A time-honored expression had it that if you owed your banker a thousand dollars, you had a problem, while if you owed your bank a million dollars, the bank had a problem. Adjusted for today’s cheaper dollars, the adage could stand reformulation: If you owe your bank 10 thousand dollars, you have a problem. If you owe your bank 10 million dollars, the bank has a problem. As a key banker for an indebted United States, China has a very big problem. But as institutional holders of bundled mortgages are learning, eventually there comes a time to face up to reality and square the books.
Like codependents in a standoff, the United States and China constantly bicker about exchange rates. It may seem peculiar that the United States should be too unhappy about a relationship that allows it to produce paper dollars at almost no cost for which valuable goods are exchanged, but unhappy it is. Washington’s insistence is to get less for its money, as though a country can become wealthier by debasing its currency. While most shoppers want the most they can get for their dollar, the United States wants less. Instead of 8 Chinese yuan for each dollar, Washington wants only 5.5. The objective is to make American goods, steel, heavy equipment, and agricultural products cheaper in China. The cost of the adjusted exchange rates would be borne by American shoppers who would find the value of consumer goods they buy in places like Target and Wal-Mart jump as much as 30 per cent virtually overnight. Of course, as prices for Chinese goods rise, other Asian competitors like Vietnam would likely fill the void. And its negative impact on China’s dollar earnings means U.S. interest rates would have to tend higher to attract other buyers of U.S. debt. This perpetual bickering over exchanges rates is one of the problems of both the nationalization of trade and of a fiat, irredeemable currency. Robert Mundell, winner of the Nobel Prize in economics, has commented about this surrealistic squabbling between countries that are one another’s best customers:
When the international monetary system was linked to gold, the latter managed the interdependence of the currency system, established an anchor for fixed exchange rates and stabilised inflation. When the gold standard broke down, these valuable functions were no longer performed and the world moved into a regime of permanent inflation. The present international monetary system neither manages the interdependence of currencies nor stabilizes prices. Instead of relying on the equilibrium produced by automaticity, the superpower has to resort to “bashing” its trading partners which it treats as enemies.
It was in this bickering environment in the second half of 2007, with whispers of trade wars in the air, that Secretary Paulson went to China to lecture its officials about their currency. This is another case of a Treasury head who should have been minding affairs closer to home. After all, at the time the dollar was in the middle of a two- year slide, setting new daily lows against the euro. But Paulson thought to demand that China adjust its dollar exchange rate “without delay.” China’s response came from two quarters; the Chinese state media called it “the nuclear option.”
China should use its huge foreign reserve holdings as a “bargaining chip,” said Xia Bin, a finance official in the cabinet in July. Then in August, in the Chinese government’s English-language paper where it was certain to be noted in the Western world, He Fan, an official at China’s leading official think tank, offered a reminder that China could pull the trigger if it wished:
China has accumulated a large sum of U.S. dollar holdings. Such a big sum, of which a considerable portion is in U.S. treasury bonds, contributes a great deal to maintaining the position of the dollar as an international currency. Russia, Switzerland, and several other countries have reduced their dollar holdings.
China is unlikely to follow suit as long as the yuan’s exchange rate is stable against the dollar. The Chinese central bank will be forced to sell dollars once the yuan appreciated dramatically, which might lead to a mass depreciation of the dollar.
It was the first time a threat to dump dollars had been made explicitly and it caused a stir. Paulson dismissed the prospect of China’s selling its holdings, telling CNBC, “I think it’s absurd, frankly.” On Fox News, President Bush said, “It would be foolhardy of them to do that.” A New York Times editorial entitled “Irresponsible Threats” called talk of Chinese dollar selling “stupefying.” The editorial also assured its readers that China’s central bank had announced it had no plans to sell its dollars. As though such plans would be announced.
Paulson was whistling past the graveyard by calling the threat absurd. Thoughtful observers like Paul Craig Roberts, assistant secretary of the treasury in the Reagan administration, had been warning for years of China’s growing influence over the dollar and U.S. interest rates. That leverage extended to American foreign policy as well. Roberts put it succinctly: “A country whose financial affairs are in the hands of foreigners is not a superpower.”
As Paulson continued to downplay the possible impact of China’s triggering the “nuclear option,” Roberts wrote that if Paulson didn’t understand the dependence of U.S. interest rates on China’s purchase of Treasuries, “Bush had better quickly find himself a new Treasury Secretary.” Since the United States doesn’t have any reserves or other means to fund China’s share of Treasury and agency debt, he said, such a sale would result in monetary ruin:
. . . the main support for the U.S. dollar has been China’s willingness to accumulate them. If the largest holder dumped the dollar, other countries would dump dollars, too.
The value and purchasing power of the U.S. dollar would fall. When hard- pressed Americans went to Wal-Mart to make their purchases, the new prices would make them think they had wandered into Neiman Marcus. Americans would not be able to maintain their current living standard.
Simultaneously, Americans would be hit either with tax increases in order to close a budget deficit that foreigners will no longer finance or with large cuts in income security programs. The only other source of budgetary finance would be for the government to print money to pay its bills. In this event, Americans would experience inflation in addition to higher prices from dollar devaluation.
This is a grim outlook. We got in this position because our leaders are ignorant fools.
Those are sharp words, but the idea that mention of the economy’s vulnerability was “absurd” merited them. The possibility always existed that the escalation of an unexpected event— the “Wang Wei” spy plane incident of 2001; the March 2009 incident involving the USNS Impeccable, a surveillance ship off China’s coast; or another American war (Iran? Pakistan?)—could trigger the Chinese “nuclear option.” But the greater likelihood is of gradual disinvestment by China through attrition. Serious officials, rather than being dismissive, would have to contemplate several very real possibilities for disinvestment. The U.S. economic slowdown resulting in reduced Chinese foreign exchange earnings, competing Chinese domestic demand for the capital, and concerns of inevitable dollar depreciation are all very real reasons to expect that Chinese investment patterns can change. There is no evidence that U.S. officials have any plan other than inflation to deal with real-world economic circumstances that are already under way.
Rewind a year to the takeover of Fannie Mae and Freddie Mac. It was widely met in populist circles (“You don’t see anybody in Kansas getting bailed out!”) with suspicion that it was more about keeping China in the U.S. debt game than it was about keeping Americans in their homes. The case was persuasive on its face. As investor Jim Rogers said in a Bloomberg interview, “The people who bought debt in Fannie Mae and Freddie Mac can read a prospectus. They can read it. It says it is not guaranteed by the government. Anybody who can read a balance sheet knew that both of those companies were a sham and they had problems.” But China, the largest foreign holder of Treasury debt, was also the largest foreign holder of Fannie and Freddie debt, followed by Japan. Fannie and Freddie’s precarious fiscal conditions were well known long before the takeover. The commitment of $200 billion for preferred stock and other guarantees may have been reassuring for the agencies’ bondholders, but it didn’t do much for American homeowners. The takeover represents money the government doesn’t have for investments it hadn’t guaranteed in the cause of arresting the falling housing market, which it cannot do. Making the federal guarantee of the agencies’ bonds explicit in the face of the stock collapse shows concern for the bondholders, Chinese and Japanese among them. Ironically, however, except for inflation, those guarantees can only ever be effected by borrowing more money from . . . places like China and Japan! America’s bankers have a problem.
(Excerpted from THE DOLLAR MELTDOWN: SURVIVING THE IMPENDING CURRENCY CRISIS WITH GOLD, OIL, AND OTHER UNCONVENTIONAL INVESTMENTS by Charles Goyette by arrangement with Portfolio, a member of Penguin Group (USA), Inc., Copyright (c) Charles Goyette, 2009).
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