We Have Them Just Where We Want Them: We Owe Them Money
In my new Verdict column, I return to the question of whether the United States government is somehow compromised by having about one-tenth of its total debt held by the Chinese government. (Yes, that is correct: one-tenth. All of the talk about how we owe all of our debt to the Chinese is simply loose talk.) The answer is -- as I have argued multiple times -- a resounding no.
What is different about this latest column is that I also look at the issues from the perspective of Chinese citizens, based on some conversations that I had with a few Chinese scholars during my recent stay in Hong Kong. Chinese citizens -- like Americans -- apparently express serious misgivings about their government having loaned money to the U.S. government, but their concerns are no more valid than are the silly claims on our side that “the Chinese now own us.”
In the column, I mention in passing the oft-heard argument that the Chinese government might be able to use its status as a large lender to extract political concessions from the U.S. government, especially in the area of human rights. I set that issue aside, however, to discuss the more mundane question of currency manipulation. I point out that, if some Chinese citizens are right to be concerned that the United States could threaten to default on its debt, to extract concessions on currency manipulation by the Chinese government, then that would actually be good for Chinese citizens.
The current Chinese policy is, after all, nothing more than a neo-mercantilist strategy to accumulate foreign reserves at the expense of the people’s well-being (by making them work to make goods that they are not allowed to consume, to allow the goods to be exported). If the U.S. government can stop that from happening, that is a good thing for everyone, especially China’s workers and their families.
It is notable that the concern from the Chinese viewpoint is that they have loaned us so much money that they are at our mercy. This is, of course, exactly the opposite of the conventional wisdom in the United States. When I give speeches about this issue, I usually invoke an old joke; “If you owe a bank $100,000 and can’t repay the loan, then you are in trouble; but if you owe a bank $100,000,000 and can’t repay the loan, then the bank is in trouble.” Clearly, many people in China have understood the real power dynamic in a debtor-creditor relationship.
Even so, this argument is arguably far too easy. It is possible, after all, that the Chinese government’s loans to the United States provide it with some amount of leverage -- however limited -- that it might use to our disadvantage. For example, we might want a human rights activist from Tibet freed from prison, but Beijing could say, “Drop it, or we’ll sell a bunch of Treasury bonds all at once, wreaking havoc on your markets.”
A few months ago, a colleague offered a version of this argument, in a spirited debate over lunch. My first response was that such a strategy would be harmful to the Chinese, who would be using their large holdings to drive DOWN the price of one of their biggest assets. Although this would raise interest rates in the United States (because interest rates and prices of debt instruments are inversely related), which would cost the U.S. government money -- and, more importantly, possibly push the economy into recession, as mortgages and auto loans became more expensive -- it would be a suicide pact on the part of the Beijing regime.
My colleague replied that the Chinese government might be willing to do just that -- to harm its own interests in the name of harming the United States. Unlike Mutually Assured Destruction, in which nuclear powers threaten actually to destroy each other, this game merely tests just how much one side is willing to suffer in order to punish the other. Given the autocratic system in China, it is easy to imagine Beijing sacrificing the well-being of its people in order to create unsustainable political chaos in the U.S. And the simple knowledge that they are willing and able to do it would, in this game, be enough to win, without the Chinese government actually having to go through with the self-damaging strategy.
Fair enough, especially given that the amount and duration of pain suffered by the Chinese people could easily be rather small potatoes. If the Chinese government dumped, say, $50 billion of its $1.1 trillion in U.S. Treasuries, it would take a financial hit, but after the U.S. capitulated, the prices of China’s remaining bonds would recover. In the meantime, the U.S. would be forced into a humiliating defeat.
Sounds awful, does it not? The good news is that there is a simple way for the U.S. to avoid even the short-term hit, preventing the putative Chinese strategy from having even a momentary impact on our financial system or broader economy. The Federal Reserve can, at a moment’s notice, “print money out of thin air” to buy any Treasury securities that the Chinese might try to dump on the market. This would immediately stabilize the price of Treasuries, so that the U.S. market would be completely unaffected.
When I raised this possibility with my colleague, he suggested that the Fed was not all that skillful, and that it might be too slow in responding to an attack. While I readily admit that the Fed is far from perfect, this is exactly what they are best at doing. They have traders who are actively involved in the markets at all times, and they would be able to move in and out of the market as needed to neutralize any attempted manipulations by the Chinese government.
Better still, the game-theoretic logic now works in our favor. Just as the Chinese would not actually have to prove that they will sacrifice their own citizens in order to harm ours, the Fed would never need to do what it is capable of doing, because the Chinese would know that there is no point in putting the Fed through the process. Chinese politicians can make speeches milking the idea that they are “emboldened” by their status as our “largest foreign creditor” (as if that matters), but their technical people would tell them that there is no possibility that such a strategy would work.
My colleague’s final response was that the Fed might not be able to reverse its strategy soon enough. That is, if it pumped up the money supply temporarily, to negate Chinese manipulation of our debt markets, it might not later be able to decrease the money supply quickly enough, possibly leading to damaging inflation in the U.S.
I replied that the evidence shows that the Fed is, in fact, quite capable of draining money from the markets as quickly as is necessary. Its huge infusions of money to save the financial system in 2008-09 were skillfully followed by operations to pull that money out again, and the continuing near-zero inflation rate since then has been testimony to its success.
And this is where my trip to Hong Kong suddenly made things even more interesting. As I write in my Verdict column, one of the concerns of the Chinese government is apparently that the Fed is on a secret mission to create inflation and thus debase the dollar, thus engaging in a de facto default on our debt to the Chinese. This, however, means that the Fed does not even need to prove that it is adept at fine-tuning the money supply, to avoid inflation. If it fails to drain money from the system quickly enough, after all, that would merely achieve the result that the Chinese government fears most.
In short, if the Fed is good at calibrating money supply changes, then there is no advantage to the Chinese government in trying to dump our bonds to mess with our markets. But if the Fed is only good at creating money, but bad at destroying it once the money has been created, then any effort by the Chinese government to manipulate our markets would risk setting off an inflationary response that would harm China’s bottom line (and do so in a non-temporary way).
The only hope, from the perspective of the Chinese government, would be that the Fed would know that it is not very good at its job, in which case it would be hesitant to respond to a bond attack. This is both unlikely (because the Fed is nothing if not confident in its ability to do its job), and too clever by half. If China’s best foreign policy strategy is to convince us that they will sell our bonds, in the hope that the Fed either would not try to respond, or that the Fed would fail to respond correctly, then we are in very good shape.
I certainly understand that foreign policy calculations are often irrational, or driven by multiple levels of deception. There is a reason, however, that we have not yet seen the kind of attack that so many people seem to think is just around the corner. We do not have to rely on the kindness of our creditors, because they know that -- at least in this arena -- they are holding a losing hand.