What Should we do About China?

Paul Krugman writes about China and their continued manipulation to keep their currency undervalued.

He writes,

Today, China is adding more than $30 billion a month to its $2.4 trillion hoard of reserves. The International Monetary Fund expects China to have a 2010 current surplus of more than $450 billion — 10 times the 2003 figure. This is the most distortionary exchange rate policy any major nation has ever followed.

And it’s a policy that seriously damages the rest of the world. Most of the world’s large economies are stuck in a liquidity trap — deeply depressed, but unable to generate a recovery by cutting interest rates because the relevant rates are already near zero. China, by engineering an unwarranted trade surplus, is in effect imposing an anti-stimulus on these economies, which they can’t offset.

This poses another tough policy decision for the Obama administration. Do we continue basically appeasing China, by not shedding a real light on their efforts. Which are supposed to be reported on.

Krugmann continues.

Twice a year, by law, Treasury must issue a report identifying nations that “manipulate the rate of exchange between their currency and the United States dollar for purposes of preventing effective balance of payments adjustments or gaining unfair competitive advantage in international trade.” The law’s intent is clear: the report should be a factual determination, not a policy statement.

Or will we help prolong our recovery by not acting, or acting strong enough. If you think about it, it really is a difficult decision. Yes shedding light on China's actions after 10 years of inaction according to sum, would be like waking the beast who owns so many U.S. dollar assets. Many say things like "China owns us" or "China now controls our every action" because they bought up so much of our debt. But according to Krugman we really have them over a barrel not the opposite.

He writes.

What you have to ask is, What would happen if China tried to sell a large share of its U.S. assets? Would interest rates soar? Short-term U.S. interest rates wouldn’t change: they’re being kept near zero by the Fed, which won’t raise rates until the unemployment rate comes down. Long-term rates might rise slightly, but they’re mainly determined by market expectations of future short-term rates. Also, the Fed could offset any interest-rate impact of a Chinese pullback by expanding its own purchases of long-term bonds.

It’s true that if China dumped its U.S. assets the value of the dollar would fall against other major currencies, such as the euro. But that would be a good thing for the United States, since it would make our goods more competitive and reduce our trade deficit. On the other hand, it would be a bad thing for China, which would suffer large losses on its dollar holdings. In short, right now America has China over a barrel, not the other way around.

Krugman makes a great argument for action in my opinion, but really the threat of action, or that report by the Fed on April 15th may send a strong enough signal to China, that business as usual is over. Only time will tell.

Click here for entire article.

UPDATE: The Economist takes on Krugman here.

Krugman Responds here.