US policy (once again) fails the Chinese test

Lots of folks in Washington don’t think the Bush Administration and the Congress are serious about cutting the fiscal deficit, and reducing the strain the federal government places on anemic US savings.

Seems like our creditors in Beijing are not all that happy either.

They think the US is blaming China for economic problems made in Washington DC. Listen to Wei Benhua -- the number two man at China’s State Administration of Foreign Exchange (SAFE), the United States’ second largest creditor (after Bank of Japan):

"I made it clear to them: this is your problem. You should put your own house in order before you blame your neighbors," said Wei, referring to a recent meeting with U.S. counterparts. ...

Wei blamed the U.S. trade deficit on "a flawed US economic policy" and said China would make currency decisions based on its own economic needs. To date, China has not put its money where its mouth is: it could rather easily increase pressure on the US to do something about its fiscal deficit rather dramatically if it ever was willing to play hardball. The fund managers at China’s State Administration of Foreign Exchange would not even need to sell dollars. All they would need to do is let it be known that they intended to aggressively reduce the duration of their dollar portfolio.

To be fair, China’s steps to clean up its own equivalent of the budget deficit -- the enormous overhang of bad loans in its banking system -- have been small and timid relative to the scale of the underlying problem. China needs to be wary of using the US tendency to put too much blame on China as an excuse for its own inaction.I suspect both Ronald McKinnon and Joe Stiglitz would agree with Mr. Wei. I do too, though I think both McKinnon (see the Mary Kissel column in the Monday Wall Street Journal) and Stiglitz understate the China-centric case for a Chinese revaluation. China imports too few goods from the world for its own and the world’s good, and buys too much US debt instead; a revaluation could help change that. China is not so rich that it makes sense for China to finance the rest of the world.

I am drawn instead toward Jeff Frankel’s analysis. I’ll summarize his argument this way: countries that can produce cars that compete effectively in the US and European markets usually have a per-capita income (in dollar terms) of far more than $1,500. China’s domestic prices are very low, relative to world prices -- China’s current dollar income understates its true level of development. Over time, the gap between Chinese income and US and European and Japanese income will fall. I would much rather see China’s incomes rise toward world levels than see US and European income sink toward Chinese levels.

One aside: I don’t think McKinnon’s conflicted virtue argument (China has lots surplus savings to lend to the world because of its high savings rate, but it cannot lend in renminbi abroad, so it is left saving in dollars, which generates all sorts of problems) works perfectly for China. Not all Chinese investment abroad takes the form of dollar debt, for one. Think, for example, of China’s growing investment in the production of oil and natural resources. McKinnon’s argument that renminbi appreciation would be to China today what yen appreciation was to Japan in the 80s needs to be considered seriously. I don’t quite see it though. China today is not quite as wealthy as Japan in the 80s, for one. And Japan’s bubble economy came about when Japan responded to yen appreciation with loose money (which for strange reasons did not lead the yen to fall, but did inflate Japanese property prices). China seems to be generating its own version of the bubble economy (check out Shanghai property prices, which some folks seem to think will keep on rising) with a loose monetary policy created by the combination of an undervalued renminbi and hot money flows.

More on this later.