The New York Times, in its series on the origins of the financial crisis it calls “The Reckoning,” pins our housing and credit bubbles on Chinese savings and the U.S.-China trade gap. This is basically the view of Alan Greenspan and Ben Bernanke. We were helpless. Monetary policy had become ineffective. The New York Times also says the U.S. failed to react to the China-U.S. “imbalances” soon enough, that we took a “passive” approach.
In fact, most of this is backward. We did not under-react to China. We overreacted. The U.S. weak-dollar policy — a combination of historically low Fed interest rates and a Treasury calling for a cheaper currency — was a direct and violent reaction to the trade gap. A series of Treasury secretaries and top U.S. economists, from John Snow and Hank Paulson to John Taylor and Martin Feldstein, explicitly backed this policy as a way to “correct” these “imbalances.” This weak-dollar policy was designed to reduce the trade gap but in fact boosted it by pushing oil and other commodity prices through the roof. It also created and pushed excess dollars into other hard assets like real estate, resulting in the housing boom and then bust.
America’s overreaction to China’s rise in particular and our misunderstanding of global trade and finance in general was thus, I believe, the chief source of our current predicament. The Fed and Treasury failed to grasp the truly global nature of the economy and the centrality of the dollar around the world. I tell the story of Chinese-U.S. interaction in this long paper, “Entrepreneurship and Innovation in China: 1978-2008.”
