We Owe the Chinese a Trillion - THEY Have A Problem

The lender, servant to the borrower.

On March 14, the New York Times "quote of the day" was:

We have lent a huge amount of money to the U.S.  Of course we are concerned about the safety of our assets.  To be honest, I am definitely a little worried.

- Prime Minister Wen Jiabao of China.

Mr. Wen must know the adage, "If you owe the bank a million, you got a problem.  If you owe the bank a trillion, they got a problem."  We owe China about a trillion; they have a problem.

The New York Times reported that Mr. Wen had "urged the Obama administration to offer assurances that the securities would maintain their value," a noble, if futile, sentiment.

In January, Mr. Wen gave a speech criticizing what he called an "unsustainable model of development characterized by prolonged low savings and high consumption."  There was little doubt that he was referring to the United States.

In saying that Americans couldn't expect other countries to keep buying US Treasury bills to finance the American consumers' spending spree, Mr. Wen was certainly correct.  The graph shown here illustrates the US National Debt over the past few administrations.

Mr. Obama proposes to increase our national debt a lot.  Mr. Wen is warning Mr. Obama that it may be difficult for the US to sell all the nice new debt he's planning to run up.

World-Wide Consumption

America has been consuming a major fraction of the world's output for many years.  We import far more goods and services than we export; the difference is called the "trade deficit."

In order to pay for the deficit, we've sold US Treasury bills all over the world.  The rest of the world has financed our consumption.

As with selling mortgages to people who couldn't pay, the music has to stop at some point.  Mr. Wen is concerned that his government's investment in our government's debt will lose value as sub-prime mortgages lost value.

That's not an idle fear.  Back during the Reagan Presidency, the US reduced the value of the dollar with respect to the Japanese yen.  With a stroke of the pen, a dollar bought fewer yen than it had before so dollars held by the Japanese were worth less to them.

The US instantly reclaimed about 30% of the value of the trade surplus which the Japanese had accumulated. What were the Japanese going to do about it, declare war?  Stop selling to the US?  Gnash their teeth?

This Has All happened Before...

The Chinese are not the first to realize that lending to the US leads to uncertainties.  Taiwan once ran huge positive trade balances and accumulated more foreign exchange per capita than any country in the world.  The Japanese sold so much more to America than they bought from us that our government put up barriers against Japanese goods.  The Koreans, too, hold many US Treasury obligations.

The Chinese live near Taiwan, Japan, and Korea.  From the beginning of their economic expansion 20 years ago, they knew how these nations' experience holding US debt worked out.  Why, then, did the Chinese allow the US government to run up a $1 trillion obligation to them?

Does a bookie encourage a gambler who's addicted to betting on horse races to run an unlimited tab?  Or is the US Government simply too big to fail?

The Times hinted at the reason the Chinese sank so much money into the US Government:

What he [Wen Jiabao] did not mention was that Chinese investments in the United States helped drive the debt-fueled boom of the last decade, during which China grew increasingly dependent on the American market - a point that was driven home earlier this week when China reported a record 26 percent drop in exports in February. [emphasis added]

When It All Began

The current financial cycle started after WW II.  Europe and the Pacific Rim had been bombed flat; American factories were undamaged.  America ran a surplus selling manufactured goods all over the world.

As other countries started to repair their infrastructure, they had two economic models from which to choose - the communist model promoted by the Soviet Union and Mao Tse Tung, and the capitalist model espoused by America.  There had been no large-scale comparison of the actual performance of the two models over a long period of time; it was not clear which was best.

When the Korean War broke out, the American government encouraged the Japanese to produce goods for use in Korea and for export to the American market.  Over the next 30 years, the Japanese were so successful in selling to America that books were written lamenting the impending takeover of America by Japan.  The Japanese invested their profits in US treasury bills.

In effect, the Japanese government subsidized the American economy to cover the difference between what Americans could sell to Japan and what they bought from Japan.  They realized that if they stopped buying up our trade deficit, we'd probably close the American market to them and their businesses would fail.

A bit later, the Taiwanese and Koreans did the same thing.  They sold more to American than America could sell to them; their governments picked up the difference.  All three countries benefited enormously from the arrangement, with the "Asian tigers" changing from third-world pestholes to first-world powers in a single generation.

Despite fulminations in Congress, the arrangement wasn't bad for the US either; not only could Americans buy cheap stuff and the Treasury borrow pretty much unlimited amounts, but the rising powers supported themselves and were no longer as dependent on American aid.

While the Japanese, Taiwanese, and Koreans were enjoying the fruits of having chosen the capitalist model and selling to the US market, the Chinese were mired in Mao's grotesquely-misnamed "Great Leap Forward" during which many millions of Chinese starved to death.  Communism didn't work any better in China than it had in Russia.

The Failure of Communism

The dead hand of communism which held back the Chinese economy was broken by Deng Xiaoping.  In a profoundly brilliant insight, he told the Chinese Communist Party that "It doesn't matter whether the cat is black or white, as long as it catches mice."  He spoke at a time when many Chinese were still at risk of starvation; his point was that the government had to make sure people were fed no matter what it took.  Whatever worked was good by definition regardless of ideology.

Although he was cast into temporary exile by communist hard-liners, Deng's ideas triumphed around 1977 when the government decided to permit Chinese businessmen to exercise their skills on the world stage.

By this time, the other three "Asian Tigers" were well on the way to becoming first-world countries from honing their manufacturing skills by exporting to the vast, extremely competitive US market.  As their citizens became wealthier, they were able to increase domestic consumption, of course, which made them less dependent on the US market.

Having watched the other 3 tigers, the Chinese had no doubt of the rules - they had to pick up the deficits or they couldn't play.  As long as American consumer spending remained high, the Chinese could hone their business skills in the American market.

"Why export," a socialist might ask, "if the government's going to pick up the costs anyway, why not just have government companies manufacture the goods?"  The Chinese knew that wouldn't work because they'd tried it.

Back in the mid 1980's, most Chinese with paying jobs worked in State-Owned Enterprises, or SOEs.  These "businesses" were fully as inefficient as their Soviet counterparts because, being government supported, they couldn't go broke and had no reason to be efficient.

Under Deng's reforms, private firms were permitted to compete with the SOEs.  Many were shut down and millions of jobs were lost.  As the private sector gathered momentum, selling into the US market provided more and better jobs than the SOEs ever dreamed.

An Era of Pure Financial Magic (PFM)

The time from the end of the Korean War in 1953 until the crash at the end of 2008 was an era of Pure Financial Magic (PFM).

Businesses in developing countries honed themselves by competing in America.  There were many failures - the first 4 Japanese attempts to sell cars in America went nowhere - but the companies learned, reorganized, and tried again. The famous "creative destruction" of Joseph Schumpeter was at work, teaching and refining those nations and companies that really wanted to learn.  Companies that didn't learn went under.

Americans may remember reading alarming news about the "balance of trade" as early as the 1960's but it didn't matter.  So long as each foreign government bought back its share of the US trade deficit, the magic played on.

Foreign governments financed American consumption by investing in US treasuries; those investments benefited their economies far more than any other investments could have.  Governments the world over are notorious for wasting money in the guise of "investment"; much better to let the businesses go at it, tax the profits, and recycle some of the money into US treasuries so that US consumers could continue buying.

Increased sales increased profits which increased tax revenue, some of which went back into US treasuries, and so on.  This was financial magic on a global scale.

When the Magic Went Away

During the Clinton administration, the New York Times pointed out the risk of the housing market collapsing due to the feds' requirement that banks loan money to people who couldn't pay.  Foreigners' continued willingness to pick up the US trade deficit increased credit availability in America which made the housing bubble worse.

Last year, people lost faith in the underlying health of the world economy.  As soon as that happened, the magic died because nobody had faith in it anymore.

The Chinese economy is suffering because Americans no longer buy their exports.  How are the Chinese going to be able to afford to buy their share of all the new US debt which Mr. Obama desires to sell?  If Mr. Obama intended to spend the money on Chinese trinkets, it might still work - but he's made it crystal clear that he doesn't.

Will the Chinese economy collapse?  Unlike the US, China abounds in places where infrastructure investments will yield significant societal benefit and there are fewer environmentalists to impose delays or run up costs.  If the Chinese can manage to keep corruption down to a reasonable level, a feat few governments ever can, they'll end up with a more efficient physical plant as the economy recovers.  As with the 3 tigers before them, Chinese manufacturers are starting to move upmarket to more complicated products which can be sold in the Chinese market until the American market comes back.

What About Their Money?

People lend you money only as long as they have faith you'll pay it back; AIG tanked when the "full faith and credit of AIG" lost its luster.  US debt will tank when the "full faith and credit" of the US government does likewise; England has already experienced a bond auction failure, where they couldn't find anybody willing to buy their government debt at the terms on offer.

It's unlikely that the Chinese holdings of US debt will become utterly worthless, but a 50% drop would not be surprising; after all, Japan took a 30% hit not so long ago.

Even if they lose a half-trillion on their investments in the US, however, China will still come out ahead.  By picking up our trade deficit so that they were permitted into our market, they bought themselves a ticket to the first world, and nothing can take that away from them.

The only question is, do they really understand that?  Let's hope they do - now that the magic has gone away, our economy depends on their forbearance.

Will Offensicht is a staff writer for Scragged.com and an internationally published author by a different name.  Read other Scragged.com articles by Will Offensicht or other articles on Foreign Affairs.
Reader Comments
Looks like the Chinese have a little problem of their own:

"China's property market will likely fall by 40% to 50% in value during the next two years... the current rebound in the property market was unsustainable and driven by a flood of liquidity and fraudulent activity rather than real demand... average housing prices are now 10 to 12 times the average income. As a result, about 60% of a homebuyer's monthly income must to go to mortgage repayments."

April 14, 2009 11:07 AM
Mr. Geithner claims that he has persuaded the Chinese to go along with us:


Chinese officials are giving U.S. efforts to pump up its ailing economy a vote of confidence and understand why higher budget deficits are a temporary necessity, U.S. Treasury Secretary Timothy Geithner said on Tuesday.

Geithner, on his first visit to China as Treasury chief, gave fresh assurances that Beijing can sleep easy over its huge holdings of U.S. Treasury debt because Washington is committed to keeping the dollar strong and inflation low.

President Barack Obama's administration, moreover, is determined to get back to living within its means as soon as the crisis has passed, Geithner said in a trio of interviews ahead of meetings with President Hu Jintao and Premier Wen Jiabao.

"I've actually found a lot of confidence here in China, justifiable confidence, in the strength and resilience and dynamism of the American economy," he said.

The Chinese are nothing if not tactful. Why should they admit what they plan to do?
June 2, 2009 10:30 AM
Reuters says China says they won't dump US treasury bonds:


China on Wednesday ruled out the "nuclear" option of dumping its vast holdings of U.S. Treasury securities but called on Washington to be a responsible guardian of the dollar.

In the third in a series of statements explaining its work to the Chinese public, the State Administration of Foreign Exchange sought to allay concerns in the outside world that arise whenever Beijing shifts its holdings of U.S. government debt.

"Any increase or decrease in our holdings of U.S. Treasuries is a normal investment operation," SAFE, the arm of the central bank that manages China's official currency reserves, said.

It said it constantly adjusts its portfolio to maximimize returns, and any changes to its U.S. Treasury portfolio should be seen in that light and not interpreted politically.

In a series of questions and answers posted on its website, www.safe.gov.cn, SAFE asked rhetorically whether China would use its $2.45 trillion stockpile of reserves, the world's largest, as a "nuclear weapon."

They say they're adjusting their portfolio to maximize returns. That's sensible, and holding dollars makes sense only so long as the US doesn't trash the value of the dollar by printing too many.
July 7, 2010 8:21 AM
The Times argues that we have a bit of a problem - we'd suffer so much if China dumped our bonds that we have to make nice.

China, Japan, America
Japan knows that its economy is hurt when China buys up its bonds. It's the same for our economy, but our policy makers just don't get it.

Last week Japan's minister of finance declared that he and his colleagues wanted a discussion with China about the latter's purchases of Japanese bonds, to "examine its intention" - diplomat-speak for "Stop it right now." The news made me want to bang my head against the wall in frustration.

You see, senior American policy figures have repeatedly balked at doing anything about Chinese currency manipulation, at least in part out of fear that the Chinese would stop buying our bonds. Yet in the current environment, Chinese purchases of our bonds don't help us - they hurt us. The Japanese understand that. Why don't we?

Some background: If discussion of Chinese currency policy seems confusing, it's only because many people don't want to face up to the stark, simple reality - namely, that China is deliberately keeping its currency artificially weak.

The consequences of this policy are also stark and simple: in effect, China is taxing imports while subsidizing exports, feeding a huge trade surplus. You may see claims that China's trade surplus has nothing to do with its currency policy; if so, that would be a first in world economic history. An undervalued currency always promotes trade surpluses, and China is no different.

And in a depressed world economy, any country running an artificial trade surplus is depriving other nations of much-needed sales and jobs. Again, anyone who asserts otherwise is claiming that China is somehow exempt from the economic logic that has always applied to everyone else.

So what should we be doing? U.S. officials have tried to reason with their Chinese counterparts, arguing that a stronger currency would be in China's own interest. They're right about that: an undervalued currency promotes inflation, erodes the real wages of Chinese workers and squanders Chinese resources. But while currency manipulation is bad for China as a whole, it's good for politically influential Chinese companies - many of them state-owned. And so the currency manipulation goes on.

Time and again, U.S. officials have announced progress on the currency issue; each time, it turns out that they've been had. Back in June, Timothy Geithner, the Treasury secretary, praised China's announcement that it would move to a more flexible exchange rate. Since then, the renminbi has risen a grand total of 1, that's right, 1 percent against the dollar - with much of the rise taking place in just the past few days, ahead of planned Congressional hearings on the currency issue. And since the dollar has fallen against other major currencies, China's artificial cost advantage has actually increased.

Clearly, nothing will happen until or unless the United States shows that it's willing to do what it normally does when another country subsidizes its exports: impose a temporary tariff that offsets the subsidy. So why has such action never been on the table?

One answer, as I've already suggested, is fear of what would happen if the Chinese stopped buying American bonds. But this fear is completely misplaced: in a world awash with excess savings, we don't need China's money - especially because the Federal Reserve could and should buy up any bonds the Chinese sell.

It's true that the dollar would fall if China decided to dump some American holdings. But this would actually help the U.S. economy, making our exports more competitive. Ask the Japanese, who want China to stop buying their bonds because those purchases are driving up the yen.

Aside from unjustified financial fears, there's a more sinister cause of U.S. passivity: business fear of Chinese retaliation.

Consider a related issue: the clearly illegal subsidies China provides to its clean-energy industry. These subsidies should have led to a formal complaint from American businesses; in fact, the only organization willing to file a complaint was the steelworkers union. Why? As The Times reported, "multinational companies and trade associations in the clean energy business, as in many other industries, have been wary of filing trade cases, fearing Chinese officials' reputation for retaliating against joint ventures in their country and potentially denying market access to any company that takes sides against China."

Similar intimidation has surely helped discourage action on the currency front. So this is a good time to remember that what's good for multinational companies is often bad for America, especially its workers.

So here's the question: Will U.S. policy makers let themselves be spooked by financial phantoms and bullied by business intimidation? Will they continue to do nothing in the face of policies that benefit Chinese special interests at the expense of both Chinese and American workers? Or will they finally, finally act? Stay tuned.
September 13, 2010 5:37 PM
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