Baker Critique

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Does Citigroup Need China?

By Dean Baker

Most of the economists and pundits who could not see an $8 trillion housing bubble are telling us that the United States desperately needs for 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 United States will rise, choking off the recovery. In reality, the decision by China to stop buying U.S. government debt may 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 rate on mortgages, car loans, and other borrowing that boosts demand.

Interest rates are lower than otherwise only if China’s maturity preference is longer than that of who would otherwise have the excess balances and buy treasury securities. And most of what they buy is probably short term and therefore has little influence on rates.

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 U.S. assets in the dark of night. It does it in broad daylight in order to keep its currency at the targeted rate.

Right. They keep their currency down to keep their domestic real wages low enough to be ‘competitive.’

Suppose China stopped buying up U.S. government debt. Interest rates in the U.S. would rise,

Very little, if any.

which would have some negative impact on growth.

Very small impact, if any.

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.

Yes, any time the Fed wants tsy rates lower it can simply buy them in sufficient quantities to keep rates at their desired target rate.

Suppose that the Fed doesn’t intervene and lets interest rates rise.

A few basis points.

This will have some negative impact on growth,


but there will also be a very positive side effect 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 U.S. consumers to purchases fewer imports from China and more domestically produced goods.

Yes, which reduces our standard of living.
Imports are real benefits, exports real costs.

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

Right, we work and produce goods and services but instead of consuming them domestically we send them to china for them to consume. We become the world’s slaves instead of China.

The net effect would be an improvement in our trade balance,

The number goes towards positive, but that’s not ‘improvement’ from a US standard of living point of view.

bringing back some of the 5.5 million jobs that we’ve lost in manufacturing over the last decade.

We can sustain domestic demand at full employment levels with fiscal policy, such that there is sufficient demand for us to buy all we produce plus whatever the rest of world wants to send us.

And fewer manufacturing jobs means people in the us are free to produce other real goods and services for domestic consumption. It’s all a matter of sustaining domestic demand with the right fiscal adjustments.

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.

Its their loss and our gain. Why should we work to kill the goose that’s laying the golden eggs for us?

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.

How about supporting incomes through a full payroll tax holiday, and a $500 per capita revenue distribution to the states, and a federally funded $8/hr job for anyone willing and able to work
To use an employed labor buffer stock rather than an unemployed labor buffer stock as a price anchor.

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.

Sustaining incomes on a moderate 3% growth path rather than the current -3% path personal income is now on will work wonders for stabilizing the housing markets, and fixing the banks as well from the bottom up, as the bad loan problem improves due to falling delinquencies. Instead, the govt has been using top down funding of the banks that has resulted in delinquencies continuing to rise.

While the decision of the Chinese to stop buying dollars might be good for the economy,

Only because we do not understand the monetary system sufficiently to know how to sustain domestic demand.

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 they hold would plummet. If the interest rate on 10-year Treasury bonds goes from the current 3.5 percent to a still-low 4.5 percent, then the banks will have lost 8 percent on their holdings. At a 5.5 percent interest rate, a rate that would still be far below the average for the 90s, the loss would be 15 percent. Citi and the other basket cases could not endure these losses in their current financial state.

Only if they currently have a maturity mismatch, which is not permitted by regulation. Bank regulators and supervisors get ‘gap’ reports for the banks to make sure they aren’t taking that kind of interest rate risk. If they are it’s a violation that the regulators need to put an end to.

This could be why we see shrill pronouncements from the likes of the Washington Post editors, and other “experts” who couldn’t see an $8 trillion housing bubble, that we need the Chinese government to keep buying up our debt.

Not likely the reason they think we need China to buy our debt.

We absolutely do not need the Chinese government to keep buying U.S. 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.

‘Money flowing’ has nothing to do with interest rates. The fed can set the risk free rate at whatever level it wants to.

And we know where the sympathies of the Washington Post’s editors and other “experts” lie.

— This article was published on October 19, 2009 by the Guardian Unlimited [].


Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of Plunder and Blunder: The Rise and Fall of the Bubble Economy. He also has a blog on the American Prospect, “Beat the Press”, where he discusses the media’s coverage of economic issues.

The Center for Economic and Policy Research is an independent, nonpartisan think tank that was established to promote democratic debate on the most important economic and social issues that affect people’s lives. CEPR’s Advisory Board includes Nobel Laureate economists Robert Solow and Joseph Stiglitz; Janet Gornick, Professor at the CUNY Graduate Center and Director of the Luxembourg Income Study; Richard Freeman, Professor of Economics at Harvard University; and Eileen Appelbaum, Professor and Director of the Center for Women and Work at Rutgers University.


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One Response to Baker Critique

  1. RSJ says:

    Great Blog. I will chime in.

    Interest rates are lower than otherwise only if China’s maturity preference is longer than that of who would otherwise have the excess balances and buy treasury securities

    You need to take into account what is happening to the underlying money flows. So a company liquidates a domestic manufacturing plant, obtaining savings, S, and offshores to China. The Chinese exporter is paid, say, S/2. The S/2 is passed on as return to capital of the firm. The PBOC takes S/2 from the exporter (reimbursing him with RMB at the prescribed exchange rate) and re-invests it in U.S. Securities.

    The net result of this is that S is transferred from wages to capital. This lifts the price of capital and suppresses the price of labor. A rise in the price of capital means that yields fall more than they otherwise would. Of course, this is not sustainable over the long term.

    This has nothing to do with the maturity preference per se, since the result is an overall reduction in rates, although this reduction shows up more on the longer end of the term structure, as the short end is controlled by the Fed.

    There is strong evidence that offshoring to low wage countries results in an industry wide reduction in wages, and since 1990 an increase in net imports/GDP corresponds to a decrease in the overall level of compensation/GDP. In addition to this, there is a shift in the distribution of wages, with bonuses going to top management, who invest are more likely to invest the windfalls.

    So the interest rate effects come from the distributional effects of the trade, not from China per se. If it was India or any other low wage country used to enforce wage-arbitrage, the result on lowering long term rates would be the same.

    Right. They keep their currency down to keep their domestic real wages low enough to be ‘competitive.’

    Agreed. And you also need to realize that U.S. businesses via the current account deficit are also keeping real wages low here in the U.S. by offshoring — that is why they call it “wage arbitrage”; both sides are using trade to suppress wages. In the same way, if we were engaging in “capital arbitrage”, then both sides would use trade to boost wages, regardless of the current account. So whether wages go up or down is not just a function of the direction of the imbalance, but of the effect of the imbalance on the supply and demand for labor and capital in each country. At the end of the day, imbalances cannot continue to grow.

    Yes, any time the Fed wants tsy rates lower it can simply buy them in sufficient quantities to keep rates at their desired target rate.

    Huh? The Fed controls the call money rate because it is an overnight bank rate. That is a very special situation as there is virtually no liquidity preference or risk involved, and there are captive buyers and sellers in the form of regulated banks that must hold reserves and must bid for reserves.

    However, the Fed does not control the other rates. It “influences” the other rates, in the sense that it has influence over GDP growth, inflation, and the call money rate, all of which together influence interest rates. But liquidity preference and risk aversion also play a role, as well as many other factors.

    At the end of the day, there are no captive buyers or sellers for treasuries or corporate bonds, unlike the situation of banks and reserves. No is required to buy them if the rates are too low, and no one is required to sell them if the rates are too high. There is always the option of equity (e.g. directly purchasing or selling capital). The nominal returns on equity, over long periods, will be the nominal GDP growth rate. And bonds must compete with those returns. In exchange for offering various benefits (e.g. a shorter duration of capital commitment, less volatile payments, tax breaks) bond issuers are able to command various discounts over the long run GDP growth rate, and these discounts depend on the investors’ liquidity preference and risk aversion. But at the end of the day, the investor can always start a business or pay someone to start a business and earn the GDP growth rate as a return, leaving the Fed as the only buyer of treasuries if the rates are too low.

    Yes, which reduces our standard of living.
    Imports are real benefits, exports real costs.

    That is like saying that eating and drinking are real benefits instead of real costs. It depends on what you consume, as there is an interplay between the current account and the structure of the economy. Some industries, such as manufacturing, have increasing returns to scale while others do not. If you liquidate your increasing-return industries in order to get a short-term consumption boost, you will end up immiserating your population over the long term.

    It may well be the case that we can just abandon domestic manufacturing and shift the population over to retail sales and construction, but those sectors do not allow for compounding productivity growth. A waiter today is not more productive than a waiter in 18th century France, whereas a manufacturer is. So even if China offers to relieve us of the burden of manufacturing and allows us to consume all the industrial output we need at waiter-level wages, it would be a bad deal, because when they change their mind later on, it will not be easy to bring those sectors back.

    Capital is not some amorphous blob that can be turned up or down with a forex adjustment. It is an ecology consisting of cross-generational institutional knowledge, education systems, distribution systems, and credit relationships. There are network effects. Many undeveloped countries have tried for decades to acquire these ecologies and have failed to do so. I wouldn’t be so quick to liquidate these because I can boost my return by a few percentage points, or because of a short-term consumption benefit; if the result of trade is to liquidate these pools and exchange them for capital that has a lower long return, then it is a long term harm, not a long term benefit.


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