Remember the dire threat posed by our financial dependence on China? A few years ago it was all over the media, generally stated not as a hypothesis but as a fact.
Obviously, terrible things would happen if China stopped buying American debt, or worse, started to sell off its holdings. Interest rates would soar and the economy would plunge, right? Indeed, that great monetary expert Adm. Mike Mullen, the former chairman of the Joint Chiefs of Staff, was widely quoted in 2010 as declaring that debt was the biggest security threat in the United States. Anyone who suggested that we didn’t need to worry about a China sell-off was considered weird and irresponsible.
Don’t tell anyone, but the much-feared event is happening now. As China tries to prop up its currency in the face of capital flight, it’s selling lots of our debt, and so are other emerging markets. And the effect on interest rates in the United States has so far been … nothing.
Who could have predicted such a thing? Well, me. And not just me: Anyone who seriously thought through the economics of the situation – the world awash in excess savings and the American economy in a liquidity trap – quickly realized that the whole China-debt scare story was nonsense. But as I said, this wasn’t even reported as a debate; the threat of Chinese debt holdings was simply a fact.
And, of course, those who got this completely wrong have learned nothing from the experience.
The economist Tim Duy pointed me to a striking speech from Lael Brainard – who recently joined the Federal Reserve Board of Governors – that takes a notably more dovish stand than what we’ve been hearing from Fed Chairwoman Janet Yellen and Vice Chairman Stanley Fischer.
Basically, Ms. Brainard comes down on the Summers/DeLong/Krugman precautionary-principle side of the debate, arguing that given the uncertainty about the path of the natural rate of interest, and the great asymmetry in the consequences of moving too soon versus too late, rate increases should be delayed until you see the whites of inflation’s eyes.
Why does she sound so different from Mr. Fischer and Ms. Yellen?
Mr. Duy argues that it comes down in part to generational differences: “I think these three players are all products of their experience,” he wrote in a recent blog post. “Yellen received her Ph.D. in 1971. Fischer in 1969. Both experienced the Great Inflation firsthand. Brainard earned her Ph.D. in 1989. Her professional experience is dominated by the Great Moderation.”
Maybe, but it’s also worth noting the difference in perspective that comes from having an intellectual background in international macroeconomics as opposed to domestic macroeconomics. I would say that Ms. Brainard’s experience is dominated not so much by the Great Moderation as by the Asian financial crisis and Japan’s stagnation; internationally oriented macro types were aware earlier than most that Depression-type issues never went away. And if you read Ms. Brainard’s argument carefully, she devotes a lot of it to the drag America may be facing from weakness abroad and the stronger dollar, which together act as de facto monetary tightening: “There is a risk that the intensification of international crosscurrents could weigh more heavily on U.S. demand directly, or that the anticipation of a sharper divergence in U.S. policy could impose restraint through additional tightening of financial conditions. For these reasons, I view the risks to the economic outlook as tilted to the downside. The downside risks make a strong case for continuing to carefully nurture the U.S. recovery – and argue against prematurely taking away the support that has been so critical to its vitality.”
So does her speech matter? She is, as I indicated, pretty much saying what some of us outside the Fed have been saying already, although she does it very clearly and very well. But does it make a difference that someone on the inside is laying down a marker and warning that raising rates could be a big mistake? I guess we’ll see.