Posted on 08/01/2005 2:05:52 PM PDT by ex-Texan
US interest rates, growth and China
In Joined at the Hip Thomas Friedman parroted the Krugman fallacy that US interest rates are being determined by China’s trade surplus with the US (New York Times, 20 July 2005). According to this line of thought the US trade deficit with China has forced down US interest rates. This in turn has had the beneficial effects of promoting growth and stimulating the housing Market.
Ergo! All a country needs to do to generate growth and put its citizens’ in their own homes is to run a trade deficit with China – and the bigger the better. Of course, as soon as we puts it this way any normal person would immediately smell a rate. Unfortunately there seems to be very few normal people at the New York Times.
Friedman would counter that the ‘experts’ have shown that the massive amount of dollars that China has acquired have been invested in US bonds and that these purchases have raised bond prices and so lowered US interest rates, the effects of which have spread throughout the US economy.
Americans determine US interest rates, not China or any other country. Two things are missing here: a) any idea of the nature of the real determination of interest rates, b) monetary policy.
Interest, as the Spanish economist Faustino Ballvé succinctly put it, is the price of time. This is why future goods are discounted. This discount rate (interest) is determined by the social rate of time preference, i.e., aggregated individual time preference scales. (See The nature of interest rates and why it’s dangerous to manipulate them).
It is no secret that monetary policy can be used to manipulate interest rates – and is. In a nutshell: Operating through the banking system the central bank artificially lowers interest rates by expanding credit. As a rule this stimulates investment and housing. It also leads to balance-of-payments problems as the inflating country begins to run a trade deficit with its trading partners.
If this explanation holds then changes in the money supply would correlate, after a time lag, with changes in the mortgage rate. The Austrian school’s approach defines the money supply as cash plus demand deposits with commercial banks and thrift institutions plus saving deposits plus government deposits with banks and the central bank.
Plotting the US mortgage rate from 1990 to the present we find that changes in the rate are preceded by changes in the money supply as defined by Austrians. When money supply tightens rates go up and vice versa. This relation still held despite the fact that China pegged the Yuan at 8.276 to the dollar in 1994. Friedman and his experts are clearly looking the wrong way.
Toeing the orthodox line, Friedman concludes that if the dollar was heavily devalued this would force US interest rates up and the send the country into recession. Therefore this calamity can only be averted if China “continue[s] holding our devaluing dollars and … keep[s] US interest rates low”.
Friedman is contradicting the theory. China is not holding US dollars — it is holding US assets, many of which are T-bonds. Exports are the price of imports. So when China exports to the US it gets something in return. Most students of economics would sagely nod their heads at this insight, saying: “What they are getting are just little bits of green paper”. Not quite.
When China gets those little bits of green paper it uses them to buy US assets, whether they are T-bonds, hotels, factories or oil companies. In short, any US asset China buys with its dollars is in effect a US export. Hence the dollars return. Therefore it is not China’s so-called dollar balances that are holding up the US currency because once these dollars come home, so to speak, they are no longer part of China’s demand for dollars.
I am not denying that if China suddenly sold off its T-bonds, for example, that their price would not fall and so raise interest rates, only that this situation would reverse itself. After all, there is no point in China increasing its demand for dollars, which is what a T-bond sell off implies, unless it is going to use them to buy other US assets.
The real problem is the US money supply over which China has no influence whatsoever. Greenspan has driven down yields by injecting huge amounts of credit into the US economy. This is why at the end of May the yield on the 10-year T-note was 4 per cent as against 4.6 per cent for June 2004. The yield on Moody’s long-term AAA Corporate Bonds was about 5 per cent last May but 6 per cent June 2004.
The same monetary policy that has driven down rates has also been driving the trade deficit. To ‘credit’ Chinese exports with low US interest rates is to completely miss what the Fed has been doing.
Gerard Jackson is Brookes’ economics editor
The current housing boom and our trade deficit are the result of our policy of cheap money. 'Too much of a good thing,' and all that. What is going to happen when the bubble pops? Your guess is as good as mine. But my guess is economic slowing and deflation in real estate prices. China probably will be selling more cheap goods in the U.S. while Americans will be lucky to have jobs at Wall-Mart. Read More?
But what do I know, anyway?
ping
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