Babysitting the US economy

Krugman is always good for a nice read. His June 14th NT Times op-ed, “Stay the Course“, does not disappoint. He writes, “For this is the third time in history that a major economy has found itself in a liquidity trap, a situation in which interest-rate cuts, the conventional way to perk up the economy, have reached their limit. When this happens, unconventional measures are the only way to fight recession.”

Back in 1998, Krugman had written a piece for Slate titled “Baby-Sitting the Economy” which talked about the liquidity trap that lay at the bottom of Japan’s economic troubles. He retells the story from 1978 of a baby-sitting co-op that went into “recession” and how it was solved by issuing more “money”.

Krugman explains in a companion piece the answer to Japan’s problem. Reading both pieces is certainly instructive for me, as I know precious little macro economics.

Back to the present. The US is in a recession and they are trying to avoid getting into a depression. The remedy, according to Krugman, is more of the on-going fiscal stimulus. Let the government spend a lot of money. But since the government does not have the money, it has to borrow. Deficit spending. It has to basically print lots more dollars. If the increase in the production of goods and services keeps pace with the increase in the monetary base, there will be no inflation. But if more money chases the same amount of goods and service, the price level goes up and that means inflation.

US consumers have started spending less and borrowing less. The question is whether the increase in private saving (or reduction in private borrowings) is sufficient to offset the increased public borrowings? I suppose the answer is no.

I assume that at least in the short run, there will be no increase in the US production of goods and services. So expect inflation. Inflation of course hurts those who save and rewards those who borrow. The biggest borrower is the US. The biggest saver of all: China!

We live in interesting times. Which is considered to be a curse by the Chinese.

Now China is in a very interesting position. It holds trillions of dollars worth of US debt. It seems like the Chinese have gotten themselves into a fine fix. They are riding a tiger and they don’t dare get off. If the dollar collapses, China loses a lot.

But there is another way to look at it, and that is that the US is looking down the barrel of a gun held by the Chinese. I really don’t like this the least bit: China can blackmail the US and indirectly threaten the whole world. If the dollar collapses, sure it will hurt the Chinese quite a bit. But it would hurt the Americans even more. It is not beyond the possible that the autocratic government of China could suddenly dump the dollars it is holding. If they do, the collapse of the dollar is pretty guaranteed. That would also send the global economy into a tailspin and that would be quite interesting, err, I mean disastrous.

Categories: Random Draws

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