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China And The United States And The Balance Of Financial Terror

By Dan Harris and Steve Dickinson

Brilliant (word NOT used lightly) article, entitled, The $1.4 Trillion Question, by James Fallows over at The Atlantic Magazine (h/t to China Economic Review Blog) Thesis is that China has essentially been subsidizing the United States for a long time and the key questions are whether this will continue, for how long, and what mind end it. Conclusion seems to be that it will continue because it is in the best interests of both China and the United States, but some major event might trigger its end. According to the article, the Chinese government has, for the most part, chosen to save/invest its money to promote growth at the expense of consumer well being. I do not think this assumption can be disputed:

The other major decision is not to use more money to address China?s needs directly?by building schools and agricultural research labs, cleaning up toxic waste, what have you. Both decisions stem from the central government?s vision of what is necessary to keep China on its unprecedented path of growth. The government doesn?t want to let the market set the value of the RMB, because it thinks that would disrupt the constant growth and the course it has carefully and expensively set for the factory-export economy. In the short run, it worries that the RMB?s value against the dollar and the euro would soar, pricing some factories in ?expensive? places such as Shanghai out of business. In the long run, it views an unstable currency as a nuisance in itself, since currency fluctuation makes everything about business with the outside world more complicated. Companies have a harder time predicting overseas revenues, negotiating contracts, luring foreign investors, or predicting the costs of fuel, component parts, and other imported goods. And the government doesn?t want to increase domestic spending dramatically, because it fears that improving average living conditions could paradoxically intensify the rich-poor tensions that are China?s major social problem. The country is already covered with bulldozers, wrecking balls, and construction cranes, all to keep the manufacturing machine steaming ahead. Trying to build anything more at the moment?sewage-treatment plants, for a start, which would mean a better life for its own people, or smokestack scrubbers and related ?clean? technology, which would start to address the world pollution for which China is increasingly held responsible?would likely just drive prices up, intensifying inflation and thus reducing the already minimal purchasing power of most workers. Food prices have been rising so fast that they have led to riots. In November, a large Carre­four grocery in Chong­qing offered a limited-time sale of vegetable oil, at 20 percent (11 RMB, or $1.48) off the normal price per bottle. Three people were killed and 31 injured in a stampede toward the shelves. This is the bargain China has made?rather, the one its leaders have imposed on its people. They?ll keep creating new factory jobs, and thus reduce China?s own social tensions and create opportunities for its rural poor. The Chinese will live better year by year, though not as well as they could. And they?ll be protected from the risk of potentially catastrophic hyperinflation, which might undo what the nation?s decades of growth have built. In exchange, the government will hold much of the nation?s wealth in paper assets in the United States, thereby preventing a run on the dollar, shoring up relations between China and America, and sluicing enough cash back into Americans? hands to let the spending go on.

A year and a half ago, in a post entitled, "Chinese Yuan Rising? -- But What About China?" I said pretty much the same thing:

More importantly, however, is that both economists ignore the political and social imperative for continued growth in China. I am of the view that the Chinese government wants growth. I am of the view that the Chinese government needs growth. I am of the view that the Chinese government's comments about wanting to slow down the economy are mainly for foreign consumption. There were some 87,000 rural protests in 2005 and the best way to reduce that number is jobs. Countless university graduates are without jobs or underemployed. The Chinese government must keep up its growth machine to create jobs for these people. And is China's economy really "overheating," anyway? I have certainly seen a lot of talk about inflation fears, but I have yet to see any numbers indicating much of it already. This Wall Street Journal article says the consumer-price index increased 1.5% in June after rising 1.4% in May. That's a problem? And will not the huge pool of peasants and university graduates keep wages in check? I ask this not to say inflation in China is impossible, but to ask why should the Chinese government go great guns to slow things down? I am not going to predict whether China will or will not allow the Yuan to appreciate further, but I will say that in analyzing this question, one must do more than just look at the economics; domestic politics must be considered and domestic politics say there will be no appreciation. Indeed, if China does allow the Yuan to rise, I would think it will do so not for economic reasons, but to mollify the United States and the EU

Fallows' goes on to note how the "Chinese public is beginning to be aware that its government is sitting on a lot of money?money not being spent to help China directly" and "Chinese bloggers and press commentators have begun making a connection between the billions of dollars the country is sending away and the domestic needs the country has not addressed." Nonetheless, the "balance of financial terror" between China and the United States, likely means little will change until something changes:

Lawrence Summers calls today?s arrangement ?the balance of financial terror,? and says that it is flawed in the same way that the ?mutually assured destruction? of the Cold War era was. That doctrine held that neither the United States nor the Soviet Union would dare use its nuclear weapons against the other, since it would be destroyed in return. With allowances for hyperbole, something similar applies to the dollar standoff. China can?t afford to stop feeding dollars to Americans, because China?s own dollar holdings would be devastated if it did. As long as that logic holds, the system works. As soon as it doesn?t, we have a big problem.

I agree China has to and will seek to keep growing rapidly -- most costs be damned -- and that the United States and China have become so economically intertwined neither country should or does want to get off their shared bus. I am just not sure what, if anything, will derail the ride. What do you think?

Full post as published by China Law Blog on January 13, 2008 (boomark / email).