Earlier this week Paul Krugman went out of his way to point out that if China stopped buying US bonds, it wouldn’t be the end of the world.
We wanted to come back to some of his points, because well, we think they are pretty good.
In his explanation, Krugman cites Wicksellian theory, which — by analysing the amount of savings with respect to demand for investment — gives economists an idea about whether the natural rate of interest is below or above the official one.
As Krugman points out, despite an earlier paper by Bill White arguing the opposite (though, we ourselves focused on White’s point that QE could be deflationary just as much as inflationary when we addressed the paper), all evidence in this regard suggests the natural interest rate is currently below the official one.
We ourselves have been making a similar point. Indeed, we’ve been arguing that, contrary to what most people believe, official Fed policy has been indirectly propping up real rates, which would otherwise have zoomed into negative territory.
With markets still crowding each other out for safe assets, because savings demand is greater than investment demand, we come to a weird and wonderful point where it’s not even that it doesn’t matter if China stops buying Treasuries very much, it actually does the US and the world a favour.
As Krugman notes:
What China does by buying bonds is add to the excess savings — which makes our situation worse. (This is just another way of saying that the artificial trade surplus hurts our economy — just another way of stating the same thing). And we want them to do less of it; far from fearing that they will stop, we should welcome the prospect.
In our opinion, this is one of the most important points about China at the moment.
Not only are global flow dynamics pushing China into a situation where it may finally release some of the Treasuries it holds, doing so would be hugely beneficial to the US.
And just so the Krugman bashers don’t get too excited that this is only his uniquely contrarian view, we spotted a note from John Higgins at Capital Economics which argues a similar point, though he comes at it from a different angle.
In Higgins’ mind China never played a role in depressing long-term US Treasury yields. After all, he notes, if this was not true, why then would yields have remained so low in recent years, during which time China’s surplus savings have fallen?
We, of course, are inclined to think that China’s surplus savings did play a big role in depressing yields earlier in the naughties, and were probably the key factor behind Greenspan’s famous conundrum.
The reason why yields have stayed low despite China’s surplus savings falling is most likely, in our opinion, because Chinese savings demand is being crowded out by savings demand from US and foreign investors more widely.
What’s more, it is this switch in UST demand — money which might otherwise be going towards maintaining China’s trade surplus — which is now reversing flows, and helping to suck up Treasuries out of China.
In short, investors outside of China are outbidding the Chinese when it comes to USTs. And with a natural negative interest rate, there’s really very little incentive for them to keep fighting for the opportunity to invest, especially given the lack of new money they have to invest anyway.
And it is in this context that Higgins makes a very good point. Whatever the causes and effects on yields, the key consequence of Chinese surplus savings has been the exportation of disinflation:
For all that, we do think there has been an important indirect effect on Treasuries from China’s surplus savings. This is because such savings have kept the level of aggregate demand and inflation in the rest of the world – including in the US – lower than would otherwise have been the case. In turn, this may have influenced the Fed’s monetary policy stance, which is the primary determinant of Treasury yields.
In short, it was the disinflation — or possibly even deflation — which China was exporting for so long, which drove the Fed to maintain rates at such low levels. In other words, because the Chinese were saving their wealth rather than spending it, aggregate demand was being pent up on their shores.
Without the ability to keep saving, all that pent up demand now stands to be released to the rest of the world. That’s to say, China will have to start redeeming the UST ‘coupons’ it holds because it is no longer in a position where foreign demand for its goods allows it to stay a net saver after external costs are accounted for.
China will, of course, try to stimulate domestic demand to stop this happening. But if this doesn’t work — because there are arguably too many goods being produced in China for them to be sold profitably at home, and because external costs are getting too high — it may just end up stockpiling ever more finished products, or declaring ‘price majeure‘ one too many times for international comfort levels.
Which means, short of giving away goods for free — or there being a massive shift in global investor sentiment — China will have no option but to start spending Treasuries, if not (eventually) funding itself through its own capital deficit.
Something which would not only help China, but aggregate demand in the rest of the world too.
China, dollars, gold, and a theory of relativity - FT Alphaville
China’s unprecedented liquidity injection – FT Alphaville
Is the PBoC starting to liberalise its rate regime? – FT Alphaville
Wicksell goes to China – Paul Krugman, New York Times