There is some evidence that the era of the “financial balance of terror” between the United States and the People’s Republic is coming to an end. The financial balance of terror, also called “Chimerica” by Niall Ferguson, are names for the situation in which the U.S. depends on massive inflows of capital from China to keep interest rates low, and China depends on massive outflows of goods to the United States to keep its people employed. China sells widgets to the U.S. and buys dollar-denominated debt, in the process keeping the price of the dollar high and U.S. interest rates low.
The balance of terror recently made an appearance in a discussion thread on Charlie’s blog. The idea was that Chinese holdings of U.S. debt limit American freedom of action ... although the Chinese, of course, would be damaged by an attempt to use their leverage.
I contend that the balance of terror is rapidly coming to an end, to China’s relative disadvantage. Emphasis on relative, of course, because everyone will ultimately benefit from getting out of this rather insane situation in which poor countries lend huge sums to rich ones.
Consider the recent indirect exchange between the President of the United States and the Chinese government. China worried about the value of its Treasury holdings. The President said, “Pshaw,” and went on to tell the G-20 that they could not expect the world of America as a consumer of last resort to return, and the Chinese president seemed to agree. Meanwhile, the head of Chinese central bank emulated St. Augustine. “America should buy less, and we should consume more, but not yet.”
In other words, the Chinese are starting to flex their muscles just as they begin to atrophy. More below the fold.
In the short term, China doesn’t have a lot of leverage right now. The U.S. government can sell all the Treasuries that it wants to at practically no interest. And China is far from the biggest buyer. If China started dumping Treasuries right now, then the worst case would be a tiny rise in interest rates on federal debt, but given the still-large spreads out there in the market I doubt that private-sector rates would budge. But that’s a worst case scenario. More likely the Fed would immediately stamp on any rise in interest rates. In a normal world, that would risk a rise in inflation, but we’re not in a normal world. We’re in a depressionary world where there is (a) no sign of inflation and (b) a little inflation would probably be a good thing. The exchange rate of the dollar would of course fall if China sold Treasuries, but right now that would be an unambiguously good thing.
A skeptical reader might argue that the interest rate data don’t mean much. The price of foreign capital is low right now, because the Chinese choose to keep buying American securities, but the quantity of foreign capital is flowing in like never before. The stimulus package, TARP, all the other federal borrowing ... surely that money is coming from abroad, right?
Wrong. America’s current account deficit (a crude measure of the amount of capital flowing into a country) is collapsing. Still, that leaves a puzzle. How can the price of government borrowing fall (those rock-bottom interest rates) while the amount of foreign capital coming in plunges?
Part of the answer, of course, is that private investment is falling.
A very skeptical reader would end the argument there. And miss the fact that private savings are rising. More and more, Americans buy our own debt.
An extremely skeptical reader would point to the shaded areas on the chart above (which show recessions) and say, “When the economy recovers, savings will go right back down.”
But why should that be? Savings were abnormally low in 1998-2008 because the economy underwent one investment bubble after another. That world, I would venture to say, is permanently gone. It would not surprise me to see household savings rise as high as 10 percent and stay there in the coming years. Especially if the recovery proves to be slow and halting.
Everyone (well, me) expected the balance of terror to end when foreigners decided that they no longer wanted to invest in dollar assets. The dollar would tank, interest rates would spike, and the U.S. would fall into severe recession. Instead the U.S. fell into severe recession because its banking system collapsed. The dollar slipped, interest rates fell to zero, and therefore foreigners no longer wanted to invest in dollar assets. The unwinding seems to be happening backwards. And rather quickly.
China and America will still need each other, but “Chimerica” will be over. In fact, it may be over already. But three points should be kept in mind:
- Angell’s logic holds even without the financial balance of terror. The two countries gain a lot from mutual trade and investment even when trade and investment flows are roughly balanced. In Charlie’s words, “This isn’t Cold War 2.” Still, Niall Ferguson’s warnings are worth thinking about: World War 1 wasn’t preceded by Cold War 0.
- The G-2 will still be the G-2, even if they aren’t grabbing each other by the short hairs.
- China (unlike Japan) doesn’t export anything strategically irreplaceable to the United States. At least not that I am aware of ... or at least not yet.
Implications of the end of Chimerica left as an exercise for the reader. But I would predict that it is ending, along with a lot of other economic certainties, in the wake of the current downturn.