Culture

What's a Little Matter of $1.4 Trillion Between Friends?

By Sean Nelson

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Harry Truman used to joke that he wished he could find a one-handed economist because he felt they would never give him a straight answer, instead opting to reply "one the one had, this idea is good in some ways. On the other hand, it is bad in other ways." A great example of this dilemma in economics is over whether it is better to have a strong or a weak currency. A weak currency makes a country's exports cheaper abroad and its imports more expensive domestically, thus helping to increase that country's trade surplus and benefiting export-oriented firms and industries. For developing countries depending on export-led growth, having a weak currency can be beneficial. However, inflation can also become a problem that eats away at consumers' incomes. Having a strong currency hurts a country's trade surplus and can cause a trade deficit to balloon, but also keeps a lid on inflation, thus boosting the amount of goods and services a domestic consumer can purchase as one's income rises over time. As a result, having a strong currency makes sense for wealthier nations that do not depend on export-led or catch-up growth, such as the US during the Clinton era when the US followed a "Strong Dollar" policy.

As one can see, the trade-off here revolves around inflation. Economists as ideologically diverse as John Maynard Keynes and Milton Friedman have claimed that there is a rather clear trade-off between inflation and unemployment in general: one can usually have low inflation or low unemployment, but not both simultaneously, which makes the danger of stagflation (high inflation and high unemployment) all the more worrisome. In addition, a period of high economic growth tends to be marked by inflation. When a country's economy grows very quickly, controlling inflation becomes a paramount concern to the point it might even be reasonable and desirable to limit economic growth to keep inflation at manageable levels and prevent a downward spiral into hyperinflation. It is into these very issues the US and China have together ventured.

The monetary elephant in the room is the US$1.4 trillion in currency reserves that the Chinese government currently holds. A basic understanding of monetary economics tells us that as a result, this means that American consumers are able to live beyond their means at a time when both the federal budget and trade deficits are large and the economy has been jumping from one bubble to the next. On the Chinese side, this arrangement has allowed to keep the Renminbi's value low to promote its exports, which, according to Frank Langfitt of National Public Radio, has also helped to keep inflation lower than it would otherwise be in the US. In addition, holding dollar reserves has also limited China to already high levels of economic growth to prevent inflation from eating away at economic gains at the national level. China has thus also been able to sidestep the need to let its currency float and be bought and sold on international money markets, which would likely lead to the Renminbi to gain value and harm China's export markets. In addition, the Chinese government holds a massive amount of American Treasury notes, which have the reputation for being among the world's soundest, if most cautious, investments. Nick Lardey of the Peterson Institute for International Economics has pointed out that Chinese "foreign exchange reserves of about 1.5 trillion are bigger than the GDP of all but a handful of countries in the world."

As James Fallows notes in a recent article in The Atlantic Monthly, this also means that over the past few decades Americans have been borrowing money from Chinese workers and are only likely to pay it back at below-market rates. Much of China's dollar holdings are invested in Treasury notes and federal-agency bonds. The returns on these investments have been hovering around 4-5% in the past couple of years, which either just matches or is less than the American dollar's inflation rates in the same time frame. This means that as the US dollar loses value, China loses money on its American government-backed investments. One cannot expect this relationship to be permanent as long as this last point holds. Ian Shepherdson of High Frequency Economics has described the situation as follows: "The US cannot afford for China to sell its US treasuries but, equally, China cannot afford to see the value [of its treasury bonds] slide… China's holdings represent about a third of Chinese GDP."

On this last point, back in the spring of 2006 I attended a talk Thomas Friedman of the New York Times gave at my college to promote his book The World Is Flat. While discussing the this face of Sino-American relations and inter-dependency, he said that some time after this arrangement ends, we will all look back on it fondly, note it had many mutually beneficial features and yet ended abruptly and unexpectedly. To paraphrase him, whatever will lead to the collapse of this arrangement will be obvious in retrospect, but we will not recognize the x-factor in time. Faced with the daunting possibility, one is stuck trying to answer a question without a clear solution. A pessimist would likely say it is better to be a Cassandra foretelling the American dollar's collapse and the Chinese government's subsequent selling off of treasury bills that would depress demand in both the US and China and possibly cause a global economic depression. An optimist expects greater fiscal responsibility in the US brought about by a new administration in 2009 and a secular movement towards greater openness in China to make such a landing soft. After all, no economic relationship in a particular form is permanent (capitalism's power has not been referred to as "creative destruction" for nothing), but we can hope that two states with a relationship of inter-dependency will follow the path of enlightened and mutual self-interest. The Chinese government knows that dumping dollars would cause inflation in the US that would make Chinese exports less affordable for American consumers. It would also lose most of the value they invested in buying up American dollar reserves. Both governments know that these bits of information are common knowledge among state officials. The implication of this is that one of the key foundations of Sino-American bilateral relations will have to continue to be crisis prevention so that a soft landing will be not just possible, but extremely probable. If a crisis does flare up, as James Fallows observes, misunderstanding can play a role in bringing about mutual economic disaster without either side holding malice and plotter against the other side. It may be a cliché to say that a pound of cure is worth an ounce of prevention. In economics, sometimes clichés can be surprisingly insightful.

A couple of years ago, James Surowiecki wrote a piece on this very topic that offered perhaps the best reason to make one cautiously optimistic about the potential of a soft landing coming to pass:

No one, in Asia or anywhere else, wants to be the last guy out. What the Chinese and the Japanese do depends in large part on  what they think everyone else is going to do. If the Chinese get the idea that Japan's commitment to the dollar is wavering, or if they decide that the United States has no interest in altering its deadbeat ways, then they may try to make a run for it. Then again, that threat could act as a prod to keep the Americans in line. The currency market is a great example of what George Soros calls "reflexivity": people's predictions about what will happen to the dollar end up having a major impact on what actually does happen to the dollar. Our lenders are trying to strike a delicate balance: they'd like the dollar's predicament to seem dire enough to make us change, but not so dire as to spark panic. So be afraid. Just don't be very afraid.

Here is to hoping that both Surowiecki and Soros are right.


Vocabulary:
Foreign currency reserves: 外汇储备 wài huì chǔ bèi
Inflation: 通货膨胀 tōng huò péng zhàng
Trade surplus: 贸易顺差 mào yì shùn chā
Trade deficit: 贸易逆差 mào yì nì chā
Economic growth: 经济增长 jīng jì zēng zhǎng

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