Sunday, March 04, 2007

Senator Clinton's Letter and Speech

In the wake of last week's market volatility, Senator Clinton made a speech on the floor of the Senate and sent a letter to Chairman Bernanke and Secretary Paulson. Greg Mankiw characterized one part, appropriately in my view, as xenophobic. PGL at AngryBear responded with other parts that were, in his view (and to a lesser extent, mine) appropriately critical of our current macroeconomic policies.

The main problem with Clinton's argument is that there is no particular connection between the amount of U.S. debt that China and Japan hold and what happened last week. Is she really saying that the U.S. market wouldn't have dropped after the Chinese market dropped if we ran a trade surplus with China? Or if we still ran a deficit but China's resulting portfolio holdings were in some other country's federal liabilities rather than ours? Our economy is connected to the Chinese economy via both current account and capital account transactions. We might want to be more mindful of the latter than we have been. But that doesn't mean that the high ownership of U.S. debt by China caused the transmission of price movements from China to the United States.

Read this excerpt and see if she actually justifies the leap she makes in going from the red to the blue sentences below:

I have long argued that a great source of vulnerability is the fact that other countries, including China, own so much of our debt. Today, foreign nations according to the most recent Treasury statistics hold over $2.2 trillion or 44% of all publicly held United States (U.S.) debt with Japan and China alone holding nearly $1 trillion. In essence, 16% of our entire economy is being loaned to us by the Central Banks of other nations. Having so much debt owned by other countries can be economically unsound. Yesterday it was the sell off of foreign stocks that had reverberations in U.S. markets. But if China or Japan made a decision to decrease their massive holdings of U.S. dollars, there could be a currency crisis and the U.S. would have to raise interest rates and invite conditions for a recession. While it can and will be debated whether yesterday's market disruption was just a blip or a larger indicator of our economy's vulnerabilities, it is clear that interdependence between our economy and that of other nations can pose a risk if we do not pursue smart policies. Precipitous decisions by any country with our debt could create much graver economic problems than what we saw yesterday. The writing may not be on the wall, but yesterday, the writing was on the Big Board.

Her "in essence" sentence is not a sensible comparison. It does not make sense to compare a stock of money--the total holdings of U.S. federal debt by foreign investors--with the flow of money that is U.S. GDP. A sensible comparison might be the flow of interest that we pay to these foreign investors, a much smaller number as a share of GDP. (For example, I don't get too worried about the fact that a bank has lent me more than 100% of my income in the form of a mortgage. The reason is that the interest on that mortgage is a very reasonable fraction of my income.)

The statement in green above is a true statement. Not only would the problems be more grave--they might actually be problems and be related to what the creditor nations did. But even this scenario that she discusses is, in Mankiw's word, alarmist. There would have to be a reason why China or Japan would intentionally precipitate a selloff of their holdings of U.S. debt, particularly since the Chinese and Japanese holders of the debt would be the first ones to suffer the capital loss due to this action. It couldn't simply be that their own economies faltered--the U.S. debt they hold is an asset to them. When my income falters, I am typically quite grateful for the assets I have in the bank (somebody else's liabilities). Their economies would have to falter so badly that they needed to liquidate their holdings of U.S. debt to pay off some of their own debts. Not too likely, unless, perhaps, we close our markets to them.

Clinton's rhetoric, particularly these statements about being "held hostage" or "losing our economic sovereignty," suggest that she's thinking about a scenario in which a policy maker in Beijing or Tokyo decides that the U.S. debt is overvalued and wants to unload it en masse. About the only thing that could really convince me to do this, were I the policy maker in Beijing, is a credible belief that my counterpart in Tokyo was about to do the same thing.

While that is something over which Washington has very little control, even in that case, all that would happen--unless you think the U.S. government wouldn't pay the interest or principal on its obligations--is that the U.S. dollar would depreciate and domestic interest rates would rise. Exports would pick up a bit, and the government would find deficits more costly to finance. I'd prefer if that didn't happen, but in the grand scheme of things, it's neither very likely to happen nor very severe in its real consequences if it does.


Anonymous said...

I am posting without spending the time to try and find the source...

When Bill Clinton was president there was a period of pestering Japan about trade deficits (and perhaps currency values). A Treasury auction came up and the Japanese held back from participation [buying] until the very last hour (or so).

The message the Bill C and the USA: IF we don't soak up your debt Who Will?

Do you want to bet there were sweaty palms that an auction might not go to completion?

[remember - this is a recollection]

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alphie said...

You're assuming China and Japan are our friends.

If their goal was to cause as much damage as possible to the U.S. economy...selling off our debt at a discount while at the same time banning U.S. imports and nationalizing all foreign owned ventures...

But, of course, China is America's best friend and would never want to see us fall off our perch.

Funky Disposition said...

"You're assuming China and Japan are our friends."

Why are you summing up this in good/bad terms? China and Japan are our trading partners. good/bad, friend/enemy don't come into play.

Don't you know that production and trade are the keys?

All anybody can hope for is a comparative advantage and that is in the short run. In the long run we are all bedtter off and the folks in China realize this.


alphie said...

I'm a big fan of trade and China, Funk, but:

1. China has a very long history of opening up to the world for short periods and then slamming the gates shut again.

2. China isn't just any country, but the next in line for the title of World's Only Superpower.

If they can shorten America's spluttering reign by a decade simply by turning our debt into junk bonds, who's to say the People's Republic won't take that shortcut?

Let's face it, we need China far more than they need us now.

History is littered with the remains of tottering empires that counted on the wrong "friends" to survive.

How about a little honesty from right-wing economists...let's have a worst case scenario.

Fritz said...

You refer to a time in the 80's when Japan forgot how collusion only works once. Capital markets always find a price, that is why they never did that again. Like Global Warming, Japan Inc. was simply the meme of the time.

Mrs. Bill Clinton appears to forget the Asian Flu & Mexican currency crisis during Mr. Clinton's presidency. Then again, greatest economy ever.

Why do the leftists cling to That 70's Show mentality, this isn't the Carter Administration considering offering US government debt in foreign currency.

China is the lefts last hope for the right balance of their dream of socialism. China, no matter how much they try to steal, will never grow to the size of our economy unless they internally develop the free market mechanisms of free thought.

Edward Charles Ponzi Jr. said...

"U.S. dollar would depreciate and domestic interest rates would rise"

"nor very severe in its real consequences if it does."

Oh? In a society totally saturated with government, speculative, mortgage, consumer and other debt?

Are you sure?

Anonymous said...

Nothing is worth anything. Over the last 25 yrs, the economic growth has been financed by the federal reserve pumping money into the system through the central banks or thru monetarization by issuing US bonds to sell to pay for war - some of which go to foreign countries to buy the bonds. People might have jobs, but the cost of living is rising very fast. The value of the dollar is falling because of paying for these billion dollar wars where issuing bonds is nothing more than signing some papers. Everyone somehow can afford a mercedes. Congress thinks money just grows on trees and the fed just printing money will solve the problems. People perceive being financially well-off, but your buying power slowly loses value because of inflation. Six-figure salaries are actually low now relative to housing prices. The reason the housing market is tanking is because the supply of houses is greater than the number of people who can actually afford. Also, there's no correlation between wealthy individuals and what they live in. There's so much money in the system, that food prices continues to rise. Unfortunately, the money is going to the CEOs and war-profiteers like Halliburton. There are jobs created, however, food-prices and cost-of-living will continue to rise because of contention for resources. Even though I live in USA, I would just wondering what would happen if China/Japan sold their debt. I would like to see $100 of gas and some crazy riots against government. We're all in "DEBT" even the wealthy because we all pay taxes for things the government wanted 20 yrs ago.