Earth to Johnson & Kwak: People kill people more easily with guns.

Simon Johnson and James Kwak attempt to rebut the notion that massive Chinese reserve accumulation was a (the?) major cause of the U.S. housing bubble. They do an extremely poor job of it. Their arguments are a collection of straw men, internal contradictions, and questionable economics.

Johnson and Kwak write:

According to [the "blame China"] story, the global financial crisis was caused by hardworking Chinese factory workers who committed the sin of over-saving, which created a glut of money that needed to be invested, conceptualized in a great episode of public radio's "This American Life" as the "giant pool of money."

This is a totalstraw man. Nobody ever claimed that the fault lay with frugal Chinese households. The problem was that the Chinese government took those savings - deposited almost entirely in state-controlled banks - and used them to buy massive amounts of U.S. Treasuries.

(Japan and the oil exporters also had large surpluses, but for political reasons, the finger generally gets pointed at China.)

There is a good reason the finger doesn't get pointed at Japan: Japan has a floating currency. It is not pegged. China's currency peg forces it to buy tons of Treasuries to keep its currency cheaper than the market wants. Japan used to do this, but it hasn't recently. The oil exporters do share some of the blame for global financial imbalances, but the reason they are rarely mentioned is that their conribution was just much smaller, in absolute terms, than China's.

This beast from the East, seeking higher yields than it could find in Treasury bonds, flooded into the housing market, pushing down interest rates and pushing up housing prices, and creating a bubble that finally collapsed, with the results we all know.

That is an absurd characterization of the "imbalances" story. Everyone knows that China's purchase of U.S. assets was primarily the People's Bank of China buying U.S. Treasury bonds and bills. China was not a major direct player in the U.S. housing market, and nobody is saying it was. This is like a straw man without the straw.

Now here comes the jaw-dropping self-contradiction:

More nuanced proponents of this theory hold, in a "fair and balanced" sort of way, that over-savers in China and under-savers in the United States -- and other countries, like Spain, Britain and Ireland -- are equally to blame; in any case, it's the imbalance that's the problem...

Like most errors, this story contains an element of truth. In general, it is not a good thing for a country to consume more than it produces indefinitely because to pay for its excess consumption it must borrow money from the rest of the world, and that country can consume more than it produces only if some other country produces more than it consumes. In particular, the U.S.-China imbalance is due in part to the Chinese policy of keeping its the value of its currency artificially low -- encouraging Americans (and other foreigners) to buy Chinese exports and discouraging its citizens from buying imported goods.

But the "blame China" story (or the "half-blame China" variant) suffers from serious problems. First, it takes two to tango. No one put a gun to the American consumer's head and forced him to buy a new flat-screen TV or to do so by taking out more debt.

So, 1) proponents of the "imbalances" theory think that the U.S. financial system and China's exchange rate peg were both to blame for global imbalances, and 2) China's exchange rate peg was indeed partially to blame for global imbalances, but 3) this somehow makes the "half-blame China" story wrong? Unless my eyes deceive me, Johnson and Kwak just explicitly made the case for the "more nuanced" version of the theory that they then reject...

Now here comes the bad economics:

Third, there is no particular reason why a "giant pool of money" should produce a bubble. A savings glut should lower interest rates, which should increase the value of housing; a bubble occurs when prices go up more than dictated by fundamentals like as interest rates. If the run-up in housing prices was a direct result of over-saving in China, then housing prices should have fallen only if China stopped over-saving -- which has not happened.

So, suppose you accept - as Johnson and Kwak seem to do - that people are irrational (so bubbles can easily exist). Now suppose you have a government policy (Chinese exchange rate peg and American financial deregulation) that makes it much easier for irrational agents to form a bubble. Johnson and Kwak are saying we shouldn't blame the government policy - we should blame the people themselves for being irrational in the first place! This is the international-finance equivalent of saying "Guns don't kill people; people kill people."

Can we (i.e. a few smart people in a room, arguing about how to improve the world) change mass consumer behavior? Maybe, but only slowly, and only by long-term media pressure. Can we change government policy? Yes, rather easily, if we can get politicians to listen to us. So why do Johnson and Kwak want to shift the blame for the crisis onto the segment of society that is the hardest to change?

No one is arguing (at least, no one serious is arguing) that the U.S. financial system, enabled by deregulation, a permissive culture, and bad finance theories, is absent of blame for the housing bubble; of course it was a culprit. But to argue that therefore China' government is blameless is just disingenuous. Without that flood of Chinese government money into U.S. Treasury bonds, the risk-shifting wizards of Wall Street would have had lot less extra leverage to play with, which would have meant less demand for subprime mortgages to securitize, which would have meant fewer NINJA loans. To say that a government can't dump a trillion dollars into financial markets and not end up radically distorting private incentives is either intellectually dishonest or silly.