Chinese Bond Purchases and Interest Rates

It is widely accepted that China manipulates the value of its currency by keeping the Renminbi artificially weak against the dollar.  However, debate persists over whether getting forceful with China (i.e. threatening trade sanctions) is a wise move.  In fact, Paul Krugman and Robert Reich — two staunch progressives who tend to agree on the big picture stuff — disagree about the consequences of taking action against China.  A key point of disagreement: the consequences if China were to retaliate by selling off some of the $800 billion plus in U.S. Treasury securities that China holds.

In his column posted yesterday, Reich warns about the possibility of China selling off US debt.

Remember, China is the biggest foreign investor in U.S. Treasury securities, with holdings of more than $843 billion. If China were to start selling off large amounts, America’s borrowing costs would soar — and we’d end up worse off.

While Krugman has not responded to Reich in particular, Krugman has addressed Reich’s argument on several occasions.

Regular readers may remember that I’ve spent more than a year trying to knock down the idea that the United States dare not get tough with China, because we need them to keep buying our bonds; as I wrote way back in May 2009, given the fact that we’re in a liquidity trap, a decision by China to buy fewer of our bonds would actually be doing us a favor — it would weaken the dollar, and help our exports.

In his March 14 column, Krugman specifically dismisses the prospect of rising interest rates:

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.

In support of Krugman’s argument, Dean Baker has stated that “China has an unloaded water pistol pointed at our heads.”

Krugman certainly seems to make a more persuasive argument.  He has specifically addressed Reich’s position on multiple occasions and basically said “we are in a liquidity trap, so the usual rules do not apply.”  If I understand Krugman correctly, then yes, China selling off US debt would raise interest rates — under normal circumstances.  However, we are in a liquidity trap; the Fed will keep short-term interest rates near zero as long as unemployment remains high (i.e. the foreseeable future).

Reich did not address Krugman’s liquidity trap argument in the column he posted yesterday; perhaps Reich will address this in the future.