Sunday, May 22, 2005

Who's been keeping interest rates low? The Chinese.

Interest rates have been at historic lows for several years. This began around the time Bush stole his first election, and despite a couple modest increases by the Federal Reserve, the interest rates have remained very low.

One effect has been a bubble of house buying. The real estate market is hopping and has been the whole time. People are on a binge of buying houses because of the low rates. The idea floating around has been that it's insane to not get into the market, because you'll never see rates this low ever again. And at the same time house prices have been skyrocketing.

The Chinese Connection ( By PAUL KRUGMAN, Published: May 20, 2005, NY TIMES.COM)

In the article Paul Krugman explains how it is the Chinese who are keeping interest rates low.

Here's how the U.S.-China economic relationship currently works:

Money is pouring into China, both because of its rapidly rising trade surplus and because of investments by Western and Japanese companies. Normally, this inflow of funds would be self-correcting: both China's trade surplus and the foreign investment pouring in would push up the value of the yuan, China's currency, making China's exports less competitive and shrinking its trade surplus.

But the Chinese government, unwilling to let that happen, has kept the yuan down by shipping the incoming funds right back out again, buying huge quantities of dollar assets - about $200 billion worth in 2004, and possibly as much as $300 billion worth this year. This is economically perverse: China, a poor country where capital is still scarce by Western standards, is lending vast sums at low interest rates to the United States.

And ...

Here's what I think will happen if and when China changes its currency policy, and those cheap loans are no longer available. U.S. interest rates will rise; the housing bubble will probably burst; construction employment and consumer spending will both fall; falling home prices may lead to a wave of bankruptcies. And we'll suddenly wonder why anyone thought financing the budget deficit was easy.

In other words, we've developed an addiction to Chinese dollar purchases, and will suffer painful withdrawal symptoms when they come to an end.