If the yuan is held down for too long, the global economic crisis may deepen. (Photo Credit: CC BY-SA/David Dennis/Flickr)

Chinese President Hu Jintao’s visit to the U.S. has financial experts wondering whether President Obama will be able to convince him to let the value of the yuan rise. China is a poor country at its core, but its population and rapid growth make it the world’s most intriguing economic superpower. China’s monetary policy could be leading the nation toward an economic crisis that will reverberate across the globe, writes Paul Krugman in the New York Times.

China refuses to see the chasm

As China’s government does not view inflation favorably, it has been trying to maintain tight control over the yuan. In in a Jan. 21 New York Times op-ed piece, Paul Krugman states this has already led to an artificially large trading surplus, which has increased unemployment in many countries, including the U.S. If China continues to hold the yuan down, employment will continue to remain depressed and China will lapse into an inflation-prone economy.

Inflation, Krugman says, is an economic market’s means by which to undo currency manipulation. China has kept the yuan weak and suppressed wages and prices. While the Chinese government’s goal is apparently maintaining competitive advantage in the global market, market forces have forced China’s wages and prices up. Thus, at China’s current rate of inflation any manipulation it has done will be erased within a few years.

China’s leaders don’t want this

For a variety of reasons, from the nationally unpopular notion of high inflation to protecting the interests of exporters, the Chinese government is fighting against forces in the world market, says Krugman. Current inflation rates are well above the interest rate China allows to accrue on bank deposits, 2.75 percent. That amounts to economic exploitation of the populace, Krugman believes, and the inevitability of rising prices will make the exploitation even worse.

Rather than allow the yuan to rise in value, China blames the U.S. – the Federal Reserve, specifically, for printing too much money. Meanwhile, China raises interest rates and restricts credit. As outside money funnels into the country, China’s credit enforcement becomes a fruitless endeavor. Price controls are China’s latest economic tool of choice, but economists have found that that tactic rarely works. Krugman says if China continues on its current course, the collateral damage to the world economy will be devastating.

Source

New York Times

China wants more U.S. investment opportunities

The Fed's latest monetary stimulus seeks to jump start the economic recovery by avoiding a liquidity trap. Think Stock photo.

The Federal Reserve is experimenting with the money supply in an effort to bring a flagging U.S. economic recovery back on track. To keep interest rates that are already near zero down, the Fed is taking interest from its vast pool of mortgage-backed securities and buying U.S. Treasury notes and bonds. This practice, called monetary stimulus, or quantitative easing, injects cash into the public market. The theory is that by expanding the money supply through monetizing debt, interest rates decline. Businesses and consumers will want to borrow and spend more, because savings essentially earns no interest.

Fed’s monetary stimulus: deep concern about economic outlook

An earlier round of monetary stimulus during the economic downturn seems to have failed to spark a sustainable recovery. Reuters reports that the second round of quantitative easing, dubbed QE2, is the most important monetary policy announcement for the Fed since it first revealed its intention to buy assets in late 2008. The announcement of QE2 has had a short-term effect exactly opposite of its intent. Another round of monetary stimulus sends a signal that the Fed is deeply worried about the fragile state of the economy. The announcement fueled a sense of doubt in markets. Stocks plunged. Talk swirled of Japanese-style deflation, where no amount of monetary stimulus is enough to jump-start economic growth.

Fed rolls the dice with QE2

The Fed’s monetary stimulus is a risky move, according the The People’s Voice. To avert the worst of the housing crisis, the Fed purchased more than $1 trillion in Fannie Mae and Freddie Mac securities to push mortgage rates to record lows. Fed officials wondered publicly how to get rid of these securities. With economic recovery going south, they have concluded they can’t without forcing mortgage rates back up again. Meanwhile, the Fed collects billions in principal and interest on this portfolio. Using the cash to monetize debt is loaded with risk. The housing market could very well weaken further and foreclosures could rise. If, and some say when, that happens, the Fed will be sitting on billions of dollars of credit losses on its portfolio.

Caught in a liquidity trap

The Fed’s latest monetary policy move makes sense on paper in a textbook economy. But Daniel Indiviglio, writing in the Atlantic, said that it relies on the assumption that demand will rise to meet supply. Interest rates are already very low, yet businesses continue to sit on cash because they aren’t convinced that the demand will exist in the near-term to expand. Consumers are paying down their debt and saving for an uncertain economic future. These conditions are what economists refer to as a liquidity trap. No matter how low the Fed pushes interest rates, it won’t help economic recovery because no one wants to borrow.