Threading a Needle

By Tim Duy · January 23, 2009: I have been on the road or swamped for much of this week, and saw this in the Wall Street Journal when I finally got time to sit down with my computer:

President Barack Obama’s nominee for Treasury secretary accused China on Thursday of “manipulating” its currency, a sharp rhetorical break from the Bush administration’s approach to Beijing’s controversial exchange-rate policy.

Bloomberg, however, had a more nuanced take on the news:

Timothy Geithner’s warning that President Barack Obama believes China is “manipulating” its currency may trigger renewed tensions between two of the world’s three biggest economies.

Who believes China is a manipulator? Secretary Geithner or President Obama? One of the relevant sections of Geithner’s written responses suggests the latter:

President Obama – backed by the conclusions of a broad range of economists – believes that China is manipulating its currency. President Obama has pledged as President to use aggressively all the diplomatic avenues open to him to seek change in China’s currency practices.

More broadly, we look forward to a productive economic dialogue with the Chinese government on a number of short- and long-tem issues. The Yuan is certainly an important piece of that discussion, but given the crisis the immediate focus needs to be on the broader issue of stabilizing domestic demand in China and the US. The latest figures show that China’s growth in 2008 was 9%, a full 4 percentage points lower than in the previous year. Because China accounts for such a large fraction of the world economy, a further slowdown in China would lead to a substantial fall in world growth (and demand for US exports) and delay recovery from the crisis. Therefore, the immediate goal should be for us to convince China to adopt a more aggressive stimulus package as we do our part to try to pass a stimulus package here at home.

Geithner sounds like he is either heeding to direction of the President or wants to absolve himself of responsibility should the “discussion” with China goes awry (Felix Salmon suggests that Geithner is getting very good at absolving himself from responsibility for things gone wrong).

Bond markets reacted as one might expect:

The drop in Treasuries sent yields on benchmark 10-year notes to as high as 2.63 percent, the highest level in almost six weeks. China held about $682 billion of Treasuries as of November, and overtook Japan as the biggest overseas owner of the debt last year.

Certainly, Geithner’s comment may have just been an excuse for traders to do what they wanted to do anyway, sell Treasuries. That seems to be something of a trend of late:

Treasury benchmark notes headed for their fourth weekly loss in five as President Barack Obama’s spending plans led traders to add to bets on faster inflation.

The difference between rates on 10-year notes and Treasury Inflation Protected Securities, which reflects the outlook among traders for consumer prices, widened to a nine-week high of 67 basis points.

“People are demanding a larger premium to hold U.S. bonds,” said Satoshi Okumoto, general manager in Tokyo at Fukoku Mutual Life Insurance Co., which has $61.4 billion in assets. The insurer trimmed its holdings in December, he said.

Bonds declines have tended to be shorted lived in recent months, but may also corresponded to a renewed, albeit fragile appetite for risk. As CR points out, some bond spreads are narrowing. A greater appetite for risk should push investors out of low-yielding Treasuries into higher yielding assets. And if these trends were to continue – A BIG IF – financing the impending US deficit spending may not be as cheap as currently believed. Add in two more pieces:

GEITHNER ON U.S. DEFICIT, ENTITLEMENT PROGRAMS: “It is absolutely critical to the efforts to get the economy back on track that we give the American people and investors around the world confidence that we’re going to have the ability and the will, working with the Congress, to get our fiscal position back down over the next five years to a sustainable position, but also that we’re willing to start to take on and find a consensus on a bipartisan basis for putting Social Security and Medicare on a more sustainable financial position longer term.

“I think we have to do both of those things together.”


Mr. Geithner said the tax incentives included in the stimulus package would have a “substantial and quick-acting effect” and that the Obama administration “tried to be careful [to] limit long tails.”

Taken together, these bits and pieces imply the Obama Administration is attempting to thread a very tight needle: Provide enough stimulus to keep unemployment from soaring well into the double digits while taking long term concerns about the national debt seriously. This would account for what many believe to be a relatively tepid and insufficient stimulus package. Presumably, they want to avoid “long tails” for policy that extends stimulus related deficit spending into the time horizons when the US Treasury will be forced to float publicly traded debt to fund entitlement obligations. Silly as it may seem given the recent runaway demand for Treasuries, the incoming officials may be greatly concerned about the sustainability of that trend.

At the same time, they want to lessen dependence on China, which requires that Chinese policymakers stimulate domestic demand to a sufficient extent to allow for China to ease purchases of Treasuries and allow the Yuan to appreciate in a nondisruptive fashion. Seems like a steep expectation for the export-dependent Chinese, you are now faced with faltering growth rates. If the Chinese don’t cooperate, a portion of any US stimulus is lost to higher imports – always remember that the US doesn’t have much excess productive capacity in tradable goods. The excess capacity exists in China. And Congress would be less than happy to see US tax dollars supporting Chinese jobs.

And, as if that wasn’t enough, the Fed would have to cooperate, and allow US rates to rise to encourage private investors to purchase debt as Chinese purchases ease. That, however, would raise borrowing costs to consumers (who are not in a position to acquire more debt anyway) as well as mortgage rates (which are bouncing upwards). Would Bernanke & Co. be willing to allow rates to rise, even on the long end, given recent avowals to support consumer spending and housing markets at virtually any cost? Tough to see…especially if unemployment is well into the upper single digits, and given concerns about withdrawing stimulus too early. As it is, I imagine the Fed is already getting nervous that efforts to contain mortgage rates have been less than effective.

Moreover, China is only one player. Geithner & Co. would have to convince European policymakers that it was no in their best interest to take advantage of US and Chinese stimulus to depreciate the Euro. In other words, we need to all rise together or all sink together.

All in all, a remarkably tricky policy maze to navigate…and I find myself with more questions than answers…even before considering the additional complications of a fresh rescue attempt for the financial system.

About Mark Thoma 243 Articles

Affiliation: University of Oregon

Mark Thoma is a member of the Economics Department at the University of Oregon. He joined the UO faculty in 1987 and served as head of the Economics Department for five years. His research examines the effects that changes in monetary policy have on inflation, output, unemployment, interest rates and other macroeconomic variables with a focus on asymmetries in the response of these variables to policy changes, and on changes in the relationship between policy and the economy over time. He has also conducted research in other areas such as the relationship between the political party in power, and macroeconomic outcomes and using macroeconomic tools to predict transportation flows. He received his doctorate from Washington State University.

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