Remember "China's nuclear option" -- the threat that China might start selling off some of its huge reserves of U.S. dollars as retaliation against unwanted pressure from the United States on trade issues? The reasoning went something like this: Don't tell us to revalue the yuan, or we'll crash your dollar.
Unless your goal was to stoke up paranoia, the theory never made much sense. Given China's massive holdings of U.S. dollars, any drop in the dollar's value would have hurt China as much as the U.S. Dropping that bomb would have blown up both countries.
The latest evidence? Without any help from China, the dollar has gone into a tailspin in 2007, (reaching a new low against the euro on Tuesday) and China is getting nervous.
Wen Jiabao, the premier, told a business audience in Singapore it was becoming difficult to manage China's $1,430 billion foreign exchange reserves, saying their value was under unprecedented pressure. "We have never been experiencing such big pressure," Mr Wen said, according to Reuters. "We are worried about how to preserve the value of our reserves."
China's central bank governor, Zhou Xiaochuan, echoed the premier's comments, telling Reuters, "we hope to see a strong dollar... we support a strong dollar."
Treasury Secretary Hank Paulson agreed, telling reporters in Ghana this week that "a strong dollar is in our nation's interests."
But is it, really? A weak dollar makes American exports more attractive to the rest of the world, and thus helps reduce the U.S. trade deficit. And of course, the U.S. has long been pressuring China specifically to let the yuan appreciate more quickly against the U.S. dollar for precisely that reason.
Some China experts in turn, have argued that such a revaulation wouldn't do much good. If the U.S. really wanted to address its trade deficit, they advised, Americans would have to start saving more and consuming less, both at an individual and a governmental level.
Intriguingly, that process may have already begun, as fallout from the mortgage crisis. In the collaborative economics blog Vox EU, Richard Baldwin takes a trip back to a paper published by economist Martin Feldstein in May exploring the question "Why is the dollar so high?" In hindsight, Feldstein's analysis looks prescient. (Thanks to Mark Thoma's Economist's View for the link.)
Feldstein argues that the personal savings rate had fallen so low because low interest rates, in combination with the rapid appreciation of home prices, encouraged Americans to borrow without restraint against their home equity. There was simply no need to save money when the net-worth of America's homeowners was rising so quickly.
But it couldn't last. Baldwin summarizes Feldstein's argument:
Feldstein not only calls the dollar's drop, he links it to developments in the U.S. housing market. True, his logic did not lead him to predict the subprime crisis, but that is more a matter of how, not what.
He notes that bringing down the trade deficit will require a closing of the saving/investment gap. He wrote that this would come mostly from higher savings: "The household saving rate will rise because the two primary forces that have driven savings down will come to an end. First, the sharp rise in wealth caused by abnormal gains in share prices and house prices will not continue. Home prices are already beginning to decline and the prices of stocks are not likely to outperform earnings in the future in the way that they did in the past. Second, the mortgage refinancing will not continue to generate spendable cash for households as it has in the past. The decline in mortgage refinancing has not yet begun. But at a certain point there will be very few households with mortgage rates that exceed the rates available on new mortgages. There will also no longer be a stock of net equity that can be accessed by borrowing."
The value of the dollar, say Feldstein and Baldwin, is largely a function of how much Americans are saving and consuming, which also determines the trade gap between the U.S. and other countries. In this game of connect-the-dots, nothing is left out. The flip side of the housing boom was the rock bottom personal savings rate. The housing bust, then, will see homeowners pull in their wings and start to save again. That retrenchment will encourage the dollar's continued decline, as will global nervousness about the state of the American economy, which itself will be largely influenced by how bad the housing bust ultimately gets. Finally, a declining dollar and a rising personal savings rate will make the massive trade deficits of the last two years a fading memory (and indeed, that is already beginning to happen.)