By Steve
The Chinese are in the news the past couple of days for talking smack about the dollar and calling for a new global standard. Media coverage has focused on how the insult is only adding to Americans’ sense of self-pity. China’s love-hate relationship with the dollar is actually more complicated- in a really simple way.
China pegs the remnimbi to the dollar. China needs to peg the remnimbi for similar reasons to why the Europeans needed to agree to the Bretton-Woods system: a growing economy needs a stable currency to maintain growth, and for an economy like China’s that is wading into new territory the “fiat” system of currency, where nothing backs the currency but the faith of the government, is risky and unsustainable, especially when that government isn’t big on transparency. People may not consider the full faith of the government all that reassuring, and a crisis of confidence would be a real possibility.
So, in order to maintain an aggressive fiscal policy that encourages rapid growth, China needs to back it’s remnimbi with something, and as in Bretton-Woods, the dollar is the obvious choice. Any choice for currency-backing must essentially meet two criteria.
First, the asset you pick must be stable. This is the original reason for the gold standard: you can be pretty sure that an ounce of gold now will weigh the same as an ounce of gold a year from now, and the relative scarcity of the metal means that the supply of gold isn’t going to suddenly explode. Second, the asset must be liquid.
This is why the gold standard was abandoned: once monetary systems got big enough, it became clear that the amount of gold being mined each year wasn’t enough to keep up with the growth of the money supply. If you can’t print a remnimbi because you can’t secure the gold, you have a real problem with growth. Simply changing the remnimbi to gold ratio at will makes the gold standard meaningless.
So what asset in the world is both stable and liquid enough to back one’s currency? The dollar, of course. Stable because the largest economy in the world, along with a democratic and transparent government, backs each note. Liquid because, well, you can always count on the U.S. government to sell you Treasuries.
There lies the rub- instead of buying gold to keep in reserve, China needs to buy enough Treasuries to keep printing the money necessary for their booming economy. So far, liquidity hasn’t been a problem. Running a deficit nearly every year, the U.S. Government has had more than enough Treasuries to sell.
The strength of the U.S. economy, and the stability of our political system, meant that no matter how much debt we took on, those Treasuries were still considered stable- sterling, even, and warranting the best ratings. So, China had it’s two criteria locked up- the dollar was both liquid and stable.
So far, China’s rhetoric focuses on the stability aspect. If China is to maintain its monetary policy, it must be convinced that the Treasuries they’re counting on are near-zero risk. That is, they have to be assured that each one really represents the dollars it’s supposed to represent. Even if we drop from AAA to AA+, it doesn’t seem likely that we’re going to miss a payment on our debt to China. Many, many things would happen before that- as in slashed defense spending, default on intragovernmental lending (Social Security, Medicare), etc. So what is China really worried about? Let’s look at the liquidity issue-
For arguments sake, let’s say that tomorrow the U.S. passed a balanced budget amendment and immediately cut enough spending to maintain surpluses each and every year. We take those surpluses and make payments towards the national debt. Moody’s and S&P are so thrilled with our fiscal discipline that they make up the AAAA rating just for us. China should be thrilled, right? The Treasuries in their portfolio just became zero risk.
But what happens when their domestic economy continues to require more remnimbi? Where do they get the dollars to back their own money? If we aren’t borrowing money anymore, then we aren’t issuing Treasuries. I’m not supposing that the concept of a Treasury will cease to exist, but the supply of long term Treasuries will decline drastically. China’s not the only economy that keeps them in reserve, and demand worldwide for Treasuries will continue to rise, especially with the AAAA rating.
Interest rates will be literally zero, until demand for the stability of the dollar makes them… negative? The U.S. would be in a situation where we could literally loan dollars to other economies so that they could back their own currencies, but we probably wouldn’t. We’d likely just give it to them at 0% yield and maintain an equal amount of cash at home to meet the requirement of the balanced budget amendment. We would do this to maintain dollar supremacy in the world economic system at a level that we haven’t seen since post WWII and Bretton-Woods.
The facts beg the question- what’s worse for a competitor like China, a U.S. default or U.S. fiscal discipline? It is, after all, in China’s best interest that we maintain the Keynesian model of deficit spending. So, when China calls for an end to the dollar’s reign, remember to ask yourself: what are they really worried about?
courtesy : Runredhot.com
