China lending its reserves to Americans don’t set American Interest rates:
also of interest
In fact, I have to say that the first article, with the utmost respect for the author, does not make perfect sense to me.
Firstly, the author seemed to be using his explanation of what determines the interest rate in an ideal free market economy to account for the factors responsible for the interest rate of American economy under the financial dictatorship of the Federal Reserve System, which is first and foremost not an ideal free market economy. Therefore, his explanation should not be taken for granted. The Fed is inflationist by nature, so obviously a low interest rate is always prefereable. In my personal point of view (and I believe this makes more sense), there are about three factors helping to determine Fed’s interest rate. The first is to prevent inflation from going too wild. The Fed wants inflation, but if the inflation goes too crazy, it will face public complaints, political pressure, and the pressure of hyper inflation. Therefore, unless the inflation is going too wild, the Fed will keep a low interest rate. (If it lacks reserves, what it really needs to do is simply “purchasing assets”, aka “printing money”.) The second is interest rate of other central banks. This factor is as crucial as the first in a globalized economy. If one central bank (under which the economy is among world’s most influential economies) suddenly raises the interest rate, many investors in other economies will take advantage of the difference of interest rate, selling their assets and then putting the newly acquired money (through selling their assets) into the aforementioned central bank with a much higher interest rate. Or some investors can simply just take their money out of their banks and deposit the money into banks which are located in an economy that has a much higher interest rate. Therefore, to keep a low interest rate the Fed has to face the pressure of capital flow, in case of some other central banks suddenly raise their interest rates. The third factor is depreciation pressure. The Fed wants to keep the interest rate low, partially because of the fact that with a low interest rate, the Wall Street financial capitalists will feel easy to take out the dollars and use the dollars to take over assets in other economies. And this phenomenon is called “Dollar Imperialism”, or “Dollar Hegemony”. However, the problem is that to keep the rate low the Fed actually generate depreciation pressure of the dollar, which can hurt American consumers’ interest as they feel the price of imported goods higher and American investors’ interest as they feel the price of foreign assets higher. Moreover, a depreciation if dollar is a source of complaints by the creditors of the government, because the depreciation means the depreciation of the value of the Treasury Bills and other assets they hold. These three factors are what the Fed actually considers when setting the interest rate.
So let’s examine why an appreciation of RMB against dollar can influence the interest rate. Firstly, it makes the American investors harder to purchase Chinese assets. Secondly, it forces the American consumers to face a higher price of imported goods. Thirdly, just like what I explained in my answer to this post, a weak RMB was actually “exporting deflation” to American economy, because a weak RMB brings about a higher revenue for our exporters, meaning that more dollars were taken out of American economy into the Chinese exporters. This deflationary pressure left the room for the Fed to keep a low interest rate. However, as the RMB appreciates, fewer dollars are taken out of American economy, so the Fed will have to face inflationary pressure. All these reasons help to explain how RMB can influence Fed’s decision on the interest rate.
As for how lending our reserves can influence Fed’s decision on setting the rate of interest? Quited obviously, lending our reserves enable the Fed to have more money to lend, therefore less money to print out (printing money can generate depreciation pressure, just take a look at how dollar was weakened on March 20 when the Fed puchased Treasury Bills) , and therefore to keep the interest rate low.
Now I’d like to directy quote some words in the second article:
“Hence if China, Europe, or any other country is having a glut of money this cannot do much for the prices of American assets. The investors from other countries to the US must acquire US dollars for their money before they can buy American assets. The amount of these dollars however is dictated by the Fed’s monetary policies and the US fractional reserve banking. It is obvious then that Greenspan’s and Bernake’s assertions that the glut of foreign liquidity is having a powerful effect on American asset prices is dubious.”
It is true that the “savings glut” is in RMB, and the investment in the US economy is in dollars, so seemingly the “savings glut” is a bit too irrelevant. However, one should not simply ignore how the Chinese central bank get these dollars. As I have explained in my answer to this post, the Chinese central bank collect the dollars from collect the dollars from the exporters who receive the dollars as their revenues. The very essence of this collection is that to compensate these exporters, the Chinese central bank have to offer the same amount of RMB for the exporters. So where does this amount of money in RMB come from? I do not have official sources suggesting the answer, but it is crystal clear that It may either come from “savings glut”, or the printing machine. If it comes from the “savings glut”, then the question is very much settled, but what if the money comes from the printing machine? In fact, to print such a large amount of money simply means a drastic increase in the monetary base, which can bring about hugh inflationary pressure. The reason why the Chinese central bank can withstand the inflationary pressure is actually the “savings glut”, which reflects extremely weak desire of spending.
Erickk,
I am still not clear about one point - the effect of savings of Chinese consumers on the PBC’s foreign reserves.
If the chinese consumer keeps his savings either in bank deposit or invest in capital markets, how the PBC gets access those funds? I understand how a central bank works and how it controls the money supply in its economy, but the link between consumer savings and the central bank is not clear to me.
Also, how does the PBC pays for the dollars purchased from exporters, by printing new RMBs or giving them credit through operating banks?
You’re committing a fallacy of composition. I can take any area of the world and say that there is overconsumption and argue that they have an economic crisis. No economic crisis can ensue, however, as long as the money that feeds that “overconsumption” is actually saved beforehand. So, to use the example presented in this thread, if China saves and America consumes, than there is no overconsumption, since the Chinese saving cancels out the American consumption. You cannot have international credit without international trade, this means that Chinese saving causes prices to be lower than they otherwise would be. This enables Americans to consume more without worrying about sky high prices.
What causes crises is overconsumption and malinvestment. When credit expansion unbacked by savings is spurred by government policies, then businesses and individuals can borrow more money to buy, finance, and produce durable and capital goods like vehicles, housing, machinery, factories, etc. However, because this credit is simply new money, inflation ensues and producers of non-durable goods are able to outbid the producers of durable/capital goods since the former receive higher profits from higher consumption rates. This then causes a crisis as producers of durable goods are forced to lay off workers and lower wages, thereby reducing the level of consumption.
However, when credit which is backed by savings is introduced into the economy, no such dynamic can occur. Prices fall as a result of the saving and producers of nondurable goods become less profitable. The lower interest rates enable the production, financing, and purchasing of durable and capital goods while falling input prices make these projects sustainable over the long term.
Thus, no increase in savings anywhere can create any kind of economic crises.
The real problem occurs when government intervenes in other ways. For example, the low Federal Reserve interest rates decimated American savings and promoted a long-term high trade deficit by inflationary processes. These, however, are completely unrelated to Chinese savings.
I am also a very firm believer of the Austrian Business Cycle Theory. I think we both agree that an artificially low interest rate can create a illusion for the investors and the producers that there is enough savings backing up their malinvestments and long term adventures when the reserves the Central Bank has are actually not enough, so eventually the Central Bank running out of reserves will have to raise the interest rate, thus pricking the artificial boom. However, what must be taken into account is that the Central Bank can simply print new money and add them to its monetary base, thus enlarging their reserves to maintain a low interest rate. Therefore, it needs to be fully understood that the Central Bank does not care about the savings for their reserves to lend out AS LONG AS printing new money will not lead to serious depreciation and inflationary pressure. You can see what really determines the Fed’s interest rate in my answer to bearing01 on his two articles suggested in this post.
OK, I can assure you that my account for how PBC built up its dollar reserve and what effects the use of those newly collected dollars to purchase American bonds can have on the American economy is correct. I appologize for not making it clear what the RMB used to pay for the exporters’ newly received dollars come from.
To be honest, I actually don’t know where the source of the RMB (the PBC used to pay for the dollars purchased from exporters) is, but maybe you can get a still unclear answer from my reply to bearing01 on the two articles suggest by him in this post.
As for the relationship between bank deposits and Central Bank, bankers deposit their reserves into the Central Bank, and part of the reason why the Central Bank can be made the lender of the last resort. (I am not very sure on this deposit thing, CORRECT ME IF I AM WRONG thanks!!)
The Keynesians think in underconsumptionist terms, though. Hence, the article and opinion are existant.
The PBC and the Federal Reserve both create a lot of new money.
As a result of this, It seems pretty self-evident to me that both the US housing and mortgage security industries were bubble activities, as well as the Chinese exporting industry. They only work while the printing presses are running, but even then their days are numbered.
An article about the subject:
Wouldn’t the fact that FRB actually make so that, even though these are actual savings, affect the interest rate?