But enough of that, this post is supposed to be about the article The 1.4 Trillion Question written by Fallow for the Atlantic in 2008 (see link to the article below). Awhile back I had written some commentary on a Foreign Affairs article, The Dollar and the Deficits by C. Fred Bergsten, in which I asked the questions: 1) How does China play into our current account deficit and the value of the dollar? 2) Why is the undervaluing of renminbi a problem for the US? Good thing I had documented these questions because this a topic that Fallows writes about in his article. I love it when I answer my own questions...
1) How China plays into our current account deficit and the value of the dollar
The current account deficit refers to the trade dynamics between America and the rest of the world, in particular China, our biggest trading partner. America has a trade deficit because it imports more than it exports; in other words, the nation's total consumption is greater than its total production. How can America sustain this practice of seemingly spending but not selling? That's where China comes in. China, in contrast to America, has a trade surplus, meaning that it exports significantly more than it imports. But here's the thing, instead of taking all the money from its exports and spending it on the nation's people and infrastructure, China takes the money and parks it in U.S. Treasury notes, approximately 1.4 trillion dollars worth. This is what enables Americans to continue spending, and buying Chinese exports, because China takes the money it gets from Americans and gives it right back to America in the form of funding its spending debt. I think of it like this: America is the spendthrift who cannot stop using its credit card to buy, well, stuff. So it has a lot of debt in order to fuel its wanton materialism, however, fortunately for America, it is able to sell its debt to China in the form of Treasure notes and bonds. In this way, China buys America's debt, and America promises a 4 to 5% interest rate on its "loans" from China. "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." What this means for the people of America and China respectively, is that Americans can afford to live significantly above their means at the expense of the Chinese living below theirs. This trade dynamic has contributed to a strong dollar which allows the following good things for Americans:
"the price of food, fuel, imports, manufactured goods, and just about everything else (vacations in Europe!) goes down. The value of the stock market, real estate, and just about all other American assets go up. Interest rates go down - for mortgage loans, credit card debt, and commercial borrowing. Tax rates can be lower, since foreign lenders hold down the cost of financing the national debt."
So why would China willingly agree to fund America's spending habits while curtailing the buying power of its own people? The main reason is because most of the stuff that America is consuming is cheap products made in China. But the reason why the Chinese products and, thus, Chinese factory operating costs are so low is because the renminbi (RMB) is cheap in comparison to the dollar and other currencies. The value of the RMB is kept low, according to my somewhat shaky understanding here, because China saves (and therefore ties up) nearly 50% of its national income in foreign assets (i.e. U.S. Treasury bonds). This is what American economists complain about when they say that China is keeping their currency artificially low. All the dollars that flow into China are handed over to the People's Bank of China. An arm of the central government, called the State Administration of Foreign Exchange, takes the dollars and decides where to invest the money for the best return, most of which goes into U.S. stocks, euros, and, most of all, U.S Treasury notes (i.e. U.S. money supply). Through this state controlled heavy investing of the RMB, China keeps the RMB out of circulation instead uses the RMB to increase the dollars supply via Treasury notes. The result of this currency maneuvering is to keep "Chinese-made products cheap, so Chinese factories will stay busy." Were the RMB to increase in value relative to the dollar and euro, Chinese factories would become too expensive for foreigners to use.
An additionally reason for China to keep the RMB value low, and therefore to decrease domestic spending potential, is because it fears that improving average living conditions for its people would intensify rich-poor tensions, already a major social problem in China. Currently, China's factory boom is creating job opportunities for the rural poor, without dramatically increasing the buying power of the Chinese population in general. It's follows the communist ideal of getting everybody to an equal footing.
2) Why the undervaluing of the RMB poses a problem for the US
While the trade dynamic of supplier versus consumer between China and the US respectively has been mutually beneficial at times, it also has the potential for being mutually destructive. First of all the value of the U.S. dollar is declining relative to the RMB even with all of China's attempts to keep the RMB value low. Soon it may not make economic sense for China to be investing all of its money in a falling currency. However, if the dollar falls in value, so does that 1.4 Trillion worth of investments that China has made in American Treasury notes. "China can't afford to stop feeding dollars to America, because China's own dollar holdings would be devastated if it did." And if China suddenly stops funding America's debt, we would have an astronomical sum to pay back that would have severe and long lasting socio-economic ramifications for all strata of Americans. This "balance of financial terror" is hardly sustainable. First off American and China, though inextricably tied to together financially, do not see eye to eye on many matters. There are a myriad of political disputes that could result in the crumbling of U.S. - China relations, which would inevitably result in the the melt down of the current financial system between the two. In the case of such a divorce between the two powers, it is disconcerting to think about the potential consequences. China is a poor country who has made incredibly strides in the past few decades, and will continue to rise in power. America is rich country who has relied on China to make it richer...without this partnership we have much further to fall than our counterparts overseas.
Questions for future readings:
1) How does supply of a currency affects its value? What is it exactly that contributes to a strong dollar?
The $1.4 Trillion Question
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