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July 27, 2005

China and the U.S. Embark on a Perilous Trip - New York Times

The great tightrope walk begins. Somehow the dollar has to decline massively but slowly, yet somehow foreigners holding dollars must not see the decline coming and demand higher interest payments on their dollar-denominated assets. It will be a neat trick.

Louis Uchitelle reports:

China and the U.S. Embark on a Perilous Trip - New York Times : By LOUIS UCHITELLE: The Cassandras who hold this view are a distinct minority, like their original in ancient Greece. Still, the most prominent, like Paul A. Volcker, the former Federal Reserve Board chairman, are hard to ignore. "The circumstances seem to be as dangerous and intractable as any I can remember," Mr. Volcker said Thursday, repeating an earlier warning in a February speech. "If people lose confidence in the dollar as a store of value, or lose confidence in the political strength of the United States relative to other countries, there is going to be trouble. I'm not saying a crisis is inevitable or that an orderly adjustment is impossible, but at some point big adjustments will have to be made."

The problem stems from America's persistent buying of much more from other countries, particularly China and Japan, than those countries purchase from the United States. The payment for the imports is in dollars, and because the foreigners do not use all of the dollars to make offsetting purchases here, they lend the excess back to Americans, who then use the loans to purchase more from abroad....

"The Asians have no choice but to hold onto our dollars," Mr. Glassman said. "If they dumped them, they would be jeopardizing their own development." To which Stephen S. Roach, chief economist at Morgan Stanley - whom many on Wall Street view as too pessimistic - replies: "Because nothing bad has happened yet, there is a growing conviction that nothing bad will happen."...

The challenge will come once the price of imports begins to rise. At that point, Americans will have to produce for themselves much more of what they consume - or pay a lot more for the privilege of importing. Ideally, the process would involve America's becoming a much bigger producing nation, even stepping up its exports to Asia, while Asia - and especially China - takes on more of the role of consumer. That is essentially the view of the Bush administration as outlined by Ben S. Bernanke, the newly appointed chairman of President Bush's Council of Economic Advisers. "We probably have little choice except to be patient as we work to create" the necessary conditions for a reversal of roles, he said in a recent speech.

That is not an easy transformation. Americans now produce only about 75 percent of the merchandise they purchase, importing the rest. That is down from 90 percent or so a decade ago....

This time the housing bubble could burst if the flow of dollars lent from Asia were to slow too abruptly. The result would be a shortage of money to lend and a rise in mortgage interest rates, which are tied to the yields on the Treasuries that the Japanese and Chinese often buy in the lending process...

Posted by DeLong at July 27, 2005 01:41 PM