Poker with China

Our politicians are puzzling me again. This time it's their fear and trembling about whether China will want to keep "helping" us finance our deficits by continuing to buy US Treasury securities.

When our politicians are visibly shaking in their boots about what China might do to us if we make them mad, it catches on with the general public. In turn, that prompts the administration to send Hillary across the Pacific to beg China to be nice to us. That in turn prompts China to play it for everything its worth.

Why are we acting like such wimps?

Uncle Sam is playing poker, Texas Hold'em. China is sitting directly across the table, hugging a big stack of dollar-denominated poker chips, and shooting a stern look across the table. The flop is showing a pair of aces. Oh, and one other minor detail: Uncle Sam's hole cards are pocket rockets.

Think about it: In that situation, should Uncle Sam tremble, then dispatch a contrite envoy to deliver the message:

"Please be nice to us, China. Please, please don't hurt us!"

How China got their dollars
First, how did China get all those dollars? Well, they decided years ago to build an economy based on manufacturing exports. That's how they've been keeping millions of their workers employed. Presumably, keeping those workers employed is important to them.

China's biggest customers are Uncle Sam's consumers — you and I. Both sides benefit from that relationship. China's workers make and sell much of the stuff we want, for bargain prices; they get our dollars in return for the stuff they make — and we consumers end up with extra dollars in our pockets because of the low prices they charge. In short, China's work force stays employed by giving American consumers the equivalent of a pay raise.

We can safely assume that keeping their unemployment rate low is important to the Chinese; that means they'll still be happy to sell things to us if we'll buy them, and that means they'll still be happy to accept US dollars from us in payment.

What China can do with their dollars
Next question is, what can China do with all those US dollars they'll keep piling up? They have four choices:

1. Sit on them, even though dollars earn no interest.
2. Buy dollar-denominated, interest-earning financial assets from us — such as US Treasury securities.
3. Buy dollar-denominated real assets from us (...some houses, maybe?).
4. Buy dollar-denominated goods and services from us.

How does any one of those four hurt us? I've thought and thought about it, and can only come up with one far-fetched possibility: If our economy were humming along at full capacity (...don't we wish), and they tried to buy more stuff from us, and we couldn't increase our capacity fast enough, THEN their dollars would create inflationary pressure. As I said, far-fetched.

In short, Uncle Sam is looking at pocket rockets. The dollar is king; the dollar is the world's reserve currency. China's export-driven economy is, in effect, part of the world's "dollar economy" — which extends far, far beyond the US borders. According to Fed Chairman Ben Bernanke, the worldwide bond market is a hundred trillion dollars in size; it has been paying high prices (i.e., low interest rates) for safe and secure US T-securities. All we need to sell is twenty billion dollars worth of new ones a week, until our economy gets back on track. Pocket rockets.

What China decides to do with all those US dollars is their decision, but refusing to use them to buy our bonds would hurt them more than us.

So, again: Why are we acting like such wimps? This continues to puzzle me.

=============
Afterthought:

Regardless of whether China decides to be one of the buyers of the T-securities we'll be offering, I have an idea for how we could wisely spend a few million, or maybe a billion, of the dollars they'll bring in: We could beef up the defensive capability of the US Navy's vessels patrolling the South China Sea.

Recent events give me the impression that our sailors could use just a little more protection in that increasingly-dangerous part of the world.

Comments

[SkylightMT]

"We could beef up the defensive capability of the US Navy's vessels patrolling the South China Sea."

http://www.timesonline.co.uk/tol/news/world/us_and_americas/article5898650.ece

"A potential conflict was brewing last night in the South China Sea after President Obama dispatched heavily armed American destroyers to the scene of a naval standoff between the US and China at the weekend."

I dunno, Steve. What one country calls protection another calls aggression. Since poor economic times create fearfulness and fragile tempers, I wonder if military blustering isn't the best response right now.

[Optimist123]

The spirit of the treaty permits our presence. It would have been nice to have unambiguous wording in the treaty from the beginning, but now it looks like we'll have to settle for better defenses. (I hope the please-don't-hurt-us strategy is off the table.)

[David L. Kendall]

Steve,

You are on target, as usual. But once again, as usual, when the U.S. Treasury borrows, whether that is a good thing depends on what the Treasury does with the money.

[Jerry McInvale]

Steve,

Another way of looking at it is to consider that while we're playing Poker, the Chinese are playing Chess. One game is short term and somewhat dependent on luck. The other game is longer term and more dependent on skill. If we were to oversimplify and say that the "competition" between the U.S. and China is represented as a pie chart of 100%, it would be clear that China is steadily increasing its share of the pie. We are increasingly dependent on China for inexpensive products to satisfy our market demand. In addition, China's leadership appears to understand economics and if anyone in our government does, they are keeping it a secret. Consequently, China has built up significant reserves and we find ourselves in the embarrassing position of "begging" them to fund more of our debt, so we can spend it on things that will make us even less formidable as a competitor.

As to the military issues, China is rapidly increasing its miliary budget and has been effective in espionage and trade to utilize American technology to improve their capability while our political leadership has announced its intention to substantially decrease military spending. It is also abundantly clear that the current administration does not have the skill or diplomatic will to resist challenges. Thus, the Clinton fiasco and the weak response to recent Chinese insults in International Waters.

So, you may be right about the Chinese having no safer option for its reserves than the Dollar currently, but they play a longer term game - and having the U.S. as a debtor gives them an additional leverage point when it is needed.

[Optimist123]

Jerry,

You're right, there's a short-term and a long-term game. But both of them come down to the strength of our economy, and worldwide confidence in its future. In spite of the current problems, it's still the biggest and safest economy, and that's the reason the dollar (and T-securities) are viewed as such a safe haven. The poker game should be a no-brainer; what would be extra embarrassing would be for our leaders to fold the hand.

To win the chess game will require inflation avoidance and a return to growing incomes and employment here at home -- although we should welcome peaceful growth abroad, too. Retaining our position (king dollar) long term will require a return to growth-friendly policies after the economic decline is arrested. Although I keep hearing a lot of talk about growth and "investments" (in the budget proposal, in the out-year assumptions, and in the repeated assurances that the stimulus is "temporary"), I learned a long time ago to keep close tabs on the results, and pretty much ignore what the politicians say.

I'm going through the budget proposal now, with the intention of establishing some tracking measures we can examine each month. For one thing, a good set of measures should help us to spot when "temporary" seems to be playing itself out (...if that ever does happen).

In any case, Obama sure is a good talker (...although I *am* getting tired of hearing the word "inherited" in every other sentence uttered by anyone in the administration, all the way to the top. It's not as if I didn't predict it, though: http://tinyurl.com/5zqnto .)

[Bob]

I'm sort of in with Jerry on this. Let me add that:

1.It is not safe to assume that we are talking about rational actors on the world stage.

2.Remember this new administration wants everyone to be cuddly with us and we want to be cuddly with the world.

[beancounter]

If China is playing chess it had better stick to poker: at least then it has a chance. It's starting without a queen, rook and knight.

http://tinyurl.com/cqogp3

Obama could cut the military to the bone and the USA could swat a Chinese invasion of Taiwan effortlessly. Much has been said about the hordes of Sukhois and all the Russian junk, but history has proven again and again that the Russians export their dud models and the Chinese as a direct Russian rival are no exception. Cash might get them a fourth generation fighter, but without thrust vectoring, the latest electronics or most importantly pilot skill they would be cannon fodder to American pilots. Amphibious invasion is impossible without air supremacy, because transports are extremely soft targets. Even local air superiority doesn't count, because the beachhead must constantly be reinforced or risk a Dieppe. Anyone who has studied the Battle of Britain closely concludes even if Hitler had knocked out the RAF in the south, Fighter Command could have abandoned the southern airfields and relocated to north England and still had enough airpower to sink a Sealion. The same situation exists for the Taiwanese, who can count on American carrier aircraft operating from the southeast of Taiwan impervious to Chinese attack. If they could not sink the first waves they would surely sink the reinforcements and supplies and strand the beachhead.

China's economic growth miracle is *not* to be envied. On paper they have a rapidly growing economy, but even with tremendous double digit growth they fear unemployment constantly, because even a small number of unemployed is huge masses of peasants waiting to revolt. China's growth is coming on the back of fossil fuels, which are nearing their peak. They do not have the infrastructure and technology to cushion themselves past peak oil like America does. An export economy producing millions of useless widgets is not anything America needs to emulate. China will lose, very badly in the long game.

What China's leaders understand is not economics, but their own five thousand year history that happy peasants are peasants that don't revolt. But they certainly don't understand economics, or they'd realize they're running off a cliff. Instead of expanding their toxic widget making factories they should have stuck with Mao's principles of self-sufficiency -- at least then when oil is 400 dollars a barrel millions of their citizens won't die off. America has its liberal social safety nets (conservatives will no doubt bemoan such safety nets while making use of it themselves) while China has poisoned rivers and toxic trash dumps.

[Bob]

"...although I *am* getting tired of hearing the word "inherited" in every other sentence uttered by anyone in the administration, ..."

I as well..in spades. Larry Summers uttered it again on Friday at Brookings. It's the beginning of the last paragraph.

http://www.brookings.edu/~/media/Files/events/2009/0313_summers/0313_summers_remarks.pdf

As I commented in a recent post this is like a new CEO coming in to GM and wining about how he didn't create the mess it is in.

Where's the leadership?

[Darrell Balmer]

Steve, yours is better stated than mine.

Foreigners investing in US government debt

Will foreigners, particularly China, reduce US government debt holdings and/or avoid new US government debt investment?

China grew its dollar reserves as follows. China exported goods to US companies. US companies paid for goods with US dollars. China's government required Chinese companies to exchange these US dollars for Chinese currency at a government managed exchange rate. The Chinese government used these US dollars to invest primarily in US government debt.

Here are some questions. Unless China changes this practice, as long as it exports more to the US than it imports, won't US dollar reserves increase? How could China slow or reverse the increase in US dollar reserves while exports to the US exceed imports from the US? It could exchange dollars with other countries or other entities (individuals and corporations) through the market. But it can't exchange dollars with the US government because the US government does not hold other currencies. It only has dollars to offer in such an exchange. If China were to exchange dollars with other countries or other entities those countries or entities increase their dollar holdings by the amount that China reduces it holdings.

Broaden this logic globally. Conceptualize the world as two entities, the US government and everything-else. Everything-else would include all non-US governments, all corporations including US based corporations and all households including US households. The everything-else entity holds and trades all currencies including dollars. The US government deals exclusively in dollars. The US government buys products and services and pays US government employees exclusively in dollars. The US government obtains dollars through taxes, borrowing and dollar creation (printing). The total dollars held by the everything-else entity can not decline unless the US government absorbs dollars by taxing more than it spends. In other words, the US government would have to run a surplus and would not be borrowing or creating dollars. It would be reducing the deficit. This situation is unlikely for the foreseeable future. For any other situation, the total dollars held by the everything-else entity must increase so long as the US government spends more than it taxes and borrows.

What happens if the everything-else entity in aggregate finds dollars undesirable? In aggregate they are stuck with the dollars already held. They can only trade among the everything-else entity. When US government securities mature they can decide to not invest again in US securities but the US government sends dollars at maturity for which they must find a home. If they shift to equities or corporate bonds traded in US dollars, they simply shift who holds the dollars and who holds the equities and corporate bonds. They can demand higher interest rates for new US government securities. But the US government can say fine and continue to increase the dollars held by the everything-else entity.

Conclusion: If we split the everything-else entity into the foreign-everything-else entity (foreigners) and the US-everything-else entity (US households and businesses), foreigners can reduce its existing and new US government debt holdings only to the extent the US households and US businesses increase their existing and new US government debt holdings.

[Grodge]

5. invest in their own human resources and infrastructure.

I have never understood why they don't take that capital and build their own version of Stanford or MIT. Hospitals, roads, telecom infrastructure... all these would seem to have a greater return on investment than the 3% return on US Treasurys.

I read once (don't have the reference) that a lot of their govt officials have been educated at our universities anyway.

(I've had the same argument with Saudi Arabia and other oil fiefdoms. Why was that Saudi Sheik investor guy buying Citigroup stock for chissakes?!!!)

You're a smart business guy... I intend this as a real (not rhetorical) question.

Thanks. Great blog, as always.

[Grodge]

BTW, if the budget isn't balanced by 2016, it *will* be partly if not mostly George W. Bush's fault. This is purely my opinion, of course, but the things Bush did with the deficit spending were wasteful and did not "protect us from another 9-11" as you assert.

I have no idea what will come of Obama's deficit spending and will reserve judgment, as I did with GWB, but I will give him the benefit of the doubt and will forgive the political posturing demonstrated with the use of the word "inherited." Good lord, with everything going on, if that's the only complaint you have with Obama and Summers, we must be doing better than it seems.

[Bob]

Another one! Today on Meet The Press
Romer again mentioned the "inheritance".

Please, will someone enroll these people in Toastmasters or something.

[SkylightMT]

Given that there is no way any country could give China the assurances it is demanding regarding the repayment of loan (unless we want to give them Alaska as collateral) in this current economic environment, one has to wonder what China's true motivations for acting "worried" could possibly be.

No doubt they are simply seeking to get the best side of the deal they possibly can.

Obama's administration's response isn't all that surprising to me. He wants to work under a new paradigm - that if you respect others, treat them fairly, and treat them kindly, they will do so in return. China can laugh about this paradigm shift and they can make all kinds of plans to exploit this shift. That's okay. They don't know how to act any other way - yet.

Obama's administrations's behavior reminds of me of the philosophy behind the old GRIT (Graduated Reciprocation in Tension Reduction)theory. I am very impressed with the integrity Obama is showing. To the world, I guess it can look like groveling. But unless we actually start making insane concessions, which I do not think will happen, Obama is right to try to bring to the world a new level of relating if it is true that such relating is of ethical and humanitarian superiority. However, doing so during a global economic crisis just compounds the difficulty of trying to put forth a healthier method of interrelating due to the increase in fear-based behavior that comes forth during stress.

Completely off subject, I want to say how much I enjoy Beancounter's thoughtful, intelligent, and insightful comments. I really enjoy reading his posts.

[Rich Johnson]

To some of these posts I must reply with a quote from the much demonized former Secretary of Defense Donald Rumsfeld. "America is not what is wrong with the world."

The previous administration was as respectful as any other administration to foreign nations. Certainly publicly. The response to Afghanistan after 9-11 was a coalition effort and my time in Afghanistan showed me that Afghans thought more highly of us than any other coalition partner (especially the mature, nuanced sophisticates of old Europe -- not to denigrate their brave fighting men and women). Even with a more "conciliatory" new Obama administration some of the responses by other nations have hardly been welcoming as many would have predicted. Think Iran, Russia, China, Venezuela, North Korea. They don't seem to be clamoring for friendship at the moment.

I do have a question for you Steve. At the risk of sounding protectionist (because I certainly am not) I do grow concerned over trade balances unfavorable to the U.S. Particularly in this sense: What value are we trading to the rest of the world? I would think that the manufacturing of technology would lead the pack. In some areas such as commercial Jets, agriculture, engineering architectural services and like items we probably have a very favorable trade balance. However, instinctively I get concerned when I rarely can touch a manufactured good of any sophistication produced in the U.S. Dell Computers? Partly. The CPU, some assorted chips and high level assembly in the U.S. (though I've seen Ireland and certainly most of the electronic components come from Asia). And of course I understand what I think was referred to by Adam Smith as the concept of comparative advantage. However with all of this talk of foreign trade and selling of treasury instruments it just instinctively feels as if the emperor has no clothes. Manufacturing has led the rise of most international powers and I'm concerned ours is shrinking rapidly. And we further constrain ourselves with regulations and bad government policies. BeanCounter talked about the pollution and heath hazards of Chinese industry and that is a legitimate problem for the Chinese but will it turn out to be a limiting factor for the Chinese vis a vis our trade balances?

[Optimist123]

Rich:

A trade deficit with a single country doesn't mean much; a trade deficit with the total of all other countries is more meaningful, but is still debatable as to its implications.

Here's an article, for example, that asserts we had a trade surplus, not deficit (as of when it was written): http://tinyurl.com/l8583

When we design an ipod in California, then assemble it in Asia, from where we "import" it for $50, it looks to the accountants as if our trade deficit increased by $50 -- when in reality most of the $50 was value added in California when it was designed.

In any case, it is not a problem when we export obsolete jobs in order to make room for newer jobs requiring more skill. That's progress -- even though it's difficult to find many progressives who support that kind of "progress," because it tends to erode union membership.

That said, however, we will be in a precarious situation very soon if we don't start educating more engineers and scientists, or increasing H1B visas and the path to citizenship for skilled foreign engineers and scientists. When other countries take over innovation from us, then we will become the country to which *they* will export *their* menial jobs (to make way for the more-skilled jobs those innovations will be creating). We might end up making blue jeans for them, in other words. (Presumably the garment-making unions would jump for joy to hear that prospect, but it sounds more like doomsday to me.)

[Harun]

Beancounter,

I hope you are right about Taiwan, but in fact, its military is not that strong - US advisors visiting here once commented "we came expecting Israel, but found Panama."

Taiwan also has not invested much in infrastructure defense - I suspect their will to fight will not be as high as people imagine.

Finally, I worry about Kerry's global test, where the UN won't support a defense of Taiwan and then the US uses that as the excuse to give up.

[Harun]

Grodge,

China does invest in hospitals, roads, schools, etc.

But they are worried about their export competitiveness more.

Personally, I think they have been very shortsighted mercantilist in their policies of forcing foreign investment by not allowing imports and keeping imports artificially low. The last case that bugged me was their government taxing imported car parts the same as imported cars...even though it was their own manufacturers who wanted to buy the foreign made parts...

[STS]

The Obama team are using 'inherited' regularly because the opposition are working overtime to declare everything Obama's fault after several weeks in office.

If you find 'inherited' annoying, do you find the constant whiny infantile distortions about 'socialism' annoying too?

[Optimist123]

Yes, 'socialism' is annoying too. Protecting the currency is straight from Adam Smith, not Karl Marx.

[beancounter]

Harun,

It may seem strange to the American mind, but overt preparation is not a necessary condition for willingness to fight in asian cultures. In any case, Dieppe was not held by fanatical SS but ordinary German soldiers in understrength units spread extremely thin. As long as the KMT has enough javelins and professional soldiers, they can drive China into the sea. As for war weary Democrats, despite their talk about violations of international law, coalition building and so on rest assured politicians care only about one thing: body bags, and not a single American boot needs set foot on Taiwan to cut off Chinese reinforcement.

[Higgs Boson]

"...we will be in a precarious situation very soon if we don't start educating more engineers and scientists, or increasing H1B visas and the path to citizenship for skilled foreign engineers and scientists."

If there is a shortage of engineers, why not let market forces correct it? A shortage would drive up salaries and attract more people to the field until supply meets demand. Flooding the country with H-1Bs would hold down salaries and exacerbate the very problem you are trying to correct.

How do you know that we need more engineers and scientists anyway?

[Bob]

I, too, find the blather from so called conservatives about "socialism" annoying and completely off base. Limbaugh's statement about wanting to see Obama fail is very offensive to me. Let me add that I don't listen to the bombastic blowhard at all.

[Optimist123]

"If there is a shortage of engineers, why not let market forces correct it?"

Before market forces can correct it, government has to get its idiotic laws out of the way.

"How do you know that we need more engineers and scientists anyway?"

It's almost common knowledge. Listen to Cato, Paul Romer, Alan Reynolds, tech CEOs, Reason Magazine, or anyone else who knows the subject. Politics is the roadblock; I believe it was political correctness that changed the subject when Larry Summers was commenting on the problem when he was at Harvard a few years ago. A few links:

Cato paper
http://tinyurl.com/coz6ex

Summary of Paul Romer's paper:
http://tinyurl.com/96uxdg

...full paper:
http://tinyurl.com/debvjz

Interview:
http://tinyurl.com/9kch97

[Iqbal Latif]

Dear Steve, I thought you will enjoy reading this. I have learned so much from your site, thank you.

http://iqballatif.newsvine.com/_news/2009/03/16/2552767-why-should-china-not-withdraw-its-1-trillion-from-us-treasury-lessons-from-history

[beancounter]

I would caution against expanding H1B visa with the German Green Card example. The German Green Card shows that executed ineptly, a work permit attracts very few permanent immigrants who return to their home countries once the permit expires. I would also caution against immigration based solely on hard skills, as the point system in Canada leads to doctors and scientists driving taxi cabs. I would also caution that many in the industry have a vested interest in seeing more engineers flood the country, as they would rather pay half to an Indian Institute of Technology graduate than a MIT graduate. I do not have a link handy, but there was a corporate scheme in the early 90's and peaking during the tech boom where American engineers would be encouraged to train their "third world" counterparts out of pity, only to be laid off when corporations hired their trainees in replacement. Science and engineering are fields you want quality and not quantity.

Nevertheless, the only way to obtain quality is to put as many as possible into the proverbial meat grinder of engineering and science schools. As long as you're prepared for 9 out of 10 engineering graduates never to get a P.Eng. and to forget their education shortly after graduation that is. Ultimately the main benefit of more engineering and science graduates will be a more highly educated quantitative thinking population, who will for example understand fractions (debt to GDP ratio anyone) and think critically, though I'm not so sure anymore after seeing this blog's comments for a few weeks and so many deficit haters who no doubt understand fractions but persist in debt doomsday.

[Higgs Boson]

The papers you linked to posit an engineering shortage as a given but offer no real proof. The Cato paper was written by an immigration lawyer with a vested interest in the H-1B program.

The Bureau of Labor Statistics (http://www.bls.gov/oco/ocos027.htm#outlook) has this to say about the outlook for engineers:

"Overall engineering employment is expected to grow by 11 percent over the 2006-16 decade, about as fast as the average for all occupations."

"Overall job opportunities in engineering are expected to be good because the number of engineering graduates should be in rough balance with the number of job openings between 2006 and 2016."

The following links explore the shortage myth:

http://www.cs.ucdavis.edu/~matloff/SFChron.txt
http://www.vdare.com/roberts/071204_america.htm

The H-1B program is a scam by industry lobbyists to gain access to cheap labor. It is a myth that employers must give preference to hiring American workers. There have been cases of Americans being forced to train their H-1B replacements prior to termination.

Common sense suggests that a shortage would drive up salaries for engineers faster than the rate of inflation. This hasn't happened.

Make the lie big, make it simple, keep saying it, and eventually they will believe it. -- Adolf Hitler

[beancounter]

It's only a half lie. There may be an oversupply but not all engineers are equal. A mechanical engineer is not a chemical engineer is not a computer engineer. There are severe shortages in certain fields, but more importantly science is not about quantity but about quality. So its entirely possible that foreign graduates are getting better education since the American education system is failing, and business are hiring who they see as more talented individuals. Lower wages can happen not just because of an oversupply but lack of talent in the pool who deserve higher wages.

"Look to your left look to your right what you see will fail alright" engineers learn first day of class. Economically, pursing an engineering degree does not make sense when the chance of failure is better than half and you have little shot at upper management compared to a finance/business major. The only real solution is to turn the tables the other way so people with 3.7 GPA no longer go into investment banking but into engineering, and for that money talks. Government had better start some social engineering and pay 5k 1st year, 10k 2nd year, 20k 3rd year and 40k 4th year to engineering and science students, otherwise in a generation we'll end up with half the population business majors. And guess who's responsible for the current financial crisis.

[Harun]

"As long as the KMT has enough javelins and professional soldiers, they can drive China into the sea."

Maybe you have not been following the news in Taiwan, but the KMT is now Pro-China and supports unification. You can regularly hear them mouth anti-American sentiment.

Your assertion about the willingness to fight is not connected to preparedness is true, but if you are willing but have no weapons, plans, etc., it won't help you. Also, I still doubt Taiwanese willingness to fight.