Rock and a hard place

My struggle with the importance of the US trade deficit (and by extension current account deficit) continues. The Economist has a good article outlining these deficits, interest rates, and the role of the yuan:

The political logic of [US and EU] tariffs is clear; the reasons for pressuring China to revalue, less so. China’s currency peg, at around 8.28 to the dollar, is widely believed to be keeping the yuan undervalued by 15-40%, making Chinese exports artificially cheap. But it also subsidises a great deal of America’s profligate spending. In order to maintain the peg, China is forced to buy loads of dollars, which are then dumped into US Treasury bonds, financing America’s hefty deficits. A sudden decline in Chinese demand for Treasuries would raise America’s borrowing costs, curbing Congress’s ability to dole out pork to constituents. Some economists fear that this would push interest rates up sharply enough to cause a sharp contraction in the debt markets (including the mortgages that are fuelling America’s housing boom) and the economy.

But the dollar is too strong, esp compared to the yuan. It should fall. Similarly, US interest rates should go up, and the real estate bubble should pop. All of these "negative adjustments" outlined by the Economist are neccessary adjustments that will happen sooner or later. If it happens sooner and more gradually, the negative shocks to the economy will be lower, but none of these consequences are negative in my book.

The Chinese POV is not so sanguine:

Either way, revaluation looks tricky for the Chinese government. It believes that for the sake of political and social stability, it needs 15m-20m new jobs a year. Increases at that level will be enough to absorb population growth, plus displaced workers from the agricultural sector and China’s ailing state-owned firms. And the export sector is seen as a crucial vehicle of job creation.

But this is not the only reason that Chinese politicians are reluctant to revalue. By some estimates, as much as three-quarters of China’s foreign-currency reserves are held in dollars; if the central bank allows the yuan to rise against the dollar, it will also in effect be allowing the value of its reserves to depreciate. Moreover, if slowing the flood of dollars that China’s central bank is pouring into American debt markets causes those markets—and the American economy—to contract, China’s exporting firms will have worse problems than a more expensive yuan. And problems for those firms could translate into big trouble for China’s frail banking system.

Firstly, the article points out that the Chinese economy is too reliant on foriegn consumption. The cure to this is to increase domestic consumption, which requires less investment and less saving at home. Moreover, if the Chinese central bank has so many dollars that they fear a devaluation, pumping up the dollar is not going to meet that goal long term because the US is simply going to inflate its way out of the debt its piled up. The long term forecast for both inflation and interest rates is higher than either of those are today. Fundamentally, the Chinese banking system does a poor job of disciplining investment, consumption, and savings, which is the point of a bank.

So yeah, the US risks a contraction as rates rise, real estate falls, and the economy finds something new to bubble up, the Chinese seem to risk violent revolution, which is much worse. Therefore, because of domestic weakness, the Chinese are forced to gift money to the US. Good for the US, bad for China. It is much cheaper for American borrowers to indulge themselves than it is for Chinese lenders. Expect actions to follow from incentives.