This morning Ambrose Evans-Pritchard of the London Daily Telegraph dropped a bomb by writing that China is considering the "nuclear option" of dumping its several hundred billion dollars worth of foreign reserves if the U.S. goes ahead with protectionist policies.
Treasury Secretary Hank Paulson, who just returned from a week of high-level meetings in China, called this idea "absurd."
Bruce Bartlett offers a good summary of why China wouldn't -- and won't -- exercise the "nuclear option" here. Quite simply, it would be against their best interest:
As economist John Maynard Keynes once explained, "Owe your banker 1,000 pounds and you are at his mercy; owe him one million pounds and the position is reversed" (Collected Writings, vol. 24, p. 258). In short, the more money we owe the Chinese, the more power we have over them. Evans-Pritchard has the whole relationship exactly backwards.
But looking more closely at the quotes in the Daily Telegraph article, an alternative reading is possible, albeit a reading that reaches the same conclusion and still mitigates against the "nuclear option" charge that Evans-Pritchard makes in his article.
He Fan of the Chinese Academy of Social Sciences said that
"China has accumulated a large sum of US dollars. Such a big sum, of which a considerable portion is in US treasury bonds, contributes a great deal to maintaining the position of the dollar as a reserve currency. Russia, Switzerland, and several other countries have reduced the their dollar holdings.
"China is unlikely to follow suit as long as the yuan's exchange rate is stable against the dollar. The Chinese central bank will be forced to sell dollars once the yuan appreciated dramatically, which might lead to a mass depreciation of the dollar,"
Instead of a "threat," He Fan's statement could also be read as a very matter of fact assertion of economic reality. If the U.S. keeps pursuing its weak-dollar policy and forces China to appreciate the yuan, the effect is to reduce the value of China's reserves. China would not want to continue holding its investments in a sinking currency. This is not some dastardly scheme, but simply basic investing. As He Fan noted, other nations have already diversified away from dollars, partly to avoid investment losses in a weakening currency.
The chief cause of all these global arguments these days is not a weak yuan but a weak dollar. The custodian of the dollar is the Fed and the U.S. Treasury. An inflationary, weak dollar has been the chief cause of the run-up in energy, commodity, and real-estate prices over the last few years. Seventy-five dollar oil and the sub-prime loan shakeout are just two of the results of the Fed holding interest rates at 1% for too long and then raising rates too slowly.
China critics should beware of their logic. The U.S. dollar has been the weakest major currency. It has depreciated massively against the euro. Using the reasoning of the China bashers, one would have to conclude that the U.S. is by far the worst currency manipulator in the world. But they have a completely erroneous economic model. Chinese exports of goods and U.S. imports of capital are driven by fundamentals -- the hyper-growth of Chinese productivity, labor supply, and manufacturing capacity on the one hand and the financial and technological sophistication of the U.S. on the other. This sophistication means profits and rates of return are far higher in the U.S. than most of the rest of the world. We therefore attract capital while developing nations export lots of countable goods.
As Don Luskin notes, we import more from Canada (mostly oil and other natural resources) than we do from China, but is Canada a currency manipulator? Other nations link their currencies to the dollar, but we do not mind it. We actually encourage it. The Chinese yuan (along with the dollar) has depreciated substantially versus the euro over the last decade, yet growth of European imports from China have grown at the exact same rate as U.S. imports from China. The exchange rate is not the issue.
Robert Mundell knows the very opposite of conventional wisdom over the trade deficit is true:
The high U.S. trade deficit, widely supposed to be unsustainable, is not only sustainable, Prof. Mundell argues, it is necessary to the functioning of the global economy.
Winner of the 1999 Nobel Prize in economics, Mundell has done the best and deepest thinking on this topic, two recent examples of which can be found in interviews in the Far Eastern Economic Review and BusinessWeek.
The Chinese have lots to answer for -- intellectual property violations, environmental degredation, and the safety of their food and manufactured exports, to name just three big concerns.
But the real "nuclear option" of self-destructive protectionism is being contemplated by our very own politicians in the Senate Banking Committee and on the presidential nomination trails.