Manipulative

Tim Geithner, in a break with Bush policy, has accused China of "manipulating its currency." In terms of plausibility, this is rather akin to accusing Toyota of making cars, but China naturally vigorously denies the accusations. We can only hope that Geithner's accusation is not just a repeat of Hank Paulson's vague, obviously toothless grumblings, but I'm not holding my breath for real concerted action on the Chinese currency issue. China is too big, powerful, and aggressive.

But that doesn't mean that the issue isn't important. Sebastian Mallaby explains why:

Geithner is correct that China manipulates its currency. What's more, this manipulation is arguably the most important cause of the financial crisis. Starting around the middle of this decade, China's cheap currency led it to run a massive trade surplus. The earnings from that surplus poured into the United States. The result was the mortgage bubble.

China's leaders protest that they are being unfairly scapegoated. Yet while there are rival accounts of the origins of the crisis, neither has the explanatory force of the blame-China narrative.

The first rival account is that the crisis reflected failings of U.S. financial regulation. Such failings exist, but most have been around for years. The mortgage bubble reached its craziest extremes in 2005-07, when China was flooding the world with cheap capital.

Moreover, regulatory failings exist not just at one regulator but many. The Securities and Exchange Commission failed to check risks at broker-dealers such as Bear Stearns. State insurance regulators failed to prevent the collapse of AIG. The Federal Reserve failed to see that banks were pouring capital into toxic securities that they then held off their balance sheets. European regulators were no better, even though they had adopted a supposedly more up-to-date set of capital standards. The lesson: Faced with a deluge of cheap money, no regulatory regime can be expected to prevent bubbles.

The second rival account of the crisis accepts that its origins lie less in regulatory failings than in economic pressures. But it blames the bubble on two mistakes at home rather than on the glut of capital from China. Americans should have controlled the urge to splurge, the thinking goes, and borrowed less Chinese money. And the Fed should have shut down the easy-money party by raising interest rates.

If Americans' insatiable appetite for loans explained the flood of Chinese capital into the United States, we would have seen the evidence in a rising price for those loans -- that is, higher interest rates in the bond market. But bond rates were strikingly low at mid-decade. This strongly suggests that it was the supply of lending that went up, not the demand for it. Chinese money flooded into the United States because of the push factor from China, not the pull factor from Americans.

Could the Fed have raised interest rates to avert the bubble? The Fed's monetary policy was indeed too loose. But as Martin Wolf argues in his recent book, "Fixing Global Finance," it's not clear that higher interest rates could have prevented the trouble. Once China decides to export vast quantities of capital, that capital has to go somewhere. Higher interest rates in the United States might have encouraged the world's savers to park even more of their capital in this country.

So there is no getting around China's culpability. The country relies on the sort of export-focused growth strategy that other Asian Tigers have pursued, with the difference that China is too big to go this route without destabilizing the world economy.

Still, as Mallaby admits, the U.S. is unlikely to mount the kind of concerted push that led Japan to revaluate the yen in the 80s. For one thing, there's the DeLong argument that earning the enmity of almighty China would prevent us from being their favorite lackey friend in the long run. And even if we were willing to anger the dragon, it's not clear that the U.S. now has the kind of power and influence to achieve any significant results.

So China will keep its currency low, hoping tha the U.S. will go even further into debt, and that that debt will continue to prop up Chinese manufacturing. It won't work. I guess our best hope is that Geithner will manage to point this fact out to the Chinese.