Monday, April 6, 2009

Krugman Sticking To His Comparative Advantage

When Krugman stays on international linkages in the economy, his columns are very impressive, and highly educational to the layman. It also illustrates why folks should consider carefully the comparative advantage of someone like Michelle Bachmann (or Maxine Waters, if we have to give equal time) before taking her to seriously. Consider this article by Krugman. We start with an old joke about trade with China:

trade with China had turned out to be fair and balanced after all: They sold us poison toys and tainted seafood; we sold them fraudulent securities.
So, how does that relate to the inane gum-flapping on the matter China's pipe dreams of an international currency? Basically, that would be an international bailout of China's myopic (and bad) decision to finance its trade surplusses with purchases of dollar-denominated bonds. That won't happen.

I've explained it to my principles students in the past, and here's Krugman's version of the same story:

China chose instead to keep the value of the yuan in terms of the dollar more or less fixed. To do this, it had to buy up dollars as they came flooding in. As the years went by, those trade surpluses just kept growing — and so did China’s hoard of foreign assets.
They are, apparently, worried about the fact that around 70 percent of those assets are dollar-denominated, so any future fall in the dollar would mean a big capital loss for China. Hence Mr. Zhou’s proposal to move to a new reserve currency along the lines of the S.D.R.’s, or special drawing rights, in which the International Monetary Fund keeps its accounts.But there’s both less and more here than meets the eye. S.D.R.’s aren’t real money. They’re accounting units whose value is set by a basket of dollars, euros, Japanese yen and British pounds.And there’s nothing to keep China from diversifying its reserves away from the dollar, indeed from holding a reserve basket matching the composition of the S.D.R.’s — nothing, that is, except for the fact that China now owns so many dollars that it can’t sell them off without driving the dollar down and triggering the very capital loss its leaders fear.
So what Mr. Zhou’s proposal actually amounts to is a plea that someone rescue China from the consequences of its own investment mistakes. That’s not going to happen.
So, love him or hate him when he goes of on wonkish liberal rants, he knows his stuff when it comes down to the subject for which he won his Nobel - international economics. And he's a darn good writer (for an economist - an acedimic at that): This is the best elucidation of the double-bluff of China's surplusses and bond holdings I've seen in the mainstream. Basically, China cannot "call in" its holdings of US public debt, and if it tries to sell those bondholdings on the open market, they drive their prices (cumulatively with the value of the dollar) down. The result would be a depreciation of the dollar that allows the US to buy back debt with internationally-cheaper dollars without the consequences of inflation domestically, and potentially boost our trade balance and boom the macroeconomy in the process.

1 comment:

  1. Incidentally I made the same points in my National Security (and for some reason in my Game Theory class as well). And yes I do wish Krugman would stick to his comparative advantage -- his "other" rants just devalue the stuff that knows about.