Brad Squared Digest: My thoughts on the Brad Setser Brad DeLong non debate.

Brad DeLong notes that Brad Setser agrees with Brad DeLong about the risks due to global imbalance and, in particular the fact that Bush is hocking the USA to the people's bank of China.

They agree that the risk is that the PBC will lose a ton of yuan when the dollar tanks. Brad S notes that this might mean that free trade with China will make the Chinese a bit irritated with us when they discover how worthless the paper they bought from us is.

The key quote re-edited

But China’s policy of buying dollars (and to a smaller degree euros) also means that China is sinking a growing share of its national wealth into a set of assets that are almost certain to depreciate over time.... The capital losses could destroy the PBoC’s formal capital: borrowing in RMB, even at an artificially low rate, to buy depreciating dollars isn’t a winning financial strategy....

When the time comes for China to realize the losses that are now accumulating quietly on the PBoC’s balance sheet ... I doubt China’s leaders will say, “you know, these losses were really incurred years ago, ... We were the ones who over-paid for US assets.”

I suspect China’s leaders will be somewhat less magnanimous. They will argue that the losses... [stem] from the failure of the US to adopt the policies needed to maintain the value of Chinese investment in the US....

This is a serious concern (especially since Brads agree that China will be a superpower by then). One thing we can do to protect ourselves from their anger is to clearly and repeatedly warn them that their central bank is going to lose big time.

However, I actually am not too worried. When countries currencies tank, the typical reaction is pity not rage. I think the same mental disability that causes people to consider it an unfriendly act for Chinese to work hard for almost nothing making cool stuff for us will cause them to not blame us for letting the dollar tank.

There is a rough historical analogy which I think is closer than the Marshall plan. Back before China was taking over the world, Japan was. In that case as well support for an overvalued dollar was part of the export promotion strategy. My understanding is that this was principally funded by huge Japanese commmercial banks as part of one of those tacit cooperative strategies which were supposed to be so superior to cut throat competition.

Then the dollar tanked and the huge Japanese commercial banks have had unsound balance sheets ever since. Japan's growth locomotive stalled and has remained still on the tracks for over 15 years. Oddly the Japanese don't blame us. Now it is true that a few hundreds of billions blown on t-bills was small potatoes compared to Tokyo real estate. However, we did sell them garbage paper and the Japanese public never noticed.

I figure the Chinese public will never wise up either.