Alliance: When two thieves have their hands so deeply plunged into each others’ pockets that they cannot separately plunder a third party.
Ambrose Bierce, The Devil’s Dictionary
The US and China bicker like an unhappily married couple, but Brad Setser warns us that the squabbling is getting nastier. And worse, both parties seem to fail to recognize how deeply enmeshed they are, and how divorce is not a realistic option.
Brad Setser, in “Uh-oh! Is China starting to blame the US for its currency losses?” notes that China is unhappy with how the US is trashing the dollar:
Mei Xinyu, a senior researcher under the Chinese commerce ministry writing in a personal capacity for the Shanghai Daily, argues that China needs to put pressure on the US at the Strategic Economic Dialogue to do more defend the dollar. With the dollar at 1.60 against the euro, it isn’t hard to see why.
Mei goes on to argue that if the US doesn’t do more to defend the dollar, it is effectively defaulting on China.
The negative results of the US dollar’s decline are evident: the rising prices of all primary products, the intensified pressure on inflation globally, the confusion in the settlement of international transactions, etc. Worst of all, this is the US’ disguised way of avoiding paying off its debts to foreign countries.
It should be noted that the US is the biggest debtor country in the world…. By the end of 2006, the US’ accumulated net debt overseas hit US$16 trillion. As most of the debts were calculated in US dollars, the US is actually welshing on its debts malignantly by allowing the devaluation of US dollars. Since China is the country with the world’s biggest foreign exchange reserves, most of which are calculated in US dollars, China thus is hurt most greatly from the US dollar devaluation.
One man’s exorbitant privilege is another man’s disguised default…..
What’s more, Mei Xinyu’s argument isn’t entirely wrong.
Setser notes (in more polite terms) that the value of the dollar is secondary at best to the Fed right now. He continues:
But Mei Xinyu’s argment is still a bit off. China invested in the US knowing quite well that the US wasn’t committed to defending the dollar’s external value. It invested in the US even though the US had a large trade deficit. It invested in the US even though the IMF indicated the dollar was overvalued and would tend to depreciate over time. It invested in the US even though a gloomy American academic and a former Treasury staff economist quite explicitly warned that China would lose money on dollar holdings back in 2004.
Mei’s complaint, in other words, should be directed in part at China’s own policy makers.
While this is narrowly correct, if you widen the frame of reference, it isn’t clear how the blame should be apportioned. China has pursued an openly mercantilist trade policy. The US was happy to pursue a macroeconomic policy described by Thomas Palley as one based on borrowing and cheap exports. In co-dependent terms, the chronic alcoholic, um, overspender, had found an enabler.
Worse, as this relationship was clearly entering the danger zone, many people who should have know better were sanguine about ever-worsening global imbalances. The flash point should have been when the US current account deficit to GDP ratio passed 4%, which is usually the limit of the currency markets’ tolerance. And indeed, as the gap has worsened, the dollar has come under more pressure. Yet pundits repeatedly argued that China would of course continue to lend to us; to fail to do so would hurt them, since they were funding our purchases of their exports. Note that Setser has not been part of this camp; he noted fairly early on that the China (and other kind buyers of our financial assets) were not only financing our present-year funding gap, but also the interest on all the prior years too. The implication was clear: at some point, this would become unsupportable.
And in a curious lack of empathy, we are driven by internal considerations above all others, yet fail to recognize that our trade partners will be too. China’s escalating inflation is a direct result of its massive Treasury purchases; it can’t sterilize them fully. I have no idea whether the government is playing this line internally, but it would not be inconceivable for them to blame the stock market crash on the US (after all, they had to raise interest rates to combat US generated inflation. Yes, rising commodity prices play a role too, but it is made worse by China’s’ maintaining a loose dollar peg).
Whether this strategem is being employed or not, I have been told that the Chinese public is unhappy about the losses on the investment in Blackstone and on US Treasuries. So a weakening dollar will almost certainly lead to harsher rhetoric; whether it goes beyond that is an open question.
But neither party is willing to deal with the fundamental problem: the US needs to consume less and save more. That means fewer goodies from China and more US exports. While China in theory could increase exports to Europe. the Europeans place much greater stock in preserving employment than does America. so will likely encounter formal and informal protectionism.
Although Setser argues from a funds flow perspective, he reaches a similar conclusion:
That strikes me as a recipe for future trouble.