Lawrence J.

Haas

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December 9, 2008

America, China and the Perils of ‘Financial Terror’

Through rimless glasses and with just a hint of a smile, one of China’s top investment policymakers stares out from the pages of this month’s Atlantic magazine and raises a fundamental issue with which the Obama Administration will have to grapple in the coming years.

“I won’t say kowtow,” Gao Xiqing, president of the China Investment Corporation, said with a laugh in describing America’s appropriate posture toward China, “but at least, be nice to the countries that lend you money.”

His advice comes weeks after the Treasury Department revealed that China had become America’s largest creditor, passing Japan and holding nearly $1 of every $10 of our public debt.  China held $585 billion in Treasury securities at the end of September (the most recent month for which we have data), followed by Japan at $573 billion. That’s a sharp shift from a year earlier, when Japan held $592 billion compared to China’s $468 billion.

Large-scale U.S. indebtedness to not just China but also Russia and a host of oil-exporting states raises key questions about America’s freedom to pursue its geopolitical interests without . . . well . . . kowtowing to nations with whom we often do not see eye-to-eye.

To be sure, experts differ on this matter, with some seeing no cause for alarm and others even suggesting that China has more at risk in this relationship than we do. Nevertheless, other experts argue convincingly that America’s indebtedness leaves it exposed and vulnerable.

In recent years, as President Bush and Congress cut taxes repeatedly and did little to control spending, Washington accumulated large federal budget deficits that are expected to continue rising. Meanwhile, average Americans chose to consume rather than save for their futures.

That forced the Treasury Department to look abroad for investors in its securities. China bought them in greater number and, in turn, grew increasingly interested in a strong dollar so the value of its holdings would not shrink.

Suppose that, in the coming years, Washington and Beijing clash on a major geopolitical issue – China’s desire for greater control over Taiwan, for instance, or China’s growing espionage in the United States.

To win a stand-off, would Beijing threaten to trigger the so-called “nuclear option” of dumping its dollar holdings – sending the value of the dollar plummeting on world markets, forcing Washington to raise interest rates significantly, and further weakening the U.S. economy?

That depends on whether China was willing to absorb its own financial losses. As a practical matter, China could not sell all of its holdings at once. Thus, as it sold them and the dollar slid, it would take greater and greater losses on what it still held.

So China is exposed. But that still leaves the United States exposed, as former Treasury Secretary Larry Summers, who will be President-elect Obama’s top White House economic advisor, warned back in 2004.

“There is surely something odd about the world’s greatest power being the world’s greatest debtor,” Summers told a gathering at Washington’s Peterson Institute for International Economics. “It surely cannot be prudent for us as a country to rely on a kind of balance of financial terror.”

Nor is a “balance of financial terror” as likely to maintain global economic stability as “mutually assured destruction” (or MAD) theory provided nuclear stability during the Cold War.

Pete Peterson, who founded the aforementioned Peterson Institute, recalled recently that the United States once threatened to trigger its own financial “nuclear option” – when it was well-positioned to do so.

It was 1956, and Great Britain, France and Israel had seized the Suez Canal. A furious President Eisenhower threatened to dump U.S. reserves of the British pound, sending its value plummeting.

The British relented, America’s allies backed down, and the world’s greatest economic power had demonstrated that it could use its financial position to achieve its geopolitical goals.

Will it ever come to that with Washington and Beijing? Hopefully not. But Summers is clearly right. A “balance of financial terror” is no prudent strategy for the world’s economic powerhouse.

It’s one more reason why, after Obama takes the needed, though expensive, steps to revive the economy in the short term, he should turn his attention to restoring America’s fiscal health for the long term.

Here’s some good news. The president-elect seems to understand the unhealthy dynamic at play. “It’s pretty hard,” he has said, “to have a tough negotiation when the Chinese are our bankers.”

© 2008 North Star Writers Group. May not be republished without permission.

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