Macro Economic Trends and Risks
China's Fortune Cooking

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By warrl
January 15, 2008

Posts selected for this feature rarely stand alone. They are usually a part of an ongoing thread, and are out of context when presented here. The material should be read in that light. How are these posts selected? Click here to find out and nominate a post yourself!

1. How, in a nutshell, does China's economy work? (It can be a big nut.)

2. And to be a little more controversial, why is everyone so afraid of China? (Regarding the U.S. bonds they own and whatnot.)

China's economy works basically the same way as everyone else's. They are in slightly different circumstances than most other nations, though, because they have a HUGE pre-industrial population compared to their industrial capacity. Kind of like what Charles Dickens wrote about in England (however it must be pointed out that, while the lot of the folks moving from farms to cities was nothing to cheer about, Dickens was a socialist before the term was invented and seriously exaggerated the misery.) They are however DIFFERENT FROM Dickens' England in that they have a 21st-century world to import technologies from and export products to; and also that they have quite a bit more of a problem with high-level blatant government corruption and government-approved market-rigging that Dickens' England did - but less of a problem than their major competitors in the cheap-labor market, India and Indonesia.

But anyway, the result is that China can apply large amounts of low-cost low-skill labor in passable accordance with capitalist principles. As compared to pretty much anyone else, they do better in that particular niche. Maybe somebody is a better fit for the niche, but nobody else can bring a couple hundred million workers to it.

As a result, China has been running a trade surplus with the world. For years.

Now why are people afraid of China?

It comes down to that surplus... but to understand the explanation, you first must understand that money isn't magic. Sorry if that sounds condescending, but most people do NOT understand this.

Money has value for one reason and one reason only: people believe that they will be able to, at need, exchange money for something they need. In other words, money is a claim on "stuff" (haircuts and other services count as "stuff", along with cars, gasoline, food, and so on), that can be redeemed more or less on demand.

But at any given moment there is only so much "stuff" out there. The relationship between the amount of "stuff" available in (say) a month and the amount of money going after it in that month, determines the overall price level. If the amount of money chasing stuff increases faster than the amount of stuff, prices go up; if not, prices go down.

Now China with its trade surplus has been accumulating reserves in OTHER nations' money. For a variety of reasons, they have for many years kept essentially all their reserves in US dollars. And in order to get something back for it, they've bought huge amounts of US government debt. They are very far from the only nation doing this - most oil exporters, for example, do the same - but they are the biggest.

Now there is concern that China might decide to unload some of that US government debt and replace it with, say, European government debt. (Probably not Japanese government debt - but mostly because of stuff that happened in WWII, not because of doubts about Japan's current economy.) China could in a single year sell more US government debt than the US government does, and still have quite a load left. Meantime, the US government continues to drive its accounts into the ground, so it NEEDS to sell its debt. And China, in taking this action, would presumably not be buying as much US government debt as it has in the past - in fact, probably none at all. So to soak up all that debt being sold by China and the US, the rest of the world would need to buy probably about 5 times as much US government debt as it normally does.

What would inspire it to do that?

The interest rate on US government debt would have to go WAY up.

That means the US government would, the next year, have to either drastically cut spending (fat chance!) or substantially raise taxes (a short-term solution at best), or borrow even more money.

It would also soak up money that would otherwise be lent to other governments, or finance new industrial capacity, or allow consumers to buy the stuff the factories are making. So it would slow economic growth, which in the long run drives down tax receipts.

And what if China does the same thing the next year?

Now, why is that not as big a worry as some people think?

There's an old saying that is something like this: if you owe the bank a thousand dollars and can't pay, YOU have a problem; but if you owe the bank a hundred million dollars and can't pay, THE BANK has a problem.

The US government owes China so much money, China can't unload the debt at a useful rate without damaging its value. Any such unloading would:
* Drive up US Treasury interest rates, directly damaging the dollar-denominated market value of China's holdings
* Drive down the US dollar, further driving down the value of China's holdings in any other currency
* Damage the US economy, decreasing China's sales
* Probably trigger a run on the dollar by other countries, further increasing all the above effects.

In fact, the US government owes China so much money, China could barely afford to see the US government lose the ability to borrow money cheaply. And China is one of the major buyers of new US government debt.

The only way that EITHER China or the US can get out of this situation, is for the US government to pretty much stop borrowing money for a while. About fifteen years should do.

But note that neither major US political party is talking about EITHER (a) doing anything substantive about Medicare and Social Security, which are going to be soaking up huge amounts of money in a few years, or (b) cutting overall government expenditures for everything else. And BOTH are needed.