Should America Kowtow to China?
Monday, 11/16/2009 - 5:09 pm by Marshall Auerback | 18 Comments
Do the Chinese really fund our deficit? Or is this more Neo-classical money mythology?
Another Presidential junket to Asia and another one of the usual lectures from China, decrying our “profligate ways”. Today’s Wall Street Journal reports:, “China’s top banking regulator issued a sharp critique of U.S. financial management only hours before President Barack Obama commenced his first visit to the Asian giant, highlighting economic and trade tensions that threaten to overshadow the trip.”
According to Liu Mingkang, chairman of the China Banking Regulatory Commission, a weak U.S. dollar and low U.S. interest rates had led to “massive speculation” that was inflating asset bubbles around the world. It has created “unavoidable risks for the recovery of the global economy, especially emerging economies,” Mr. Liu said. The situation is “seriously impacting global asset prices and encouraging speculation in stock and property markets.”
Well, “them’s fightin’ words”, as we say over here. And of course, the President and his advisors are supposed to accept this criticism mildly because in the words of the NY Times, the US has assumed “the role of profligate spender coming to pay his respects to his banker.”
The Times actually does believe this to be true. They refer to China’s role as America’s largest “creditor” as a “stark fact”. They do not seem to understand that simply because a country issuing debt which it creates, it does not depend on bond holders to “fund” anything. Bonds are simply a savings alternative to cash offered by the monetary authorities, as we shall seek to illustrate below.
It is less clear to us whether the Chinese actually believe this guff, or simply articulate it for public consumption. China has made a choice: for a variety of reasons, it has adopted an export-oriented growth strategy, and largely achieved this through closely managing its currency, the remnimbi, against the dollar.
One can query the choice, as many would argue that it is more economically and socially desirable for China to consume its own economic output. According to Professor Bill Mitchell, for example, “once the Chinese citizens rise up and demand more access to their own resources instead of flogging them off to the rest of the world…then the game will be up. They will stop accumulating financial assets in our currencies and we will find it harder to run [current account deficits] against them.”
But there have undoubtedly been certain benefits that have accrued to the Chinese as a consequence of this strategy. The export prices obtained by Chinese manufacturers are about 10 times as high as the prices obtained in the more competitive domestic markets, and the challenge of competing in global markets has forced Chinese manufacturers to adhere to higher quality standards. This, in turn, has improved the overall quality of Chinese products. In the words of James Galbraith:
“Is there a way for the Chinese manufacturing firm to turn a profit? Yes: the alternative to selling on the domestic market is to export. And export prices, even those paid at wholesale, must be multiples of those obtained at home. But the export market, however vast, is not unlimited, and it demands standards of quality that are not easily obtained by neophyte producers and would not ordinarily be demanded by Chinese consumers. Only a small fraction of Chinese firms can actually meet the standards. These standards must be learned and acquired by practice.” (”The Predator State, Ch. 6, “There is no such thing as free trade”, pg. 84).
What about the US government? What should it do? Should it actually respond to China’s complaints by trying to “defend the dollar”?
I hear this recommendation all of the time in the chatterplace of the financial markets, but seldom do those who fret about the dollar’s declining level actually suggest a concrete strategy to achieve the objective. In fact, it is unclear to me that there is any measure the Fed or Treasury could adopt which might support the dollar’s external value.
And why should they? Given the horrendous unemployment data, and 65% capacity utilization, it is hard to view imported inflationary pressures via a weaker dollar actually becoming a serious threat.
But wait? Don’t the Chinese (and other external creditors) “fund” our deficit? And won’t they demand a higher equilibrating interest rate in order to offset the declining value of their Treasury hoard?
Again, this displays a seriously lagging understanding of how much modern money has changed since Nixon changed finance forever by closing the Gold window in 1973. Now that we’re off the gold standard, the Chinese, and other Treasury buyers, do not “fund” anything, contrary to the completely false & misguided scare stories one reads almost daily in the press.
This claim is seldom challenged, but our friend, Warren Mosler, recently gave an excellent illustration of this fact in an interview with Mike Norman. Mosler provides a hypothetical example in which China decides to sell us a billion dollars’ worth of T-shirts. We buy a billion dollars’ worth of T-shirts from China:
“And the way we pay them is somebody pays China. And the money goes into their checking account at the Federal Reserve. Now, it’s called a reserve account because it’s the Federal Reserve, and they give it a fancy name. But it’s a checking account. So we get the T-shirts, and China gets $1 billion in their checking account. And that’s just a data entry. That’s just a one and some zeroes.
Whoever bought them gets a debit. You know, it might have been Disneyland or something. So we debit Disney’s account and then we credit China’s account.
In this situation, we’ve increased our trade deficit by $1 billion. But it’s not an imbalance. China would rather have the money than the T-shirts, or they wouldn’t have sent them. It’s voluntary. We’d rather have the T-shirts than the money, or we wouldn’t have bought them. It’s voluntary. So, when you just look at the numbers and say there’s a trade deficit, and it’s an imbalance, that’s not correct. That’s imbalance. It’s markets. That’s where all market participants are happy. Markets are cleared at that price.
Okay, so now China has two choices with what they can do with the money in their checking account. They could spend it, in which case we wouldn’t have a trade deficit, or they can put it in another account at the Federal Reserve called a Treasury security, which is nothing more than a savings account. You give them money, you get it back with interest. If it’s a bank, you give them money, you get it back with interest. That’s what a savings account is.”
The example here clearly illustrates that bonds are a savings alternative which we offer to the Chinese manufacturer, not something which actually “funds” our government’s spending choices. It demonstrates that rates are exogenously determined by our central bank, not endogenously determined by the Chinese manufacturer who chooses to park his dollars in treasuries (credit demand, by contrast, is endogenous).
Here is how the mechanics actually work: government spending and lending adds reserves to the banking system because when the government spends, it electronically credits bank accounts.
By contrast, government taxing and security sales (i.e. sales of bonds) drain (subtract) reserves from the banking system. So when the government realizes a budget deficit (as is the case today), there is a net reserve add to the banking system, WHICH BRINGS RATES LOWER (not higher). That is, government deficit spending results in net credits to member bank reserves accounts. If these net credits lead to excess reserve positions, overnight interest rates will be bid down by the member banks with excess reserves to the interest rate paid on reserves by the central bank (currently .25% in the case of the US since the Fed started to pay interest on these reserves). If the central bank has a positive target for the overnight lending rate, either the central bank must pay interest on reserves or otherwise provide an interest bearing alternative to non interest bearing reserve accounts. But this is a choice determined by our central bank, not an external creditor.
Yet we are constantly being told by the financial press that the dollar’s weakness was supposed be the factor that would “force” the Fed to raise rates, since the Chinese supposedly “fund” our deficits.
So far, that thesis hasn’t been borne out. And it won’t be, because this isn’t how things operate in a post gold-standard world.
And a second and equally salient point: what would those who fret about the dollar, have the Fed do? Should they raise rates to defend it? It is unclear that this would work. The relationship between a given level of interest rates offered by the central bank and the external value of a currency is tenuous. Consider Japan as Exhibit A. The BOJ has been offering virtually free money for 15 years and yet the yen today remains a strong currency (much to the chagrin of the likes of Toyota or Sony).
Of course, higher rates can have an offsetting beneficial income impact (what Bernanke calls the “fiscal channel”), but it does not follow that a decision to raise rates would actually elevate the value of the dollar (and the benefits of higher rates from an income perspective could just as easily be achieved via lower taxation).
The reality is that private market participants could well view the move as something akin to a panicked response by the Fed, and the decision could well trigger additional capital flight, which could weaken the value of the dollar.
So it is unclear to me what the Tsy or Fed should be doing about the dollar. My view is that this is a private portfolio preference shift and I don’t think central banks should be responding to every vicissitude of changing market preferences. The US government should simply ignore the market chatter and idle threats from the Chinese and do nothing.
Yes, I will believe anything Warren says, after he explains his tax situation with his hedge funds, apologizes for his invention of mortgage swaps and the ensuing shitstorm of defaults, and explains how much he paid to get a degree in economics (obviously he didn’t study for it).
Posted by Byron Boozer | November 16th, 2009 at 6:49 pm
basicly, we can no longer provide the world with artificial demand, to create busy-work and misdirection, to diffuse tensions from an archaic government system that can no longer function under the microscope of global communication and associated disclosure acceleration.
…and the answer is too-big-to-fail, mutually assured destruction, making destruction inevitable due to opportunity costs.
it’s amazing what people will do for numbers in a computer. in a nutshell, as they install more and more computers in economic series between and among consumers and producers, the intermediary transaction costs accelerate exponentially, starving the real economy.
they can’t fix the software, so they have been replacing entire systems. replacing a home computer at a $1000 isn’t so bad, but entire industry information systems, when money is no longer free, is another proposition.
…and it appears the states are beginning to see the writing on the wall. Michigan and CA are already planning on parabolic declines in tax receipts.
Posted by kevinearick | November 16th, 2009 at 7:29 pm
Byron,
How about trying to respond to the argument, rather than engaging in pointless ad hominem attacks?
Posted by Marshall Auerback | November 16th, 2009 at 8:46 pm
Marshall,
I’d watched the Mosler interview. He makes the case that the only real purpose of taxes is to control demand for the purpose of containing inflation.
The wealthy pay a much larger share of income tax but also save more than the middle/working class. So I don’t understand how income tax paid by the wealthy is an effective way of controlling inflation, since the wealthy are less likely to put those $ into the economy than the rest of us.
Posted by Alan | November 16th, 2009 at 9:48 pm
Well Alan, the taxes on the wealthy used to be much, much higher…top marginal rate was 91% during the roaring 50s.
Try and raise it to 40% now, and see what the right-wingers call you.
Posted by Zach P | November 16th, 2009 at 10:11 pm
Alan,
I’ll give it a shot. Consider what happens should you go to the Federal Reserve to pay taxes with actual cash. First, you hand over a pile of currency to the Fed as payment. Next, the Federal Reserve counts it, and then gives you a receipt and a thank you for helping to pay for social security, the interest on the national debt, and the Iraq war. And as you, the tax payer, leave the room and close the door behind you, they take that hard earned cash you just forked over and throw it in a shredder.
Yes, they throw it away. Destroy it! Why? They have no further use for it. Just like a ticket to the Super Bowl. As you go into the stadium, you hand the man a ticket that was worth maybe $1000, and then he tears it up and throws it away.
So if the government throws away your cash after collecting it, how does that cash pay for social security, and the rest of the government’s spending? It doesn’t. Something else is going on.
Now let’s look at what happens if you pay your taxes by writing a check. When the government gets your check, and your check ‘clears,’ all the government does is change the number in your checking account (downward) when they subtract the payment from your bank balance. Does the government actually get anything real? No, it’s not like they get a gold coin to spend. All they did was change a number in your bank account.
So why does government tax us if it doesn’t actually get anything to spend? There is a VERY good reason they tax us. Taxes function to reduce what’s called aggregate demand - a fancy phrase for ‘spending power.’ The government taxes us and takes away our money for one reason - to keep us from spending it. Taking away our money leaves room for the government to spend without causing ‘inflation.’
The issue how the distribution of tax is a very separate issue. Distributional issues like this are why we have elections. But it does not change the underlying purpose of taxation. You might, however, think that the tax policy is deployed inefficiently in terms of unnecessarily reducing aggregate demand and therefore keeping the economy slower than it ought to be. And I would agree with you. Given current aggregate demand and a virtual absence of inflationary pressures, we should have MUCH lower levels of taxation, on everybody. But a payroll tax holiday (which I have suggested in the past) would be one which would have an immediate impact on the middle and working class, given the comparative lack of discretionary spending power.
Posted by Marshall Auerback | November 16th, 2009 at 10:55 pm
Isn’t the premise - and I’m not disputing anything you said necessarily, I just want to understand better myself - that in order to issue a fiat currency, you must have willing borrowers, and that the borrowers will flee to “stronger” currencies that they can, essentially, trade for more physical “stuff”? Bearing in mind there is, of course, not really an alternative to the dollar as the world’s leading currency … but one could emerge in time.
Again, not disputing what you’re saying, just seeking additional information/clarification.
Thanks as always…
Posted by James Call | November 17th, 2009 at 6:27 am
James,
No when you issue your own currency and set your own rates, you are never dependent on “funding” from external sources. You have to get the causality straight. First, when a particular government bond matures (that is, becomes due for repayment) the government would simply credit the bank account of the holder with the principal and interest and cancel the accounting record of that debt instrument. Simple as that. The banking reserves would rise by that amount and the wealth of the private investor would change in mix from bond to bank deposit.
Second, the massive fiscal deficits that the US Government is now running work in the same way – adding reserves on a daily basis to the banking system (as people spend the dollars and deposit them back into bank accounts etc). The bond issues are designed to give the private sector an interest-bearing financial asset to replace the non-interest earning bank reserves. That applies whether the party holding cash is a domestic holder of dollar assets or a foreigner like the Chinese.
The other angle on this that is often overlooked is that the bond holdings of the private sector also constitute an income source – that is, the government interest payments on its outstanding debt constitute another avenue for stimulus. So when the Government retires debt it reduces private incomes, which is why I think cutting taxes are a good idea when you’ve got low interest rates.
Still, let us consider what happens when the government runs budget deficits and ask whether this will push up interest rates. First, overnight interest rates are set by the central bank. This does not mean that rates are set arbitrarily without regard to any economic considerations. The central bank may believe it needs to raise rates in response to deficits, to fight inflation, or to protect the currency, or to achieve any number of other goals. Bonds are then sold by the central bank or the treasury to drain excess reserves to keep the overnight rate on target (the exception, again, is in a nation with a zero target or in which interest is paid on reserves). The rate on short term government bills is then arbitraged closely in line with overnight rates. Longer term government bond rates are determined mostly by expectations of future central bank overnight targets. Since bills/bonds paying a positive interest rate are preferred over non-earning, undesired, excess reserves, the rates on sovereign debt can, indeed, be kept at half a percent, or lower, if desired, irrespective of the size of deficits.
China or Japan or any other foreign creditor has nothing to do with it.
I hope this makes it clear.
Posted by Marshall Auerback | November 17th, 2009 at 12:42 pm
“The other angle on this that is often overlooked is that the bond holdings of the private sector also constitute an income source – that is, the government interest payments on its outstanding debt constitute another avenue for stimulus.”
This has been another, more recent complaint of the right-wingers in their media empire: the increasing size of interest payments on the national debt in the federal budget. So, it’s really little more than payments into the American and foreign financial sectors?
Posted by Zach P | November 17th, 2009 at 12:58 pm
I guess what I continue to fail to understand is this: “No when you issue your own currency and set your own rates, you are never dependent on ‘funding’ from external sources.” Aren’t you still dependent on someone wanting to purchase your bond issue? Don’t they want to see said bonds come to maturity with a “strong” currency, so that the net result allows the purchase of more other currency, or what have you?
I’m sorry if this is the stupidest line of question you’ve had to endure in a while. I promise after this question I’ll quit.
Posted by James Call | November 17th, 2009 at 4:16 pm
James
You are not dependent on someone to buy the bond. The choice they have: 1. Buy something with the dollars (which would be great for the real economy) 2. Keep it in cash (no yield, but they may not want to hold Treasuries because they might think that the currency is going down) or 3. convert it to another currency (which means a weaker dollar, which probably enhances the US export position, which means less bonds are sold in the first place) and means less bond supply for the Chinese.
Hope this clears it up for you.
Posted by Marshall Auerback | November 17th, 2009 at 4:43 pm
“… government … sales of bonds … subtract reserves from the banking system. So when the government realizes a budget deficit … there is a net reserve add to the banking system.”
Marshall I would surely like to understand the Moslerian worldview but I always run into some statement like this that makes my head spin.
As I understand it, a government budget deficit occurs when the government — instead of imposing taxes — raises funds by selling bonds. Thus “sales of bonds” and “budget deficit” imply each other. Yet you say that one subtracts reserves from the banking system while the other adds.
What am I missing?
Posted by Flummoxed | November 18th, 2009 at 1:10 pm
No, that’s not quite right, “Flummoxed”. When the U.S. Government makes payment by check in exchange for goods and services (including labor), or for any other purpose, the check is deposited in a bank account. When the check ‘clears,’ the Fed (i.e., Government) credits the bank’s account for the amount of the check. Operationally, ‘revenue’ from taxing or borrowing is not involved in this process, nor does the government ‘lose’ any ability to make future payments per se by this process.
Conversely, when the U.S. government receives a check in payment for taxes, for example, it debits the taxpayer’s account to the amount of the check. While this reduces the taxpayer’s ability to make additional payments, it does not enhance the government’s ability to make payment, which is in any case operationally infinite.
In the case of direct deposit or payment by electronic funds transfer, the government simply credits or debits the bank account directly and, again, without operational constraint.
The government of issue in such circumstances may be thought of as a “scorekeeper.” As in most games, there is no reason for concern that the scorekeeper will run out of points.
On the other hand, non-government agents can only spend when in possession of sufficient funds from current or past income, or from borrowing. They are indeed revenue constrained—their checks will ‘bounce’ if there are not sufficient funds available.
Given that a government of issue is not revenue constrained, taxation and bond sales obviously must have other purposes. Taxation (and the declaration of what suffices to settle the tax obligation) serves to create a notional demand for the government’s (otherwise worthless) currency. The process can be viewed in three stages:
1. THE GOVERNMENT IMPOSES A TAX LIABILITY PAYABLE IN ITS CURRENCY OF ISSUE.
2. FACED WITH THIS NEED FOR UNITS OF THE GOVERNMENT’S CURRENCY, TAXPAYERS OFFER GOODS AND SERVICES FOR SALE, ASKING IN EXCHANGE UNITS OF THE CURRENCY.
3. THE GOVERNMENT ‘ISSUES’ ITS CURRENCY—SPENDS—IN EXCHANGE FOR THE GOODS AND SERVICES IT DESIRES.
The non-government sector will be willing to sell sufficient goods and services to the government to obtain the funds needed to pay tax liabilities and satisfy any desire to net save (financial assets) in that unit of account.
Note that, from inception, and as a point of logic, in order to actually collect taxes, the government, as the monopoly issuer of the currency, must, logically, spend (or lend) first. Note that it would be logically impossible for the government to collect more than it spends (or run a budget surplus), unless it had already previously spent more than it collected (past budget deficits). Thus the normal budgetary stance to be expected under these institutional arrangements is a budget deficit.
On the specific question of bonds, the Treasury can offer interest-earning ‘bonds’, purchased by holders of dollar cash AS A SAVINGS ALTERNATIVE TO HOLDING CASH, but the rate of interest offered is entirely up to the discretion of the Departmental Treasury. The bond does not “fund” the government’s operations, if understand the causality correctly. If the Treasury did not offer interest-earning bonds, the base rate on the currency would be zero, or close to it, as is the case in Japan today.
Posted by Marshall Auerback | November 19th, 2009 at 9:45 am
Marshall thank you for your detailed response. I’m hoping you’ll indulge me with another!
I get that government/fed “spending” is ultimately just the crediting of bank balances and that there is no operational limit to this.
I get that the imposition of taxes serves to create demand for the currency.
I get that bonds provide a way for people to save in the currency.
But, going back to the statement from your article:
“…taxing and security sales (i.e. sales of bonds) drain (subtract) reserves from the banking system. So when the government realizes a budget deficit (as is the case today), there is a net reserve add to the banking system…”
You seem to be saying that the government today has a “budget deficit” that exceeds the combined revenues from both taxes and bonds. Am I understanding that correctly? I can see how that would add to bank reserves.
But I thought the phrase “budget deficit” means the amount by which spending exceeds tax revenues alone. Thus the notion of “funding the deficit” by issuing bonds. Indeed it seems like people use “budget deficit” and “government borrowing” and “bond issuance” almost interchangeably.
Apologies in advance if I’m just missing something very obvious.
Posted by Flummoxed | November 20th, 2009 at 12:01 am
Marshall,
I very much enjoyed your article. However, I need your assistance to better understand the “alternative to cash” comment.
1) When bonds are sold, they seller raises cash.
2) The Chinese are taking their US Dollars and purchasing Treasuries sold by the US.
3) When the US collects the money on the sale, is that cash just sitting in a “savings account” as you described? I was under the impression that once bond sales raise cash, that money is then used.
4) Even in a savings account the money doesn’t just sit in the account. Rather, the bank lends it out many times over for each dollar in that savings account.
If you could please explain, I’d greatly appreciate it.
Thanks!
Posted by Damien Hoffman | November 23rd, 2009 at 11:10 am
Just to follow up, I got some useful answers to my questions by reading the article “What If the Government Just Prints Money?” by Scott Fullwiler.
Instead of “budget deficit” Scott uses the phrase “government deficit” and makes clear that, indeed, this is spending in excess of all revenues from taxes or anything else. I.e. in effect “the government just prints money.”
Posted by Flummoxed | November 23rd, 2009 at 11:16 pm
how does a currency become so debased that you literally need to cart a wheel barrel of it to the store to buy a loaf of bread?
if monetary policy is so abstract as you suggest then how does the very real threat of runaway inflation happen?
and why am i really concerned that the buyers of us treasuries, which you suggest are kind of irrelevant to the us economy, are going to change their minds and stop buying us debt….and that is going to cause really serious problems…
your theories are too self-contained by half, i don’t think they are going to withstand the harsh winds of reality blowing at you just around the corner.
time will tell of course
Posted by peepod | February 3rd, 2010 at 5:55 am
You say there is a reason for collecting the taxes; that there is a ‘purpose’ to the taxation regime, related to nothing more than affecting aggregate demand in the non-government financial sector.
I differentiate between the cause and the effect.
You are saying it is the cause, the reason for doing, the purpose of the action.
I see the effect.
But how do you know that ‘reducing aggregate demand’ is the cause? The purpose?
Were you there when the proposal for taxation of income came down the pike and just overheard how we would sell it - to balance the expenses of government - versus what it really is?
Do you know somebody in the back room of the Treas., somebody that keeps the ‘real truth’ behind government taxation policy?
How do you know?
The purpose?
The reason?
The why?
Posted by joebhed | February 3rd, 2010 at 8:09 pm