China and the U.S. - one of us in this room is a sucker

Greg Mankiw finally tosses his hat into the China policy debate ring. His basic claim: China's exchange rate peg hurts only China, and only helps the U.S. This is an argument I've often heard from a variety of smart people, so I thought I should use my (still very basic) understanding of economics to dissect it (Warning: prepare for "dorkonomics").

Basically, China is doing two things. First, it's keeping its exchange rate low, so that Chinese-made stuff is cheaper for Americans to buy. Then, it's lending America tons of money with which to buy that stuff (it seems this second step makes the first possible). Mankiw, and a lot of other economists, have good reason to believe this system is hurting someone; after all, it's a government distortion of the economy, and government distortion of the economy tends to be inefficient (at least according to Mankiw and most mainstream economists).

The question is: Who is this distortion hurting?

First, the exchange-rate peg. This means we get cheap Chinese stuff if we want it. According to most economic theories, more choice is better - if we don't want the cheap Chinese stuff, we are perfectly free to not buy it. But we do buy it - oh, do we buy it.

Some people argue that this leads to job losses in America, because American workers can't (actually won't) make stuff cheaply, so American companies have to lay off workers. But, as Mankiw wisely points out, the job losses here are not one-for-one. Companies that save money by moving factories to cheapo China can use that money to hire workers in the U.S. to do other stuff. And apparently they do, because even though our trade deficit with China has gone through the roof, U.S. unemployment is pretty darn low.

But job losses aren't the only way the exchange rate peg could hurt the U.S. It could also hold down salaries here. American workers whose jobs could be shipped out to China won't exactly be in a position to demand raises. And, looking at the data, that's pretty much what we see happening. Real wages have been basically flat for this whole decade (coincidentally, since we started trading massively with China). Note that these are real wages we're talking about. That means that, even though there's lots of cheap Chinese stuff on the shelves, Americans can't buy any more stuff now than they could 7 years ago. That's just a cold hard fact.

Of course, that wage stagnation may be because of something other than China (like automation, for example). That's an open question, and I can't even begin to answer it.

But now on to the other part of China's policy - lending America cheap money. Specifically, China buys a lot of U.S. government bonds. This means our government can borrow money cheaply from China - and in fact, our government borrows a ton of money from China. And that means that interest rates in the U.S. go down, so we Americans can borrow more cheaply on our credit cards and mortgages. And oh, do we borrow.

Is that bad? Classical economic theory says no. China gave us the opportunity to borrow cheap money, and we did. We didn't have to. No one twisted our arm. We could have left China's cheap money lying on the table, just like we could have left that cheap Chinese stuff lying on the table.

But debt is different than material goods, because it involves uncertainty. If I buy a can of dog food, I probably know what I'm getting for my money (well, usually). If I borrow some money, though, I'm only making a guess about how easily I'll be able to pay it back in the future.

Classical economic theory says that people are good guessers. If we happen to guess wrong, the theory goes, we may get screwed, but we made the best guess we could have made with the information we were given. But the theory does not say that governments are good guessers. And the U.S. government, with our massive budget deficits, is the biggest borrower of that cheap Chinese cash. Even if individuals, en masse, never make mistakes (which is still an open question), governments certainly do.

So, to reiterate: China's government could be stupid for offering us cheap loans. Or our government could be stupid for taking them. Or both. If you believe, as Mankiw does, that government policy distorts the economy, then you must believe that at least one of the two countries is a sucker.

Which one is the sucker? Anyone care to take a guess?

For the record, my bet is on "both." One danger is what they call "rapid adjustment." This whole cycle of cheap money and cheap stuff is dependent on China's policy, which it could decide to change at any moment (like, say, if the U.S. had a recession). We have no idea when that moment is. And if they pick the wrong moment, all those cheap loans we took out could get more expensive in a hurry, just as all that cheap stuff at Wal-Mart gets more expensive. At that point, it'll be little consolation if a bunch of American factories open up and offer us jobs.

And if that "rapid adjustment" is so rapid that we suddenly can't make payments on all that debt we owe China...bad news. Because then other countries won't want to lend us money either (fool me once, etc.). And then our economy will take a big hit - that means you'll have no job with which to pay the suddenly-bigger monthly payments or buy the suddenly-more-expensive stuff at Wal-Mart.

There are probably lots of other dangers involved with this policy of China's, but my economic knowledge is still far too rudimentary for me to think of what those could be. Is the U.S. government smarter than me, though?

Of course, if we somehow get hurt, China would probably be hurt too. But if someone handcuffs himself to you and then jumps off a cliff, it's little consolation that he's going to get splattered right next to you.

So no, I don't share Greg Mankiw's rosy enthusiasm that what China is doing can't possibly hurt us. His assumption - that the U.S. as a whole always does what's best for itself - has been proven wrong in the past and will be proven wrong in the future. When offered a rope with which to hang oneself, not everyone will do the smart thing and turn it down. The kabillion-dollar question is whether China's trade policy is offering us that particular sort of rope.