more difficult to guess what will happen when specific decision makers or committees are involved. At its best economic analysis provides insight into what will happen on the margin. Economists expect some people on the edge of making one decision or another to change their mind because of changes in policy or expectations of policy. But, if we reasonably think that some change in policy will change everyone's mind (or all the big player's minds) instantly, then there is no telling what will happen. Suddenly timing is everything and the system is chaotic.

That said, I am of the mind that some inflation would probably be good for the US. Some people thinking about buying productive assets will do that instead of hording cash. Of course, other people hording cash will buy art, classical instruments, and gold (non-productive assets). But, most horders will just keep on hording cash.

Furthermore, it seems to me that a lot of wealth has been destroyed recently, which means people have less collateral, which means less loans are going out, which means there has been a contraction of the money supply. A bit of quantitative easing is probably in order -interest rates are reportedly not alleviating the drought of loans.

Some devaluation of the dollar is probably good for job growth in the US, though those with jobs find things more expensive. Trade deficits are not bad in their own right -nor is debt. The real enemy is lack of economic opportunity. If people can't raise debt when they have a way of producing something worth more than it costs, we have a problem. We need to wonder whether the products being purchased on loan by China are worth being purchased on loan. If not, it will be bad for China when they try to collect on the loans and bad for the US when we run out of credit.

Posted by: MGriebe | November 9, 2010 7:02 PM | Report abuse

Karl wrote:

"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:

There is no serious question that it's a liquidity bubble. Average price for production of a barrel of oil is on the very high end of estimates, $55 a barrel. The rest is currency speculation. Don't believe me though check out the production numbers produced every week and see that the world is awash in oil. This will only get worse as more production comes online at higher prices. You have the very interesting paradox that at some point the two lines will inevitably cause a tremendous crash in energy prices.

Posted by: 54465446 | November 9, 2010 8:07 PM | Report abuse

Karl wrote:

"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."

This would only happen in a textbook, never in the real world.

1) China does not encourage imports and given their control of the economy would not allow it to happen.

2) What would we produce that China wants? We are not a major exporter of any type of consumer goods. We can export agricultural products and unique industrial products such as airplanes. That's about it.

3) Since we are a consumer and service economy, there would be a massive economic dislocation as industries based on the sale of cheap consumer goods such as computers, tv's and cell phones crash and native production industries take 5-10 years to rise. This is a real through the looking glass scenario that no one can accurately portray.

Posted by: 54465446 | November 9, 2010 8:16 PM | Report abuse

Karl:

You also really missed the boat on the Treasuries argument. China doesn't have to stop buying them. It only has to slow purchases enough for yields to rise. In that scenario, the Fed is forced to do QE3, 4 etc. to sustain the market, OR watch yields rise.

If you think you have a real estate mess on your hands now, just wait for a significant rise in the 10 year in a still 10% unemployment economy and watch the world burn down around us!

Posted by: 54465446 | November 9, 2010 8:25 PM | Report abuse

Karl:

I'm bored, so I looked it up. Current par value of China's US Treasury holdings is about 870 billion dollars.

Posted by: 54465446 | November 9, 2010 10:32 PM | Report abuse

Karl:

To buttress my point about oil being a liquidity bubble:

"U.S. crude stockpiles reached 368.2 million barrels at the end of October, 14 percent above the five-year average level, according to the Energy Department"

Posted by: 54465446 | November 9, 2010 10:44 PM | Report abuse

What seems to be unclear in these questions is the motive for the Chinese decision to buy Treasuries.

They make it sound like this is some sort of investment decision, or even favor - they are 'buying our debt'.

You don't understand what is going on. They MUST buy our debt because that is HOW they peg their currency, which subsidizes their exports.

Exporters earn dollars which are stopped at the border by the central bank and turned into Treasuries, enforcing a peg.

So stopping buying Treasures would mean they stopped the peg, which is exactly what they are saying they don't want to do.

They buy our debt as part and parcel of enforcing a currency peg.

If they stopped buying our debt, our exports would become very competitive.

Posted by: mminka | November 10, 2010 2:45 AM | Report abuse

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