July 22, 2005
China Unpegs Itself
By PAUL KRUGMAN
http://www.nytimes.com/2005/07/22/opinion/22krugman.html?th=&emc=th&pagewanted=print
Thursday's statement from the People's Bank of China, announcing that the yuan
is no longer pegged to the dollar, was terse and uninformative - you might say
inscrutable. There's a good chance that this is simply a piece of theater
designed to buy a few months' respite from protectionist pressures in the U.S.
Congress.
Nonetheless, it could be the start of a process that will turn the world
economy upside down - or, more accurately, right side up. That is, the free
ride China has been giving America, in which the world's richest economy has
been getting cheap loans from a country that is dynamic but still quite poor,
may be coming to an end.
It's all about which way the capital is flowing.
Capital usually flows from mature, developed economies to less-developed
economies on their way up. For example, a lot of America's growth in the 19th
century was financed by investors from Britain, which was already
industrialized.
A decade ago, before the world financial crisis of 1997-1998, capital movements
seemed to fit the historic pattern, as funds flowed from Japan and Western
nations to "emerging markets" in Asia and Latin America. But these days things
are running in reverse: capital is flowing out of emerging markets, especially
China, and into the United States.
This uphill flow isn't the result of private-sector decisions; it's the result
of official policy. To keep China's currency from rising, the Chinese
government has been buying up huge quantities of dollars and investing the
proceeds in U.S. bonds.
One way to grasp how weird this policy is would be to think about what a
comparable policy would look like in the United States, scaled up to match the
size of our economy. It's as if last year the U.S. government invested $1
trillion of taxpayers' money in low-interest Japanese bonds, and this year
looks set to invest an additional $1.5 trillion the same way.
Some economists think there is a deep rationale for this seemingly perverse
policy. I think it's something the Chinese government stumbled into as it tried
to protect itself from the 1997-1998 crisis, and it is reluctant to change
because the Chinese economy has been doing well. That is, China's leaders don't
want to mess with success.
But pressures against China's dollar purchases are building. By keeping the
yuan down, China is feeding a trade surplus that is creating a growing
political backlash in America and Europe. And China, which is still a poor
country, is devoting a lot of resources to the accumulation of a basically
useless pile of dollars instead of to higher living standards.
The question is what happens to us if the Chinese finally decide to stop acting
so strangely.
An end to China's dollar-buying spree would lead to a sharp rise in the value
of the yuan. It would probably also lead to a sharp fall in the value of the
dollar relative to other major currencies, like the yen and the euro, which the
Chinese haven't been buying on the same scale. This would help U.S.
manufacturers by raising their competitors' costs.
But if the Chinese stopped buying all those U.S. bonds, interest rates would
rise. This would be bad news for housing - maybe very bad news, if the interest
rate rise burst the bubble.
In the long run, the economic effects of an end to China's dollar buying would
even out. America would have more industrial workers and fewer real estate
agents, more jobs in Michigan and fewer in Florida, leaving the overall level
of employment pretty much unaffected. But as John Maynard Keynes pointed out,
in the long run we are all dead.
In the short run, some people would win, but others would lose. And I suspect
that the losers would greatly outnumber the winners.
And what about the strategic effects? Right now America is a superpower living
on credit - something I don't think has happened since Philip II ruled Spain.
What will happen to our stature if and when China takes away our credit card?
This story is still in its early days. On the first day of the new policy, the
yuan rose only 2 percent, not enough to make any noticeable difference. But one
of these days Chinese dollar purchases will trail off, and we'll find ourselves
living in interesting times.
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* Copyright 2005 The New York Times Company
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