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Paul Krugman Versus Economic Reality

Economics / Economic Theory Mar 18, 2010 - 12:08 PM GMT

By: Peter_Schiff

Economics Best Financial Markets Analysis ArticleIn his latest weekly New York Times column, Nobel Prize-winning economist Paul Krugman put forward arguments that were so nonsensical that the award committee should ask for its medal back.


Recent rhetoric from Washington has put the economic relationship between the U.S. and China squarely on the front burner, and Krugman is demanding that we crank up the flame. This week 130 members of Congress sent a letter to Treasury Secretary Timothy Geithner demanding that the Obama administration designate China as a "currency manipulator". Following that, a bipartisan group of senators introduced a bill that looks to force the Obama administration's hand. For its own part, Beijing invites criticism by continuing to deny its utterly obvious currency agenda.

As these tensions escalate, most economists urge Washington to tread lightly because of the negative fallout for America if China were to begin selling its enormous cache of U.S. Treasury bonds. Krugman pushes back, asserting that the U.S. risks little by playing hardball, and that China has more to lose. He asserts that a Chinese decision to end its purchases of U.S. Treasury debt would make only a marginal impact on long-term interest rates. Did you hear that Stockholm?

According to Krugman, our secret weapon of economic invincibility is the Fed's ability to print dollars endlessly. If China were to foolishly decide to attack us by selling our debt, the Fed could simply step in and buy the excess with newly printed greenbacks. (In other words, Krugman sees no difference between funding the debt and monetizing it. See my latest video blog on the subject.). For Krugman, China would gain little from such an attack, but would lose the ability to export to its best customer and suffer severe losses in the value of its dollar holdings. Krugman's worldview is reassuring - but it has absolutely nothing to do with reality.

There is a huge difference between selling your debt to another and "selling" it to yourself. When China buys our debt, it uses its own savings. In order to purchase a trillion dollars of U.S. Treasuries, the Fed would have to expand our money supply by a corresponding amount. Even Krugman acknowledges that this would cause the dollar to lose value; however, he feels that a weaker dollar is good for America and bad for China.

Krugman does not believe that a tanking dollar will translate into higher interest rates or higher consumer prices at home. No matter how many dollars the Fed creates, or how much value those dollars lose relative to other currencies, he is confident that as long as unemployment remains high, rates will stay low and inflation will remain under control. This is absurd.

If the dollar were to nosedive, the Fed would normally look to protect the currency by raising interest rates, thereby increasing foreign demand for the currency. But with an economy currently on crutches, the Fed will ignore a weakening dollar and continue to try to boost employment with near-zero rates.

But keeping the Fed Funds rate low only holds rates down for U.S. government debt. If the dollar weakens substantially, other rates offered to other borrowers will rise as investors demand greater returns to compensate for inflation. To keep rates low for homeowners, credit card borrowers, corporations, municipalities, and state governments, the Fed would be forced to buy, or guarantee, all forms of dollar-denominated debt. The Fed would become the lender of only resort.

Once the Fed shows that its commitment to low rates is limitless (the value of the dollar be damned), private creditors will quit the game. Even average Americans would hit the Fed's bid. It would be a race for the exits, with no one wanting to be left holding a bag of worthless paper dollars.

Most economists, Krugman included, see cheap money as a panacea for all ills. And while it's true that a falling dollar, by lowering the real value of U.S. wages, would help make U.S. goods more competitive, it would also lead to skyrocketing consumer prices, rapidly rising interest rates, and a collapse in American living standards. Make no mistake: this is the end game of Krugman's "get tough on China" policy.

This apocalyptic scenario can only be avoided if Washington jealously guards the status quo, avoiding confrontation with China at all costs. Yet, even that is an outcome that no one can rationally expect. Given exploding U.S. government deficits and the inability of U.S. citizens and corporations to repair their balance sheets, the United States faces financing needs that even China's gargantuan savings stockpile will be unable to cover.

Krugman is right about one thing - China's currency peg is destabilizing the global economy and must end. But he fails utterly to understand the implications for the U.S. and China. If China were to reverse its role in the U.S. Treasury market, both economies would be destabilized in the short-term. But in the medium- and long-term, China would clearly emerge as the winner.

Absent Treasury-bond purchases, the value of the Chinese currency would rise sharply, causing goods prices to tumble in China. This long-delayed increase in purchasing power for everyday Chinese will unleash pent-up demand in what is already the largest middle class in the world. Chinese factories would retool in order to produce goods for their own citizens to consume. In RMB terms, commodity prices would plunge, making it easier for China to produce all kinds of stuff, such as automobiles, while also making it cheaper for the Chinese to buy gas. Millions will trade in bikes for cars, and Chinese oil imports will swell.

The opposite would occur in America, where an artificial, consumer-based economy, supported by Chinese lending, will come tumbling down. Without the ability to import cheap goods from overseas, Americans will pay more and get less. While gas and food become cheaper for the Chinese, they will simultaneously become much more expensive for Americans - so too will automobiles, consumer electronics, furniture, and just about every other product we want or need (even those few we still make ourselves).

Washington's best option is to recognize that the current relationship is unsustainable and to plan, as best as possible, for a more viable future. We Americans also must be honest with ourselves and recognize that we have been living beyond our means and that our lifestyle has been largely financed by austerity in China. We must conceive of a plan that weans us from this dependence without provoking China to pull the rug out from under us before we have a firm footing. To construct a policy around Krugman's ridiculous assumption that we benefit China more than they benefit us is to invite catastrophe on an unimaginable scale.

For a more in-depth analysis of how the weaknesses in the U.S. economy could threaten dollar-based investments, subscribe to The Global Investor, Peter Schiff's free online newsletter. Click here for more information.

Regards,
Peter Schiff

Euro Pacific Capital
http://www.europac.net/

More importantly make sure to protect your wealth and preserve your purchasing power before it's too late. Discover the best way to buy gold at www.goldyoucanfold.com , download my free research report on the powerful case for investing in foreign equities available at www.researchreportone.com , and subscribe to my free, on-line investment newsletter at http://www.europac.net/newsletter/newsletter.asp

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