How is the present policy abnormal? Firstly, under any measure of reserves adequacy that I know, the present level of US reserves is far too low - more anomalously low than China’s reserves are anomalously large. And that is now - at China’s rate of growth, it will not take long for its existing stock of reserves to look no larger than reasonable. It is not that America has reduced the nominal value of its reserves; rather that it has not maintained their adequacy in the face of rising economic activity, financial flows and trade flows. Secondly, despite the large government deficits in recent years, the US government debt to GDP ratio is not high by international standards. It is not that the treasury market would have been unable to absorb the additional sales without an excessive rise in long term rates. Effectively, the US has funded part of its budget deficit from its foreign exchange reserves.

The present policy seems to have arisen as the least line of resistance, rather than deliberate choice in the light of rigorous analysis. There does not seem to be any US foreign exchange reserves policy. The US authorities seem to think that reserves are not necessary for them, but the reserves have not been actively reduced, and as far as I know, neither the Fed nor the US Treasury has done, let alone published, any analysis of what the appropriate size of the US foreign exchange reserves should be. It is, I would say, a case of complacent neglect.

Of course, to restore the adequacy of the US reserves to the level of, say, twenty years ago would require large bond and dollar sales, which would be inopportune now that the US housing market and the dollar have weakened. But from time to time there are chances to at least make some progress, such as last month when the yen was weak.

I like your idea. However, how would the US pay for its foreign exchange reserves? Print dollars? Sell bonds? Presumably the latter. However, the annual bond sales required to offset official inflows would run to hundreds of billions per year. More than the budget deficit right now. Presumably the bond sales would cause interest rates to rise and the dollar to fall.

Regarding Peter Schaeffer’s comment: as I say from time to time, the prudent US response to the official inflows from Asia and the oil producers would have been to add to America’s own foreign exchange reserves (even now, the opportunity to do so may not be entirely lost). But they take the Leona-Helmsley-like view that reserves are for little people. I would urge the EMU countries to avoid repeating America’s mistake and build up the ECB reserves as the use of the euro as a reserve currency grows, especially when complaining that other reserve currencies are unreasonably weak. The same advice probably applies to the UK (my country) too.

Brad asks how China might respond to losses sustained on its dollar reserves. It depends on how they arise. If dollar depreciation is driven by some “unconventional” monetary policy operation engineered by Bernanke to forestall deflation, and if China’s attempts to diversify into real assets have been blocked by CFIUS, then they would have a right to feel aggrieved. One economic sanction that the Chinese might consider in such circumstances is to disregard US intellectual property rights for some period.

It is often said that, if you owe the bank a lot of money, it is more their problem than yours. This is only true if you have a viable plan to avoid depending on the bank in future.

Niall Ferguson gave some numbers for UK exports, imports, and overseas earnings before WWI, in his book Empire. Yes, the UK ran a vast trade deficit financed by profits from investments. I think the numbers were exports (7%), imports (12%), and earnings (7%). The 2% current account surplus flowed back out into new investments. I read the book a few years ago (and no longer have it), so these numbers could well be somewhat off.

I once purchased an economic history of the UK to find some hard data. No such luck. However, the big picture is clear. The UK declined as a manufacturing power (in part) because overseas earnings paid for imports instead. That is (was) saner than what the US is doing. We are liquidating our manufacturing sector and replacing it with debt accumulation.

Brad,

I think the basic disagreement - which we either have to live with, or disprove one way or the other - is that East Asian economies easily substitute for each other in supplying goods to the US. There is the capacity to produce $1.2 terabucks worth of goods outside China (and, at a price tag likely to be 10-30% higher); it just isn’t being utilized to make stuff for the US. There won’t be an automatic, easy and swift shift from Made in China to Made in (Non)China, but there’s nothing to say it is impossible.

Profitably making things for US consumers in the US, to the tune of $1.2 terabucks (more like double the price) has not been proven. Hence, “if not China, then someone else.”
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You have given very good reasons why the Chinese RMB should rise in value. However, I haven’t seen much material (from anyone) on the reverse side of this adjustment. What must US do in the face of RMB’s rise to reduce the deficit. Like you, I originally believed exchange rate was the solution and it was (pretty much) the only thing that mattered. However, recent events amid Yuan’s (slight) move upwards has me rethinking that position.
First off, I agree with you that increase in RMB appreciation will reduce Chinese exports. However, I am not convinced the converse side of that argument, that a weaker dollar will increase US exports is true. I base my doubts for the following reason: a weaker dollar means more expensive inputs for US production. Not only will cost of capital go up, but cost of (foreign) equipment, resources and marketing will go up. Take for example the semiconductor industry. The weaker dollar means the silicon die is cheap, but the final assembled chip (coming from China) will be more expensive. Supply and demand dictate that China will assemble fewer chips, which means less US production of silicon die. Now consider a worse scenario, one in which Chinese packaged chip is expensive in US, but is cheaper in Yuan denominated China. So demand shots up in China. However, that doesn’t necessary translate into a increase in US production capability because cost of expansion in US dollar is high. Cost of expansion in China, however, is relatively cheaper (because of stronger Yuan) so the new fab gets built in China. What’s alarming to me is that I have seen trends like this happening since the higher value of Yuan has been factored into corporate decision making.
Second, I think you polarize the situation a bit by making the CEOs and Hedge Fund managers as winners and auto workers (as well as textile workers) losers. There are many (small) winners in between these extremes. People who perform necessary corporate functions such as accounting, sales and marketing have (to various degree) benefited from a cheap RMB. It makes travel costs cheaper (to China) and corporations can pay for US overhead to mentor Chinese counter parts. With a stronger Yuan, corporations may no longer be able to afford these overheads and as most of sales and revenue growth occur in China, will be forced to cut back in US. (Most people blame that as outsourcing.) Also, auto workers who are displaced get $100,000 buy outs. Poor Chinese farmers get subsidized by Chinese government. What do these people have?
Third, I think your point of China blaming US is a bit disingenuous. China has blamed US before and will no doubt find many reasons in the future to blame US again. What I find more interestig is why aren’t we Americans blaming our government? Where is our policy that would encourage expansion of production in US while capital is cheap rather than waste it on real estate?
Finally, I’d like to see more thoughts on what US should do in face of rising RMB to expand our production assets before we blindly force Chinese to revalue. If we don’t, the cost associated with a disorderly exit from BWII will be very high.

2) China does not have the internal mechanisms to efficiently allocate this wealth. The last thing you want to do to a broken system is to throw money at it.

3) The currency losses that China faces by investing in the United States are less than the losses it faces investing in China with a bad financial system.

4) China gets stuff for its losses. The surplus that China is exporting is about $200 billion/year and given a 30% revaluation that’s a $60 billion/year. For that $60 billion, China gets the US Navy guarding lines of communications with the Middle East, and influence over US foreign and defense policy especially with respect to Taiwan.

It’s a bargain.

I don’t…have a problem, that is. The essence of their strategy is to NOT let US debt be devalued. Even if they know it is, in reality, they don’;t wanbt it devalued on paper. that’s why they’re buying bonds. If they really didn’t care if it got devalued, they wouldn’t care about buying bonds to prop up our finances in the first place.