Writing in today’s New York Times, Paul Krugman argues  that China’s recent practice of buying so much debt issued by Uncle Sam – that is, China’s practice of lending so many of its dollars to the U.S. government – is fueling what Krugman believes to be a housing bubble in the United States. Here’s the crux of his argument:
Dollar purchases by China by and other foreign governments have temporarily insulated the U.S. economy from the effects of huge budget deficits. This money flowing in from abroad has kept U.S. interest rates low despite the enormous government borrowing required to cover the budget deficit.
Low interest rates, in turn, have been crucial to America’s housing boom. And soaring house prices don’t just create construction jobs; they also support consumer spending because many homeowners have converted rising house values into cash by refinancing their mortgages.
This analysis is incomplete.
It doesn’t ask what the Chinese would do with the dollars it earns (from its exports of goods and services to the U.S.) if Uncle Sam ran no budget deficits. And it ignores the fact that fiscal responsibility by Uncle Sam would itself keep interest rates lower.
Suppose that, in the fantasy world in which Uncle Sam is fiscally responsible, the Chinese spend all of their dollars on U.S. goods and services – rather, than, say lending these dollars to U.S. banks or investing them in U.S. housing-development projects.
Would interest rates be higher than they are today? Would housing prices be lower than they are today? One part of Krugman’s argument says ‘yes.’ His claim that foreigners’ purchases of U.S. government debt keep interest rates lower than they would be if Uncle Sam balanced its budget is key to his argument that foreign purchases of U.S. government debt are fueling a housing bubble in America. But Krugman’s full argument contradicts itself.
According to Krugman, the current budget deficits would raise interest rates significantly were it not for the happy fact that foreigners lend so willingly to Uncle Sam. So if Uncle Sam stops running budget deficits, Krugman’s argument suggests that interest rates in the U.S. will remain low — hence keeping mortgage-financing costs low. Insofar as low interest rates are fueling the housing boom, such a boom – on Krugman’s own logic – would be fueled by fiscal responsibility on the part of Uncle Sam just as it is now being fueled by foreigners’ willingness to by U.S. Treasury notes.