Understanding the Misunderstandings on Both Sides of the U.S.-Chinese Financial Relationship: Who Is Taking Advantage of Whom?
Every few months, when some politicians in the United States decide to stir up hysteria about the national debt, they hint darkly about the dangers of foreign ownership of our debt. The favorite target is, of course, China’s government, which is inevitably described as the “largest single holder of U.S. debt,” or words to that effect.
It seems not to matter that the actual amounts of money are nowhere near as dramatic as the rhetoric suggests. As of the end of 2011, China’s government held just over $1.1 trillion in United States government debt securities. The total national debt held outside of the U.S. government at that time was just under $10.5 trillion, giving the Chinese a bit more than one-tenth of the total—hardly a situation in which one lender dominates our balance sheet. This has not, however, stopped Americans from feeling queasy about borrowing from China.
Usually, it is American conservatives who whip up anti-Chinese hysteria, claiming that somehow, lending money to finance the U.S. federal deficit will give foreigners control over Americans’ lives. For example, last year Representative Michelle Bachmann, while warming up for her ill-fated run for the Republican presidential nomination, reportedly told a conservative political conference, “Hu’s your daddy,” referring to Chinese president Hu Jintao. Her implication was that President Hu could control U.S. politics, because we owe his country money.
It is not, moreover, merely politicians who stoke fears about America’s owing money to foreigners. Last year, in a post on the Dorf on Law blog, I critiqued comments along these lines from one of George W. Bush’s former chief economists. A prominent professor at Harvard, this economist insinuated (for supposedly comic effect) that China’s government would someday be able to use its power as a creditor nation to move the International Monetary Fund’s headquarters from Washington, D.C. to China.
The fear-mongering, however, does not come only from the political right. As I noted in a column late in 2010, even the normally reliable liberal commentator Rachel Maddow got into the act, describing as “intolerably gross” the idea that United States owes money to China. Maddow’s motivation was a good one—specifically, she noted that the Chinese government was then trying to organize a boycott of the Nobel Peace Prize ceremony, for political reasons. Even so, her gut-level assumption that there is something inherently bad, or even dangerous, about the U.S.-Chinese financial relationship, is simply incorrect.
The inchoate fear that we will become subservient to foreign overlords due to debt peonage is, therefore, hardly limited to the fringes of American politics. In my writing, I have tried to calm such worries by focusing on why the existence of the national debt is actually a good thing for this country. Recently, however, I gave a lecture in Hong Kong about the United States debt situation, and I was offered some feedback and concerns, from the Chinese side of the equation. Interestingly, these concerns complement my analysis of the U.S. debt situation, rather than contradicting it.
As it turns out, Chinese citizens might be just as worried and unhappy about their government’s holdings of U.S. debt as American citizens are—and for equally ill-formed reasons. On both sides of the Pacific, people need to take a deep breath and think about what really matters. The debtor-creditor relationship between the United States and China is not worthy of such ongoing public angst. What does matter, and what is getting far too little attention, is the continued failure by both the Chinese and United States governments to focus on broad-based prosperity for all of their citizens, rather than catering to their elites.
The Relationship Between Lenders and Borrowers: Trust, Distrust, and Mutual Dependence
A loan, of course, is a contractual relationship between two willing parties. Money initially changes hands, from lender to borrower, based on the promise that more money will move in the opposite direction in the future, when the borrower pays interest and repays principal. Both parties, therefore, have reason to be worried about the future of their relationship. The borrower is worried that he will not be able to repay the loan (on time or in full), which could result in sanctions, under the contract itself, or even under the public law.
The lender, however, might have even more reason to be worried. It is she, after all, who has ceded control of her money, based on words on pieces of paper saying that it will ultimately all be worth it. Any lender knows, however, that her financial plans can go awry if the borrower becomes “nonperforming”—that is, if collecting on the loan becomes in any way problematic. Even when a loan is secured (that is, backed by collateral), or when the terms of the contract (and the government’s role in enforcing the loan) can ultimately make the lender whole, the very process of enforcing those guarantees is costly in terms of time, legal fees, and economic uncertainty. All of those costs can affect a lender’s ability to engage in other financial transactions.
In any lender-borrower relationship, therefore, both parties are worried about the future. Even though they have voluntarily entered into the loan (subject to the constraints of their own situations), they know that their economic future is now in part to be determined by the actions of others. Of course, that is always true—as, for example, when employees worry about losing their jobs, and employers worry about not having enough customers—but the nature of a loan makes the mutual dependence more personal and bilateral, and thus prone to spark distrust.
The International Context: Politics Adds to Fear, But the Fundamental Mutual Dependence of China and the U.S. Is Healthy
When the borrowers and lenders in a loan relationship are not people or businesses, but are instead national governments, the trust relationship takes on added urgency. While Americans worry that somehow a Chinese collection agency will arrive soon at our door and say, “Pay up!,” the Chinese might worry that the United States is simply playing them for chumps, by planning to one day simply repudiate our debts. If the roles were reversed, one could easily imagine U.S. politicians railing about the dangers of loaning money to “unreliable foreigners.”
However, the Chinese—indeed, all lenders to the United States—should not have to worry about the ability of the United States to pay its loans. The Treasury securities that legally govern those loans stipulate that the United States must repay in dollars, which is the currency that the United States government alone can control. The Chinese politicians who decided to lend money to the United States government did so in full knowledge that the loans would be repaid in dollars. Indeed, that is one of the most appealing aspects of the financial investment in the U.S. on the part of the Chinese government.
In general, therefore, there is no need to worry about the inability of the United States to repay its debts. And, I have recently been told, this is not a serious concern among the Chinese citizenry. They know that the United States has a strong interest in maintaining its spotless credit rating, and they expect that rating to continue to be pristine.
In that regard, however, the message of my lecture was a bit disheartening. The recent political farce in the United States over the debt ceiling has, for the first time, raised the possibility that we might actually default on our obligations—an entirely politically-induced catastrophe that would harm both the United States and its lenders (and indeed, the entire world).
If anything, therefore, people in China might be behind the curve in trusting that the United States Congress would never do anything so stupid as to default on its obligations—even though we always have the means to pay our debts. I hope that their trust in our politicians will be validated, but there is no denying that the events of 2011 make the United States appear to be a less reliable financial partner than it was before.
Another Worry for Our Creditors: Stealth Repudiation of Our Debt, Through Deliberate Inflation
Even if the United States never deliberately refuses to pay up on its obligations, it is still possible that we could take actions that would harm our lenders. During my Hong Kong lecture, a listener asked me about the actions of the Federal Reserve with regard to expanding the money supply. He suggested that, rather than refusing to pay our debts, the plan in the United States was to create inflation, a classic technique that many governments over the centuries have used to make debts less burdensome.
The factual predicate for such a concern is simple. During the recent financial crisis, it was essential for the Federal Reserve to fulfill its key role as “lender of last resort,” pumping money into the economy to prevent key players from defaulting on private debts, which would have resulted in a cascade of defaults that could have destroyed the global economy. As beneficial as the Fed’s actions were, however, they did result in the creation of “new money.”
As I explained in a column several years ago, even sophisticated financial writers sometimes succumb to the temptation to describe the process of creating money as “printing money,” or “creating money out of thin air.” Such descriptions are meaningless, however, because money can only be created by a process (even if it includes gold) that amounts to a social agreement. We accept that money is valuable, because we know that others will treat it as valuable, too.
Even so, it is certainly possible for countries to abuse their ability to increase the supply of their own currencies, resulting in losses to those creditors who will be repaid in debased currencies.
Although such a concern is hardly fatuous, there is absolutely no evidence that the Fed is engaged in any such plan to indirectly “stiff” our foreign creditors. Indeed, the Fed’s increases in the money supply have been accompanied by low inflation, and there is every indication that the Fed’s actions have been an essential element in preventing the economic situation from becoming much worse than it otherwise would have been, over the last few years.
If the concern among Chinese (and other countries’) citizens is that the United States is going to inflate away its debt, therefore, they can certainly rest easy. There is no cause for even the slightest concern that we will—deliberately or inadvertently—engage in a concerted effort to repay our debts with worthless currency.
Will We Exert Political Power Over China Due to Our Debt? The United States and the Value of the Chinese Currency
Just as Americans worry that our debts to China give the Chinese government power over our lives, so too do Chinese citizens worry that the American government has power over Chinese political decisions by virtue of that very debt. Because China’s financial net worth will plummet if the United States does not make good on its debts, a reasonable Chinese citizen might think that the U.S. could gain political leverage over internal Chinese decision-making processes by threatening to default on our obligations.
Although disagreements between our governments over human rights issues are often at the center of debate, there are much more prosaic economic issues at stake as well. The United States government has been trying, with only limited success, to convince the Chinese government to allow the value of its currency (the yuan) to rise. If that were to happen, the prospects for American manufacturers would improve, as U.S. goods would become more affordable for both domestic and foreign consumers.
The very idea of allowing the yuan to rise in value, however, feeds back into the debtor-creditor relationship that exists between the U.S. and China. As one Chinese law professor pointed out to me, an increase in the value of the yuan would effectively reduce the value of the U.S. debt that the Chinese government holds.
The logic works like this. Suppose that the Chinese government were to loan $100 to the United States government, when the yuan and dollar were of equal value (an exchange rate of 1-to-1.) If, after the loan is executed, the yuan were to rise in value to be worth two dollars, then the one hundred dollars in principal that the United States would ultimately repay would be worth only fifty yuan, not one hundred.
Although the Chinese government is content to hold plenty of its assets in dollars, it is certainly true that it cares about its own currency as well. Therefore, China is worried about the appreciation of the yuan not only from the standpoint of industrial competitiveness, but also from the standpoint of concern about the financial impact of that appreciation on its own balance sheet.
The Real Concern for Citizens Around the World: Shouldn’t Their Governments Do More to Improve the Lives of All, Rather than Merely Those of Elites?
Such concerns, however, hide what is really at stake. The very reason that the Chinese government has so many dollars to lend is that the Chinese people have been working so hard. That is, as a nation, the citizens of China have been producing many more goods and services than they have been consuming. This trade surplus—which is fueled by the depreciated yuan—has done wonders for the Chinese government’s financial statements, but it has not benefited the citizens of the nation as a whole.
When a government deliberately sets out to export goods, it prevents its citizens from consuming the fruits of their labor. There are, of course, many good things about international trade, but there is nothing inherently good about trade surpluses. Indeed, as that same Chinese law professor pointed out to me, China’s government is expanding its country’s industrial might without sharing the resulting wealth among its own citizens.
Entire regions of that vast nation remain poor by any standard, yet the government continues to devote economic capacity toward manufacturing goods for export. The average level of consumption (for the nation as a whole, even taking into account the European-level consumption in some Eastern regions of China) has stagnated since the 1990’s, and any equivalent to Social Security—and the dignified retirement that it provides in the United States—remains unavailable to most Chinese citizens. (There is not sufficient room here to discuss the environmental aspects of each of these issues, but they too ought to be a topic of grave concern.)
As in the United States and elsewhere, the Chinese government’s true duty is to improve the lives of its citizens. That means investing in their well-being, bringing education to all citizens as a right, and working to improve their health and longevity. While the Chinese government deserves much credit for its investments in infrastructure—an area in which the United States continues to lag—far too little effort is being put toward making sure that the resulting wealth is benefiting the Chinese people in anything remotely resembling an equitable distribution of well-being.
In short, the lender-borrower relationship between the United States and China is important, but misunderstood on both sides. Both sides have much to gain, and much to lose, from that relationship. Managing that relationship intelligently requires setting aside hoary old myths about debt servitude and stealth defaults.
What really matters, on both sides of the Pacific, is that our governments devote themselves to investing in the lives of all their citizens, not just their elites, in order to allow economic prosperity to be shared by all.