Disagreeing with Paul Krugman

Krugman recently asserted that there was no conceivable way that a lower government deficit could lead to a stronger dollar and a lower trade deficit without causing a recession. But there is a fairly straightforward way this could happen...

China is basically using our Treasury notes as a bank for future consumption, and, like all banks, it could fail by a series of poor business decisions. Under the Bush administration, the "bank" has been making such decisions, and China has, therefore, recently entertained ideas of diversifying. This contributes to widespread consternation (among other countries) and confidence in the "bank" declines.

We can solve this problem, therefore, by making better business decisions. One way to do so is to address budget deficits, real and imagined (the imagined are various entitlement shortfalls), so other countries will regain confidence in the bank.

While this does not solve the problem directly, it gives America time to get some fundamentals in place- namely, handling the savings rate. The rate plunged for two reasons: first, the Fed flooded the country with money, which made housing artificially cheap and led to a speculative bubble. This made people feel rich and they increased their consumption accordingly. This is why our economy is still growing at a decent rate even though real income is down. Second, income amongst nearly all Americans has declined due to the tax and regulatory policies of the Bush administration, so maxing out on home loans was necessary to maintain the standard of living. A change in tax policies, which would provide money to middle class Americans, combined with the current readjustment in the true cost of money, should allow for an eventual increase in the value of the dollar while simultaneously avoiding a recession.