The Perils Of Prostitution

I’m going to give you a glimpse at my current research area without torturing you with models and data.  You’ve probably noticed I’ve been less than consistent with my blogging since the end of semester in mid December.  This will continue awhile as I torture trade theory, exchange rates, and the world financial system in pursuit of a few pubs.  However, I still am, at heart a teacher and I like to answer questions. 

I’ve gotten a lot of questions recently about the current economic stimulus package in terms of increasing the U.S. debt.  Many of my students ask me what would happen if China simply decides one day to stop buying our Treasuries or dump all the ones they own, at once, on the market. The answer is worldwide chaos but unlikely to happen.  However, there are things afoot that could make it likely that the Chinese might not buy further debt and could slowly shed its current portfolio holdings of both dollars and debt.  This could have enormous ramifications for our ability to stimulate the economy via debt financing as well as maintain the dollar as the world currency.

It is also possible that the other sovereign fund countries ( that would be the oil producing countries) may also stop buying further debt.  It’s easy to explain that.  Less oil revenues means less free money to invest.  But what about China? 

This is really a side show to what I am currently studying which is monetary policies, trade, and exchange rate policies.  But, it is an interesting sideshow. So here’s some questions, some discussion, and enough information to be mildly dangerous.  What about China?

Let me first direct you to an extremely interesting article in The New Republic by John B. Judis call Debt Man Walking.  It’s an extremely interesting discussion of our debt financing, exchange rates, and the relationship between our debt driven growth policy and China’s export driven growth policy.  Basically, they fund our debt, and we buy their stuff.  We have the same sort of symbiotic relationship that you see between prostitute and john. (This article was published in early December.)  This keeps the primacy of our dollar and lets us borrow our way to the American dream.

For decades, the United States has relied on a tortuous financial arrangement that knits together its economy with those of China and Japan. This informal system has allowed Asian countries to run huge export surpluses with the United States, while allowing the United States to run huge budget deficits without having to raise interest rates or taxes, and to run huge trade deficits without abruptly depreciating its currency. I couldn’t find a single instance of Obama discussing this issue, but it has been an obsession of bankers, international economists, and high officials like Federal Reserve Chairman Ben Bernanke. They think this informal system contributed to today’s financial crisis. Worse, they fear that its breakdown could turn the looming downturn into something resembling the global depression of the 1930s.

Now, let me highlight something published by Reuter’s today under the headline China Factories cut Output at Record Pace.  I’ll also point out this from the New York Times: Manufacturing Report Shows Depth of Global Downturn.   This is a quote from the NY Times piece.

“China’s economic outlook for 2009 will be best characterized as ‘getting worse before getting better,’ laying the foundation for a firmer recovery in 2010,” said Qing Wang, chief economist for Greater China at Morgan Stanleyin Hong Kong.

Mr. Wang expected growth to continue to slow in the first six months, before stimulus measures could take effect. “The authorities have already made delivering economic growth a top policy priority by adopting a campaign-style policy execution approach,” he said.

So, China depends on us to buy their plastic trinkets.  We depend on China to fund our government debt.   This has let us avoid tax increases, let the wealthy get wealthier, and preserve the dollar as the international currency. So, let’s go back to my student’s question:  What stops China from threatening to dump either U.S. dollars or U.S. debt on the market since they hold so much?  Also, since they hold so much of these things, what impact does it have?   Economist Nouriel Roubini has argued that this threat or even the implicit threat has limited U.S. foreign policy and effectively gives China a veto over any U.S. Foreign Policy.  (This includes smiling while they roll over Tibet and pollute like it’s 1899.  It also means smiling while they ship us toxic drugs, baby food, pet food and products that violate international patents.) Additionally, it  has led to low incentives for any growth in U.S. manufacturing to expand or retain U.S. factories because U.S. labor, safety, and pollution standards have distinct disadvantages in a world where China has none.  We also allow China to peg their exchange rates to a level where nothing made in the U.S. could EVER compete on a dollar-for-dollar basis with Chinese goods and services.

Up until recently, I’ve emphasised to my students that because of our prostitute/john relationship with China, the questions of China dumping dollars or U.S. debt are merely hypothetical or rhetorical.  China is unlikely to do anything because they need us as customers as much as we need them as creditor.  However, the recession has changed this bargain.  America’s downturn has led to a decrease in demand for Chinese goods which has led to a significant decline in the Chinese economy as shown by the statistics outlined in the Reuter’s link.  China’s growth has now dropped to a point where it is unable to provide jobs to the 24 MILLION new workers that join its labor force each year and as stated in the NY Times article is going to turn to Keynesian style stimulus.

Bottom line:  China may no longer have the surplus dollars to buy U.S. Treasury bills which could be a major source of funds for the huge Obama Stimulus plan now in the works unless they decide to fund OUR recovery above their own.  We’ve already mentioned that oil producing countries like Saudi Arabia, UAE, and Kuwait no longer have those incredible oil revenues either.  If our money is not flowing out of our borders, that means it must be sitting back here in the USA somewhere.

In the recent past, countries like China and the other Pacific Rim manufacturing countries could rely on countries not in recession as customers for their exports and investments.  With both the U.S. and the E.U. in recession, what can these developing nations do but pull into themselves and practice some self stimulation?  So again, where is the money going to come from for the Obama stimulus package?  This is something that has not really been discussed publicly.  Will the money come from the bits that some of us have been tucking beneath our mattresses?  We that find its way to the U.S. Treasury market or go back to buying Chinese trinkets and gas?  Will the Chinese fund our recovery first and risk potential social unrest over its own employment issues?

So, I ask you, what about China?