By Sebastian Mallaby
Sunday, January 25, 2009
At his confirmation hearings last week, Tim Geithner branded China a currency manipulator. This is a designation that the Bush Treasury Department never formally affixed to the Chinese. It may signal a nerve-racking shift in how the United States manages its most pivotal relationship.
Geithner is correct that China manipulates its currency. What's more, this manipulation is arguably the most important cause of the financial crisis. Starting around the middle of this decade, China's cheap currency led it to run a massive trade surplus. The earnings from that surplus poured into the United States. The result was the mortgage bubble.
China's leaders protest that they are being unfairly scapegoated. Yet while there are rival accounts of the origins of the crisis, neither has the explanatory force of the blame-China narrative.
The first rival account is that the crisis reflected failings of U.S. financial regulation. Such failings exist, but most have been around for years. The mortgage bubble reached its craziest extremes in 2005-07, when China was flooding the world with cheap capital.
Moreover, regulatory failings exist not just at one regulator but many. The Securities and Exchange Commission failed to check risks at broker-dealers such as Bear Stearns. State insurance regulators failed to prevent the collapse of AIG. The Federal Reserve failed to see that banks were pouring capital into toxic securities that they then held off their balance sheets. European regulators were no better, even though they had adopted a supposedly more up-to-date set of capital standards. The lesson: Faced with a deluge of cheap money, no regulatory regime can be expected to prevent bubbles.
The second rival account of the crisis accepts that its origins lie less in regulatory failings than in economic pressures. But it blames the bubble on two mistakes at home rather than on the glut of capital from China. Americans should have controlled the urge to splurge, the thinking goes, and borrowed less Chinese money. And the Fed should have shut down the easy-money party by raising interest rates.
If Americans' insatiable appetite for loans explained the flood of Chinese capital into the United States, we would have seen the evidence in a rising price for those loans -- that is, higher interest rates in the bond market. But bond rates were strikingly low at mid-decade. This strongly suggests that it was the supply of lending that went up, not the demand for it. Chinese money flooded into the United States because of the push factor from China, not the pull factor from Americans.
Could the Fed have raised interest rates to avert the bubble? The Fed's monetary policy was indeed too loose. But as Martin Wolf argues in his recent book, "Fixing Global Finance," it's not clear that higher interest rates could have prevented the trouble. Once China decides to export vast quantities of capital, that capital has to go somewhere. Higher interest rates in the United States might have encouraged the world's savers to park even more of their capital in this country.
So there is no getting around China's culpability. The country relies on the sort of export-focused growth strategy that other Asian Tigers have pursued, with the difference that China is too big to go this route without destabilizing the world economy. The real question is whether it is diplomatically fruitful to push China to change. The Bush administration tried and failed. Why would the new team fare better?
The wrong answer is to say that Barack Obama's guys will be tougher. However egregious China's currency policy may be, it's counterproductive to punish Beijing with sanctions. For one thing, a trade war is the last thing the world economy needs. For another, as Geithner explained, the immediate priority is to get global growth going, so it's more important to persuade China to extend its fiscal stimulus than to revalue its currency. Besides, reforming China's exchange-rate policy is not the only way to wean the country off its high-savings, high-export model. The savings rate partly reflects China's lack of social safety nets. If the Chinese spend some of their stimulus on pensions and health care, they will be heading in the right direction.
Still, there is an opportunity to nudge China toward currency reform, and the Obama team should take it. China's leaders are not fools: They can see the effects of their policy not only in collapsing Wall Street banks but also in their own collapsing exports. The bubble that China inflated has brought China's foreign customers to their knees. Because China pushed its export model too aggressively, its export markets have cratered.
Think of it this way: China's position is akin to that of OPEC in the early 1980s. Two oil shocks taught oil producers the limits to their power: When they jammed prices up, the world economy sputtered and motorists bought smaller cars -- and oil prices fell precipitously. OPEC learned to balance its lust for higher oil prices with the fear that customers might revolt. China's leaders may be ready for the same lesson -- and Geithner's words may encourage them to learn it.