The Dollar Is Now China's Problem

J. Paul Getty once said:

If you owe the bank $100 that's your problem. If you owe the bank $100 million, that's the bank's problem.

In modern times it could rephrased:

If the U.S. owes China $100bn, that's the U.S.'s problem. If the U.S. owes China $2tn (and growing), that's China's problem.

The question is what can be done about it.

As Kenneth Rogoff notes, the current U.S./China imbalance resembles the U.S./Europe imbalances of the 1960s-70s. Europe didn't do so well in that deal, as the inflation of the 1970s eroded much of the dollar's value. But the issue is bigger now, and affects more than just China:

In the run-up to the financial crisis, the U.S. external deficit was soaking up almost 70% of the excess funds saved by China, Japan, Germany, Russia, Saudi Arabia, and all the countries with current-account surpluses combined. But, rather than taking significant action, the U.S. continued to grease the wheels of its financial sector. Europeans, who were called on to improve productivity and raise domestic demand, reformed their economies at a glacial pace, while China maintained its export-led growth strategy.

He says a dollar crisis is not imminent, but is "certainly a huge risk over the next 5 to 10 years". Recall that before the financial crisis Nouriel Roubini and Paul Krugman (among many others) were predicting a dollar crisis, and the U.S. now faces a much worse fiscal position than it did before the crisis. So there are legitimate reasons for worry, but Rogoff says this is China's problem, and only China can fix it:

Any real change in the near term must come from China, which increasingly has the most to lose from a dollar debacle. So far, China has looked to external markets so that exporters can achieve the economies of scale needed to improve quality and move up the value chain. But there is no reason in principle that Chinese planners cannot follow the same model in reorienting the economy to a more domestic-demand-led growth strategy.

Yes, China needs to strengthen its social safety net and to deepen domestic capital markets before consumption can take off. But, with consumption accounting for 35% of national income (compared to 70% in the U.S.!), there is vast room to grow.

I'd add that some adjustment needs to come from Germany and other export-biased industrialized economies too, but Rogoff's point is sound: China desperately needs to develop its domestic market. This will hurt the U.S. some in the medium run as its borrowing costs go up, but it is a necessary transition.

Fortunately, we have a mechanism for gradual, relatively painless, macroeconomic adjustments: floating exchange rates. But that only works if the exchange rates are truly allowed to float. If they are not, then imbalances will continue to pile up until there is some sort of currency crisis, and then the adjustment becomes much more painful.

Right now almost every economic issue seems to be on the table, and this is the most pressing: the U.S. cannot continue to soak up all the excess savings in the world forever, and exporting countries need to reinvest some of those savings domestically. The global economy needs to transition, and there's no time like the present.

Comments

[CautiousInv...:]

The imbalances between China and the US remain a a bilateral problem; both countries must address their respective weaknesses.

For China, as the author correctly points out, it is the need to move towards a more consumption driven economy through improving education and epanding healthcare and retirement benefits. Along with rising incomes, this should help in making China more consumption driven.

The US, on the other hand, must do something to contain its reckless spending and borrowing policies to reduce its reliance upon sucking up all of the surplus capital available on the planet.
If we do not, we will place ourselves at economic risk and expose our creditors and currency to losses.

The depreciation of the dollar, while helpful, must be accompanied by efforts to expand savings, reduce consumtion, become more cost-effective and shift production to export goods and good that compete with imports. Currency alone is not sufficient.

China, India, Brazil, Turkey and other emerging market countries are providing the kind of domestic demand-driven growth stimuli that could pull the US along in its wake but these are the same countries that are most unlikely to prevent a real depreciation of the US dollar and a real appreciation their currencies.

China may allow a slow appreciation of their currency as internal consumption replaces exports, making it a long term process.

Oct 13 10:38 AM

[Klutz:]

Just spitballing here but perhaps the fed could declare a dollar "reverse split". For every 50 you get a troll shaped eraser made in China. Problem solved.

Oct 13 11:07 AM

[LilBob:]

The Obama administration appears to be pursuing a path of managed inflation to make US production relatively more competitive versus other countries. The real challenge for China, is that international oil markets are priced in dollars, and the decline of the dollar leaves China susceptible to significant long term losses from rising oil prices. The flip side of that is that if-as the Chinese have proposed-a new international currency was created to facilitate commodities trading, the resultant untethering of the US dollar from international markets could create a situation not unlike when Roosevelt untethered the dollar from the Gold standard, resulting in the potential for a gigantic leap in the cost competitiveness of the American worker, and subsequent decline in China's competitiveness in its largest export market.

The real problem that everyone has to face right now is the over-abundance of investment capital that is available in a world where consumer capital is in rapid decline. Even though the government of China controls trillions in currency reserves, many in the Chinese countryside still live in abject poverty. Stimulation of domestic demand absent significant government subsidies for consumers-something which would virtually guarantee significant declines in Western capital investment-could easily result in goods being produced without any potential buyers. To say that China can stimulate internal demand because the government is holding so much in currency reserves is akin to saying we can all live in million dollar condos because Bill Gates is still a billionaire.

Oct 13 11:34 AM

[The Geoffster:]

"`Yes, China needs to strengthen its social safety net and to deepen domestic capital markets before consumption can take off. But, with consumption accounting for 35% of national income (compared to 70% in the U.S.!), there is vast room to grow.'"
Give me a break. Save less so you can spend more and Uncle Mao will make sure you don't starve when you're deep in debt and can't take care of yourself any more. Wake up people. This is what "health care reform" is ultimately all about. Impoverish everybody until government is all that's left.

Oct 13 11:49 AM

[Moon Kil Woong:]

China's real problem is not the dollar but the RMB. No longer can they sustain a devalued RMB in the face of a rapidly depriciating dollar. Inevitably they must face what all developing contries face as the mature from Japan to S. Korea, a rising cost of labor and the rising value of their local currency.

If they want to be productive they should focus on fixing their own house first. If they want to dump dollars and devalue our currency let them. It may be bad for the US short term but long term it's good for us long term. Otherwise, they wouldn't want to keep the Yuan weak.

Oct 13 12:03 PM

[Duude:]

Its more than an understatement to say that it will be difficult for China to evolve into a consumer-driven economy. The culture in China is such that the young take care of the older family members. With China's minimal safety net this is an essential part of their culture. Add to that the one child per couple birth control that's been in place since the 1970's and the demographics make it more than difficult to evolve. This is in a country where a fair percent of the entire workforce is still employed in highly inefficient government jobs which are remnants of a socialist planned economy. The government wants to end these job programs but must wait for private enterprise to replace the lost jobs, and yet still they have another 400-500 million unemployed or underemployed.

Oct 13 12:36 PM

[Glen88:]

While I agree with you typically good comments, I do wonder about the US's ability to capitalize on any comparative advantage a devalued currency would bring.

As Japan has shown, as with most other mercantilist, even when exchange rates tip the advantage to foreign production, it does not occur. Japan never became a good customer of the US. I doubt China will either. If markets were truly free, Toyota and Honda would not be closing plants in the US while keeping Japanese ones open.

Trade with such nations needs to balanced by force.

On Oct 13 12:03 PM Moon Kil Woong wrote:

> China's real problem is not the dollar but the RMB. No longer can
> they sustain a devalued RMB in the face of a rapidly depriciating
> dollar. Inevitably they must face what all developing contries face
> as the mature from Japan to S. Korea, a rising cost of labor and
> the rising value of their local currency.
>
> If they want to be productive they should focus on fixing their own
> house first. If they want to dump dollars and devalue our currency
> let them. It may be bad for the US short term but long term it's
> good for us long term. Otherwise, they wouldn't want to keep the
> Yuan weak.

Oct 13 02:42 PM

[imagtek:]

There is more global wealth in the form of fiat currencies than there is physical resources to produce goods. Talk of China and India 'increasing consumption' is pathetic nonsense that can only lead to global eco-disaster. What is going to happen is global inflation of all currencies relative to food and commodities; i.e commodities are going to cost dramatically more in all currencies. It is physically impossible for India and China to achieve 1st world living standards except for tiny minorities. It is also economically impossible for the USA to maintain its existing living standards, except for tiny minorities. At some point, the world will share the same standard of living; probably akin to Cuba or Brazil. The age of opulence is over forever. Those who strive for what others cling to in a zero sum game can only resort to conflict. This is going to get ugly.

Oct 13 05:07 PM

[Madcow2:]

That is right Imagtek -

Last Spring, we saw all kinds of commodity markets red-lining as a "global growth and prosperity" story was being sold to hopeful workers and investors (and tax collectors) across the globe. To prevent hyper-inflation, the Central Bankers pulled the plug on the credit machine.

Now, they're trying to have their cake and eat it. They want the bonds to maintain their integrity, but they don't want commodity prices to go up 50x. Something has to give.


On Oct 13 05:07 PM imagtek wrote:

> There is more global wealth in the form of fiat currencies than there
> is physical resources to produce goods. Talk of China and India 'increasing
> consumption' is pathetic nonsense that can only lead to global eco-disaster.
> What is going to happen is global inflation of all currencies relative
> to food and commodities; i.e commodities are going to cost dramatically
> more in all currencies. It is physically impossible for India and
> China to achieve 1st world living standards except for tiny minorities.
> It is also economically impossible for the USA to maintain its existing
> living standards, except for tiny minorities. At some point, the
> world will share the same standard of living; probably akin to Cuba
> or Brazil. The age of opulence is over forever. Those who strive
> for what others cling to in a zero sum game can only resort to conflict.
> This is going to get ugly.

Oct 13 09:47 PM