This is one of those rare cases where I have to disagree with Paul Krugman. His column today implies that China is somehow surprised that it is in a situation where it stands to face large losses on its dollar holdings. This is implausible on its face. Did China not notice when the dollar fell from being worth 1.2 euros in 2002 to just a bit more than 0.6 euros last year? Did it not occur to China that they might place better bets on other currencies than a rapidly declining dollar? The "China just discovered view" implies that China thought the dollar was a good place to invest its money and is now surprised to find that this is not true. The alternative perspective is that China understood all along that it was going to get whacked on its dollar investments. It chose to invest in dollars to prop up the dollar against the yuan. This made Chinese exports very cheap for people in the United Sates, thereby leading to the boom in U.S. imports from China. In effect, China was subsidizing the purchase of its exports by inflating the value of the dollar relative to the yuan. Given its extraordinary growth over the last decade, this was clearly an effective development path and it may justify any subsequent loss on its dollar holdings. (Obviously, alternative paths were possible, whether they would have been better for China is an open question.) Anyhow, the reason why the distinction between the China surprise versus strategy view is important is that the bad guys are already using the China threat as an argument to cut Social Security and Medicare. The argument goes that if we don't get our budget in order (i.e. cut Social Security and Medicare) then the Chinese will pull the plug on us. The Peter Peterson crew have already been vigorously pushing this line. As I have argued elsewhere, we have nothing to fear if China stops investing in the U.S., but it is also important to point out that they are not suddenly surprised (shocked, shocked) by the fact that they are going to take a hit on their dollar investments. This was the deal that they consciously entered, eyes wide open.
--Dean Baker
