US-China Co-Dependent Behavior Worsens

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.

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  1. Jojo

    Funny. I had just posted this article over on Mish’s blog a few minutes before yours popped up. :)

    The Chinese are subsidizing the American way of life. Are we playing them for suckers—or are they playing us?

    by James Fallows
    The $1.4 Trillion Question

    Through the quarter-century in which China has been opening to world trade, Chinese leaders have deliberately held down living standards for their own people and propped them up in the United States. This is the real meaning of the vast trade surplus—$1.4 trillion and counting, going up by about $1 billion per day—that the Chinese government has mostly parked in U.S. Treasury notes. In effect, every person in the (rich) United States has over the past 10 years or so borrowed about $4,000 from someone in the (poor) People’s Republic of China. Like so many imbalances in economics, this one can’t go on indefinitely, and therefore won’t. But the way it ends—suddenly versus gradually, for predictable reasons versus during a panic—will make an enormous difference to the U.S. and Chinese economies over the next few years, to say nothing of bystanders in Europe and elsewhere.

    Any economist will say that Americans have been living better than they should—which is by definition the case when a nation’s total consumption is greater than its total production, as America’s now is. Economists will also point out that, despite the glitter of China’s big cities and the rise of its billionaire class, China’s people have been living far worse than they could. That’s what it means when a nation consumes only half of what it produces, as China does.

    Neither government likes to draw attention to this arrangement, because it has been so convenient on both sides. For China, it has helped the regime guide development in the way it would like—and keep the domestic economy’s growth rate from crossing the thin line that separates “unbelievably fast” from “uncontrollably inflationary.” For America, it has meant cheaper iPods, lower interest rates, reduced mortgage payments, a lighter tax burden. But because of political tensions in both countries, and because of the huge and growing size of the imbalance, the arrangement now shows signs of cracking apart.

    Full article:

  2. Anonymous

    Everybody wants to talk about the past when they most need to talk about the future. The nut to be cut is this: Will the EU side with US or with THEM (China)? With us, I expect: the price will be the reserve currency.

    I could see the EU raising protectionist barriers to Chinese imports while the US does the same, implicitly or explicitly. That would be very nasty, but might well force all parties to a real negotiation over terms. Pretty high stakes Texas hold-em. It’s important to remember that the US acquired the reserve currency propping up a bankrupt Britain locked in a bitter (and military) confrontation with a third party. It would be better if we just took our medicine, sez I, but I suspect we’ll think we can fight it out.

  3. Asset Allocation Insights

    Yves, a very sensible “Chimerica” post. And a good reminder of the 2/5/07 WSJ op-ed titled “Chimerical? Think Again” which concluded, “If either U.S. trade policy or Chinese monetary policy goes awry, then the Fed model could return to the bond market with a vengeance. Then, and only, then, will it be possible to dismiss Chimerica as — a chimera.” Oh, where to start on that one.

  4. Anonymous

    >>Mei goes on to argue that if the US doesn’t do more to defend the dollar, it is effectively defaulting on China.

    These guys are geniuses… IF? IF? IF the US doesn’t do more to defend the dollar? The question is when do the Chinese become upset enough to really do something about it.


  5. Max

    This is the problem with the Chinese – conformist and overly Stoic thinking, the absolute rule of authority, inability to see change.

    Who are the most numerous buyers in the uncertain and often declining real estate market now? The Chinese. They think if it worked before it must work again, and that California real estate never goes down in price.

    In the coming years China will get its first hard lesson for being complacent.

  6. S


    B/S posts on this frequently and one would like to think the US actually thought this policy out but that would be giving way too much credit. The question was always who is the bigger fool: the US for selling the debt or the Chinese for buying it. At this point looks like US got the better end of the trade, but it as yet a TBD.

  7. Anonymous

    China is screwed. Even if the U.S. doesn’t implement protectionist pose, the dollar will continue to , because the fall is directly related to Chinese de-pegging of their currency.
    The more treasuries they sell the more inflation they will incur and the less the dollar is worth.
    So look for Bastille type revolution there in the next couple of years.
    I find it curious that people believe you can become what the economic U.S. has became in a couple of decades. There has been a lot of blood in the streets in the past 230 years to get where we are and China isn’t going to do it in 20 years.
    They are in their wild west stage at this point and just wait until they hit their first recession.
    The U.S. will walk away with most of China’s wealth due to the shrinking dollar and like they say, “A fool and his money are quickly separated”.

  8. jm

    If the US government hadn’t continued running deficits and selling Treasuries, and the US public hadn’t kept buying homes so the GSEs could keep issuing bonds, what would the Chinese have been able to buy with their dollars?

    US land? US corporations? Hmm, political backlash, and perhaps a demand for countervailing duties. No good.

    US manufactured goods? Their whole strategy has been to import all the world’s factory jobs into China.

    The reason the Chinese government had to buy all those dollars was that a dollar simply isn’t worth 8.2 yuan, or today’s 7 yuan, and no one but the government would pay that for a dollar. And it was they who revalued the yuan to 8.2 from it’s much lower level in the mid-70s (around 5.9 to the dollar, IIRC).

    The fact is, the Chinese lost money the very instant that they bought those dollars at pegged exchange rates having no basis in market or value reality. The dollars weren’t worth 8.2 yuan when they bought them. All that remained in question was when they would be forced to admit to the losses.

    This was just vendor financing fraud on a Brobingnagian scale.

  9. Lune

    All the comments laughing at how China got the short end of the stick may wish to reconsider the implications of what they’re saying. As the Chinese say, be careful what you wish for. You might get it.

    It’s true that China will take a huge loss on their reserves. But they have the strength to absorb that loss. The U.S. on the other hand, when (not if) it loses its reserve currency status, has far fewer reserves to cushion the pain.

    Which country will have blood in the streets? Lets see: China loses $500 billion on its dollar holdings (less than what we’re going to cough up to bail out Wall St., I imagine). But it still has the jobs, the factories, and a huge domestic market with high savings that can be converted to consumption if/when the government finally stops pursuing exports and concentrates on developing domestic consumption. While this is a painful transition, it’s something that’s doable, and has been done before without bloody revolution (think Europe, which was the emerging economy of the 50’s/60’s).

    America, on the other hand, will see the dollar plummet, and international investor confidence vanish, leading to drastically higher interest rates, and markedly reduced ability to import the world’s savings to fund our consumption. And our debt-fuelled lifestyles will come crashing to an end.

    In essence, China must go from a saver economy to a consumption economy to keep growing. America must do the reverse. I’d argue that the former transition is far easier to accomplish, especially if the latter change has to be done under duress.

    So again, which country has a higher possibility of seeing blood on the streets? (NB: While America’s democracy might allow for an overthrow of the govt by more peaceful means than China’s communism, I’m sure there are currently plenty of laid off manufacturing workers who would love to see the streets lined with the heads of Wall St. bankers)

  10. Lune


    I wouldn’t call it vendor fraud, just the pursuit of non-economic goals by economic means. You have to remember all the positives that China has gained from its economic policy. China has gone from being the largest third world country to a world power, likely to eclipse the U.S., Japan, and Europe in the next 50 years. It’s a military superpower that is slowly usurping America’s Pacific Ocean hegemony, not to mention its influence in Africa and even in our nominal backyard, South America. It has re-acquired “lost” territory such as Hong Kong and Tibet, and is closer to its goal of annexing Taiwan as well. And it has raised the living standards of its people tremendously (although without as much focus on reducing disparities).

    The basis for accomplishing these domestic and geopolitical goals has been its economic policy of rapid growth and an undervalued RMB. Even if its dollar reserves were to become completely worthless, that means it will lose ~$1.4trillion. A small price to pay for all that it has managed to accomplish in the past 30 years.

    If anything, I think the U.S. has been the shortsighted one here, burning through all the geopolitical and economic advantages/strengths we have accumulated over the past 200 years to fund a bigger house and a Hummer in the garage.

    As Lenin noted, a capitalist will sell you the rope with which to hang him.

  11. Anonymous

    FXP – China Ultrashort recently got whacked from 120 to 63. In part because of the fear about the government intervention. Now that the good news is all out, does FXP start moving up again? Comments on risk/reward on an FXP trade?

  12. Anonymous

    China is the US circa 1929.

    Massive over-production and massive bank losses are coming.

    Emerging economies don’t grow in a straight line. All these ra-ra China/India boosters that look toward this 50 year string of uninterrupted growth should start reading history books.

    When the Depression hits China, let me know how well their social fabric stays intact. The path that the Chinese leadership has chosen (to print colossal amounts of money in order to rig their exchange rate) is suicidal. But hey, I know how important it is to put up this nice image for the coming Summer Olympics. Total stupidity.

    Don’t kid yourself, the Chinese/Arabs are just as stupid as the Americans.

  13. Anonymous

    Lune nailed it.

    Small price to pay for the knowledge in manufacturing, engineering, logistics, and etc. in about 8 years what it took the U.S., Japan, and “Europe about 50.

    Most of the big deals that really do matter like aircraft manufacturing, automobiles, electronics and nuclear power plants all required the U.S. or Europe to give the blue prints and show Chinese how to do the job.

    I read that the company from France that won the contract to build 10 nuclear power plants also have to give up the blue prints on how to build the plant. China will learn in 5 years what it took the rest of the world 50. China will most likley build the other 20 that have planned themselves and then compete with this same French company for other nuclear power plant contracts in other contries and probably will put them out of business in the long run. To give away your core compentacy is so stupid. This is one example of many.

    In the meantime the U.S. has not been sitting still. We have been training the worlds best coffee baristas (thanks starbucks).

  14. jmv


    Alas, I’ve too little time to write a proper refutation, but note that the reason why China has to subsidize its exports with a pegged currency is that at unsubsidized prices foreigners wouldn’t buy enough of their stuff to keep the factories busy. If it were just a matter of segueing to domestic demand — well, why haven’t they done it already? The reason is, of course, is that the things the Chinese people really want and need are quite different from what they’re making for export.

    Prices are the signals by which we communicate to each other how we want to allocate scarce resources. When prices are falsified by subsidies and fraud, resources are misallocated.

    China will not surpass the US under it’s current government — rather, it will disintegrate, just as the Soviet Union did, for the same reasons.

  15. Richard Kline

    Lune, I completely agree with the sum of your two posts, and would have said the same if I hadn’t read your own comments. China’s $ loss won’t come to the whole $1.4T, but considering what they have bought for that it has been a fantastic investment.

    I’ll add one small thing which you didn’t cover in your otherwise thorough summary. China has quietly built a trading network in all the areas of the world that the high-cost manufacturing countries of Europe and the US couldn’t be bothered to service: poor Latin America, SE Asia, and Africa. Political issues have limited Chinese penetration of India, but I see that changing to a degree in the next ten years also, and Russia to a lesser degree. China is in a position to acutally service small money demand from large populations around the world on a large scale, and to grow this base by _real investment_ in these countries over time. This gives them the potential to export to demand even with potential disruptions to their current major markets. The income presently isn’t great but the populations involved are large. China can’t afford to lose either the US or the EU entirely, but they have FAR more options than the US.

    China’s overall strategy has been highly successful; they stayed with it a bit too long is all. The Yuan needed to come up a little faster 2-3 years ago, but I think they got a tad greedy, and they like everyone else have been surprised by the extremity of the US asset bubble. So they’ll lose a couple of $100B on currency depreciation. That’s a ‘political issue’ but not really a major deal as an economic issue; the loss of face at getting stiffed will matter more than the financial loss. And they have been well-paid in a macroeconomic sense for their strategy. I can’t say the same for the US: we borrowed their money and spent it on gewgaws and speculation, to quote myself. Which have declined in value, leaving us nothing but the sweat of our brow for the immediate future.

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