The New China Syndrome

The term “China syndrome” refers to fear of a catastrophic nuclear meltdown, (where some of the nuclear material might ultimately bore through the earth and reach China).   So far, no nuclear power plant has suffered that extreme of a fate.  But just as fear of nuclear war gives way to fears about the economy, there is danger of a new kind of China syndrome, one involving China holding vast amounts of US dollars and US debt.  The risk, however slight, is of an economic meltdown.

China is the largest holder of foreign currency reserves, having nearly $2 trillion worth of currency assets.    China has also run consistent current accounts surpluses; the trade deficit between the US and China was $84 billion in 2000, but reached $266 billion in 2008.    China has already announced intentions to diversify its foreign currency holdings to replace dollars with other currencies, fearing that the large influx of dollars into mortgage markets, as well as high deficits thanks to the stimulus program, creates an undue risk.  The dollar, China fears, could lose considerable value, thereby depreciating the value of both China’s foreign currency reserves and bond holdings.

The US has about $3 trillion worth of foreign owned treasury bonds out there, just under $1 trillion belongs to China.  China is the largest holder of US debt, followed by Japan.  It’s likely that 70% of China’s currency reserves are currently in dollars, meaning that China’s dollar exposure is well over $2 trillion.   Moreover, that does not include other Chinese investment in the private sector in the US.

Of course, by holding so much debt China puts itself in a relatively weak position in one way — they have to worry about the US economy, the value of the dollar, and the danger of American default (which seems unthinkable, but…)  The idea that China could simply dump loads of currency and bonds, and refuse to buy more bonds, doesn’t make sense.  This would cause a run on the dollar and tremendously higher interest rates within the US, creating ‘stagflation on steroids.’   The impact on the US would be devastating, it would be a collapse of our entire system.

The fact China could do that — we are vulnerable to China in a way and at a level that would have seemed unbelievable in the past — scares a lot of people.  Yet for China this would mean that their primary market for Chinese goods would stop buying while China’s dollar and bond assets would rapidly deteriorate in value.   Moreover, given the globalized nature of the world economy, the impact of this on the system could come back with unexpected and severe consequences for China.   Given China’s very conservative approach to foreign policy and economics, it seems inconceivable that China would, out of the blue, choose to torpedo the American economy.

One can, of course, imagine some kind of international crisis that could lead to China deciding to hurt the US, but the US and China are in a kind of economic mutually assured destruction mode.   Most likely, these ties will cause both sides to avoid letting a situation get out of hand.

But what about an accidental meltdown?  What if US fiscal and monetary policy can be likened to a nuclear power plant which is powering the economy by injecting massive amounts of liquidity into the mortgage markets, and going further into debt in order to try to stimulate the economy.    This creates a fear in China that the US, by increasing the money supply and expanding debt is setting up a run on the dollar.  Their goal is to make sure that if the US dollar does lose value, China is not hurt too badly, or in fact finds a way to gain some benefits.

For instance, China joined Russia is calling for some kind of new global currency to replace the dollar.   They were only partially serious.  They know this isn’t likely to happen any time soon — you can’t just get currencies out of nowhere — but they wanted to send a message to the US that we can’t simply throw dollars around, unafraid of the consequences.   They also reportedly cut back on treasury purchases earlier this year, again signalling that we can’t assume continuing low interest rates and a highly valued dollar if we don’t have a responsible monetary policy.   In March, bond purchases went back up.

Still, as with the nuclear arms race, you can’t discount a nightmare scenario.  With nukes, in fact, the incentive to avoid error was greater — everyone knew how dire and devastating nuclear annihilation would be.  The economic stuff is more complicated, and most people really don’t understand how interdependence works.  It’s easy for people to say “stop trading with Communist China” or “protect American jobs.”   Even political leaders who should understand this often give in to populist or ideological mindsets that promote policies that are not rational economically.

One could imagine some kind of row over North Korea, human rights, or trade policy taking place just when the dollar starts showing signs of strains thanks to increased debt.    China might choose that moment to dump a small amount of US currency or stop buying bonds to remind Washington how much the two countries need each other.  The US might, however, decide that backing down in response to such an act would be a sign of weakness, and feel a need for some sort of retaliation.  Populist rage might rise in both states against the “predatory practices” of the other.   And unlike nuclear war, where it becomes clear when the button is or is not pushed, a dollar panic could reach a point of downward spiral unexpectedly fast, catching both the US and China by surprise, forcing them to react to events.  China might decide to shed dollars defensively, forcing the US economy off a cliff.    The result could be an accidental global economic meltdown.

Adding to the pressure is the fact that the current relationship is unsustainable.  The US can’t maintain high debt permanently financed by China.  China can’t simply gather up foreign reserves and US debt forever.  Indeed, China is poised to over time, perhaps decades, slowly lower the value of the dollar and create bargains in the US.   By bargains I mean cheap businesses, corporations, and other valuable assetts that will be relatively cheaper for foreign concerns as the value of the dollar drops.   Such a controlled transfer of economic clout, internationalizing the US economy, would still be traumatic for an America used to independence and skeptical of foreign influence.   This would also coincide with a lengthy decrease in the US standard of living, though if done over time might be tolerable to the American public.

But would the US acquiesce to this loss of control over our economy?  Would we decide that it’s better than economic collapse and learn to live witih it, recoginizing that the alternative might be horrific?  Or would we try to fight back, perhaps igniting the meltdown?

Finally, can we recover?   It seems a long shot, given high debt and deficits, but ultimately the US has a productive work force, a large market and the capacity to remain an economic powerhouse.   Some internationalization of control of the US economy (which has already begun) isn’t necessarily a bad thing, and if the US can get the economy moving again and combine that with decreases to debt (both public and private), it’s possible to manage this in a way that maintains vibrancy.  Yet the unsustainable bubble economy and hyperconsumerism of the last ten to fifteen years cannot return.  Reviving America’s economy will mean having to learn to live within our means.

So the best case scenario is China and the US recognizing that their economic destinies are linked, the US making fundamental readjustments in its economy to make it sustainable (reduce debt, bring the current account back into balance), and China avoiding the temptation of a power grab — to think they can dump dollars and bonds and manage to nonetheless remain on top.

The worst case scenario is a global economic meltdown, with China and the US going into the economic equivalent of total war.

Perhaps the most probable outcome is economic decline in the US due to an inability to get budgets and private debt in line, and an unwillingness to admit that that the old system could not be sustained.  In such a case we may avoid meltdown, but we’ll end up with a devalued dollar and a much lower standard of living.

  1. #1 by Mike Lovell on April 15, 2009 - 15:55

    “and China avoiding the temptation of a power grab — to think they can dump dollars and bonds and manage to nonetheless remain on top.”

    China really can’t do this. As their top benefactor, if they choose to dump our currency and call in the debts, not only will they find themselves unable to be paid, but I have a feeling that such a move would also suck business right out of their country so fast (ie, all the american toys and other things made there) they’d end themselves economically in quite possibly the largest implosion in the history of global economics.

    Who knows, maybe its just a bit of American arrogance speaking there????

  2. #2 by henitsirk on April 15, 2009 - 16:47

    Seems like holding that much of our debt is a bad idea all around — too many eggs in one basket in their case, and a lack of independence in our case. I’d like to hope that our consumption of cheap (read: unnecessary and with hidden environmental and other costs) Chinese goods will go down. Not sure that will really happen, or if it does that it will be sustained for the long term. We’re just so complacent in our materialism here!

  3. #3 by Scott Erb on April 15, 2009 - 17:11

    Mike — yeah, that’s why I wrote that this is sort of an economic equivalent to Mutually Assured Destruction. Yet I think there’s still a risk that China might think it could do manageable harm to the US and then find it’s started an economic chain reaction that runs out of control. After all, some people thought in terms of ‘winnable nuclear wars’ during the Cold War. Still, both sides have strong incentive not to see this happen!

    Henitsirk – I agree! Last night I met with some students in the dorm (a program called ‘Let’s Talk,’ which tries to get professors out of the classroom and on the students’ own turf for more informal discussions) and this is the point we got to as well. The problem is really cultural, and maybe I’m just optimistic, but I think the current generation of college kids realize that. I apologized to them on behalf of “my” generation for partying for a quarter century and leaving them the bill.

  4. #4 by hsb83 on April 6, 2010 - 13:00

    Mike Lovell is entirely correct on this…

    • #5 by hsb83 on April 6, 2010 - 13:09

      I also wanted to add that the US has a lot more control in this situation then one might think.

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