Embrace the Dollar's Downfall

Banks might suffer if China stopped buying US debt, but the US economy as a whole would be much better off

Most of the economists and pundits who could not see an $8tn housing bubble are telling us that the United States desperately needs the Chinese government to keep buying its debt. This crew of failed analysts argues that without the support of the Chinese government, interest rates in the US will rise, choking off the recovery. In reality, the decision by China to stop buying US government debt might not harm the economy's recovery, but it could be devastating to the recovery efforts at Citigroup and other basket-case banks.

The basic logic is simple. China's central bank has been buying up huge amounts of dollar-based assets for the last decade. Their purchases include short- and long-term government debt, mortgage-backed securities and, to a lesser extent, private assets.

The Chinese central bank's purchases have two effects. First, they help to keep interest rates low. This supports economic growth by keeping down the interest rates on mortgages, car loans and other borrowing that boosts demand.

The other effect of China's purchase of dollar-based assets is that it keeps down the value of its currency against the dollar. This is the famed currency "manipulation", that draws frequent complaints from politicians. Of course, it is not exactly manipulation. China has an explicit policy of keeping down the value of its currency against the dollar. It is not buying up hundreds of billions of dollars of US assets in the dark of night. It does it in broad daylight in order to keep its currency at the targeted rate.

Suppose China stopped buying up US government debt. Interest rates in the US would rise, which would have some negative impact on growth. Of course, the Fed could try to offset this rise in rates by simply buying more debt itself. It has already been buying debt, and it could simply buy enough to replace the lost demand from China. This would leave interest rates largely unchanged.

Suppose that the Fed doesn't intervene and lets interest rates rise. This will have some negative impact on growth, but there will also be a very positive side from China's decision to stop buying dollars. The dollar would fall in value against China's currency. This would make Chinese goods more expensive in the United States, leading US consumers to purchases fewer imports from China and more domestically produced goods.

A lower-valued dollar would also make our exports cheaper in China. That would allow us to export more to China.

The net effect would be an improvement in our trade balance, bringing back some of the 5.5 million jobs that we've lost in manufacturing over the last decade. In fact, since nearly all economists agree that the current trade deficit can't persist for long, China would be helping the country bring about a necessary adjustment if it stopped buying up dollars.

Even the rise in interest rates would have a positive effect since it would allow for the completion of the deflation of the housing bubble, with house prices finally settling back to their trend levels. This drop in house prices will be a painful adjustment, but there is no way to avoid it. Bubbles cannot be sustained indefinitely, and we are better off allowing the housing market to return to normal so we can get back to a path of sustainable growth.

While decision of the Chinese to stop buying dollars might be good for the economy, it is likely to be disastrous for Citigroup and the rest of the basket-case banks. If interest rates rose, then the value of the government bonds the banks hold would plummet. If the interest rate on 10-year Treasury bonds goes from the current 3.5% to a still low 4.5%, then the banks will have lost 8% on their holdings. At a 5.5% interest rate, a rate that would still be far below the average for the 1990s, the loss would be 15%. Citi and the other basket cases could not endure these losses in their current financial state.

This could be why we see shrill pronouncements from the likes of Washington Post columnists and other "experts" who couldn't see an $8tn housing bubble that we need the Chinese government to keep buying up our debt. We absolutely do not need the Chinese government to keep buying US debt and would almost certainly be better off if it stopped tomorrow. Citigroup and the other big banks do need the Chinese government to keep the money flowing if they are to have a chance of getting back on their feet. And, we know where the sympathies of the Washington Post's editors and other "experts" lie.

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