How Does Chinese Currency Hurt U.S. Debt?

BY Paul Solman  October 14, 2010 at 2:00 PM EST

Paul Solman answers questions from NewsHour viewers and web users on business and economic news most days on his Making Sen$e page. Here’s Thursday’s query:

Name: Brian P.

City and State: Madison, WI.

Making Sense

Question: 
There has been a lot of talk recently about China’s currency devaluation and how it hurts the U.S. economy’s recovery by making our exports less competitive. Mostly it sounds like we simply beg China to stop. One option is tariffs on Chinese imports, but it seems that is too sensitive politically. Don’t we have any other options? My understanding is that for China to maintain a weak Yuan, it must purchase large amounts of U.S. debt essentially at excessive prices (too low interest rates). So China must be paying us more than we think it should for our debt. Could we figure out a price we think is “fair”, and use the money that everyone pays above the fair price to even out the playing field or at least give us some other benefit? Perhaps it could go to tax cuts, jobs programs to stimulate our economy, paying down our debt, or purchasing higher yield debt from someone else?

Paul Solman: Nice job on the economic logic, Brian, but something of a hole in your policy prescription.

If, as so many insist, the Chinese are indeed artificially hoisting the dollar by gobbling up our debt, it would follow that they’re paying too much for it. Without them, as you say, we’d have to pay a higher rate of interest, which is the equivalent of a higher price for a bond.

Now before I get to the rather gaping policy hole, a few words to explain what we’ve both just agreed upon, since it has bedeviled editors of mine (and presumably viewers) throughout my long career. Why is it that lower interest rates mean higher bond prices? In other words, why do the two numbers so counter-intuitively move in opposite directions? (Readers who already understand this, please skip ahead past the asterisk below.)

Let’s say you’re the Finance Minister of Yeswecan-istan. The way you raise money to finance your sovereign dreams is by borrowing money and giving the lenders IOUs (generally known as “bonds”), promising repayment by a certain date, with a promised interest rate until then.

Obviously, the more desperate you are to borrow the money, the more you’ll have to pay in interest. Also obvious, I trust, is that the more desperate you are, the less your IOUs will be worth.

And that’s really the answer. The more desperate you are, the higher the interest rate; the lower the value of your IOU, your bond. What happens if you become even MORE desperate? You have to pay an even higher interest rate on any new bonds you “sell.” What happens to your OLD bonds? Promising to pay an old, lower interest rate, they are now worth LESS than the new ones, and so they are worth less in the open market.

*

Now back to your question, and the hole in the policy you mention, which might also suggest an internal contradiction in U.S. currency policy vis-a-vis China.

Right now, we’ve got more than ten trillion dollars worth of our IOUs sitting out there on which we’re paying interest. Since government expenses exceed revenues by a healthy margin every year, that means our bonds have been funding much of our expenditures — everything from TARP to DARPA, food stamps to postal stamps.

Leaving aside the role of the Fed in helping determine interest rates and other factors, let’s say China is a major factor in setting them, and paying too much for our bonds. Ten percent too much, just to make up a number. And to keep the numbers simple, say we’ll be borrowing only one trillion dollars this year to cover our budget deficit.

So your proposal, if I understand it, would be to charge China an additional 10 percent and then use the $100 billion windfall on programs with the letters ARP in them, stamps, or just reduce the deficit and thus our cumulative debt.

And China would pay the extra 10 percent WHY exactly? They can buy the bonds 10 percent cheaper on the open “bond market” any second of any day in the twinkling of a pixel. So this is kind of like an early Christmas present in return for our consumption of their food? Because we were kind enough to let so many of them do our laundry in the 19th and 20th centuries? Because we invite them to our graduate schools so they can make us look bad at math?

Or maybe your idea is to coerce them to pay more — by threatening to slap tariffs on their goods, as the recent bill that handily passed the House proposes. But then we’re back to the problem with which you began.

Look, the overarching problem is that we want the Chinese (and everyone else) to lend us money. If they don’t lend, we’ll have to pay a higher interest rate. Yet we decry Chinese currency manipulation though part of it involves propping up the value of the dollar relative to the yuan, thus keeping the yuan artificially low.

I have a question for you, Brian: How can we have it both ways?

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