Page 1 of 2 China's sleepless nights By Hossein Askari
The Chinese delegation at the United States-China Strategic and Economic
Dialogue held in Washington on July 28 conveyed serious concerns over the
growing US national debt.
China, the biggest creditor nation to the US, has an estimated two-thirds of
its more than US$2 trillion in reserves in dollar assets, including more than
$800 billion in US Treasuries. The Chinese delegation maintained that as the
major reserve currency issuing country in the world, the US should pay special
attention to the supply of dollars; this, in turn, would require controlling US
fiscal deficits, and taking credible steps to prevent fiscal risks and to
ensure sustainability.
While the Chinese lose sleep over the value of their colossal dollar assets, US
Treasury Secretary Timothy Geithner, as any debtor, sleeps like a baby with no
worries of tomorrow. He is simply not
concerned about Chinese worries, saying that China and the US were in "a very
similar place" and that both agreed on the need to keep fiscal and monetary
stimulus in place. This is a classical creditor-debtor conflict - a debtor
country never relegates domestic priorities to maintain the real value of what
it owes or even to insure its ability to service its external debt.
How did the US get to where it is today, in the worst post-World War II
financial crisis that struck in August 2007? It was brought about by a
cheap-money policy and expansionary fiscal policies in the US, Europe and
Japan. To combat it, the Group of 20 summit in April in London called for
deliberate inflationary policies through unprecedented fiscal stimuli and
unorthodox monetary policies. Historically, re-inflation has been the
instinctive response of most governments to financial crises that cause
widespread bankruptcies, deep credit contraction and which threaten deflation.
The period between the two World Wars provided examples of a number of
re-inflationary experiments, including the German and continental European
hyperinflations. The immediate US response to the present financial crisis is
no exception. By running a fiscal deficit projected at 13% of gross domestic
product (GDP) in 2009, forcing interest rates to near zero, expanding money
supply at unprecedented rates and aiming to push Federal Reserve credit to $4
trillion by the end of 2009, the US has deliberately sought to inflate its way
out the crisis, with little or no concern for creditor countries such as China.
This would not be the first US re-inflationary experiment. In 1934, president
Franklin D Roosevelt took the US off the gold standard and unilaterally
devalued the dollar. The move wiped out some 75% of dollar-denominated debt (a
possible retort to the United Kingdom abandoning the gold standard in 1931). In
the 1960s, the US pursued deliberate expansionary fiscal and monetary policies
to finance the Vietnam War, in turn forcing it to abandon the Bretton Woods
system of fixed exchange rates in August, 1971.
In 2009, China's response to the crisis was to expand its money and fiscal
policies in an attempt to absorb part of its reserves and reduce unemployment,
as millions of jobs were lost following a sharp downturn in exports. However,
the expansion of credit has rapidly fueled a housing bubble.
The Japanese, US and European housing bubbles provided a clear lesson to the
Chinese about the long-term destabilizing effects of asset bubbles and made
them move quickly to rein in credit expansion. Moreover, a rapid depletion of
reserves through large import programs would certainly harm employment, weaken
exports, destabilize fiscal and money policies and could turn highly
inflationary.
Hence, as an orderly absorption of reserves could stretch over time and
necessitate the longer-term holding of dollars, China has no other choice
except appealing to the US to preserve the value of the dollar.
On March 26, Zhou Xiaochuan, governor of the People's Bank of China, formulated
proposals for creating a super-sovereign reserve currency as a way to achieve
financial stability and sustained trade growth. He noted that the credit-based
reserve system was inherently unstable. It was characterized by large
exchange-rate instability and fueled considerable speculation in assets and
commodities.
The country issuing a reserve currency receives significant benefits from
seignorage (defined as the benefit accruing to an issuer of a currency as the
printing of currency cost very little while it can be used to purchase goods
and services that equal its face value) and can finance its external debt with
no pressure or discipline.
However, the issuing country would face what is commonly referred to as the
Triffin dilemma. Economist Robert Triffin noted that if under the Bretton Woods
System (with gold and dollars as reserves) the US failed to keep running
deficits, the reserve system would lose its liquidity and not keep up with the
world's economic growth, and would thus bring the system to a halt. But
incurring such payment deficits also meant that, over time, the deficits would
erode confidence in the dollar, as the world's holdings of dollars kept on
increasing. In other words, there was a continuous debate about the desired
size of the US external deficit.
Many prominent figures have echoed the same message as Zhou Xiaochuan. Nobel
Laureate economist Joseph Stiglitz argued that the dollar reserve system meant
that a large part of the world's cash was funneled into the US and multiplied
itself into an expansion of credit. He called for a global reserve currency
system. Zhou's proposal aimed essentially at reviving John Maynard Keynes' 1943
bancor currency, defined as a world currency based on a commodity basket formed
of 30 commodities and issued by a world central bank.
Although Zhou's proposal was intended for the G-20 meeting in London, it was
simply ignored by all participants. China reiterated the same message for a new
reserve system at the Group of Eight summit in Italy in July. The Chinese
message was even rebuked by some countries as untimely and far removed from
pressing other challenges.
The present international payments system could be classified as a hodgepodge.
It is a akin to what prevailed during 1931-1945, when some currencies were
floating against each other while others were fixed, governments were resorting
to beggar-thy-neighbor policies, undertaking competitive devaluations,
inflating their prices and opposing wage or price adjustments. Freed from any
standard and thus with no obligations, governments had no limit to inflationary
finance and currency depreciation as a way to tackle mass unemployment and
reduce real debt. Such monetary chaos caused trade restrictions and ultimately
escalated into a world war.
The world economy was under the gold standard until 1914 (although the system
showed earlier strains with Britain's growing deficits while the pound sterling
was the major currency reserve asset besides gold). Each country had its paper
currency defined in relation to a quantity of gold and was redeemable in gold.
Such a system worked smoothly and allowed for sustained world growth and
expansion of trade over many decades. Banking crises were systematically caused
by over-expansion of bank loans, but although frequent in industrial countries,
those crises did not shake the foundation of the gold standard. However,
pre-war financing by Britain led to large external deficits, increased the
global holdings of sterling and shook global confidence in sterling as a
reserve asset.
The Genoa Conference of 1922 recognized that fiscal deficits undermined the
gold standard. It called for a gold exchange standard aimed at economizing on
the use of gold as a reserve asset, enhancing the use of the dollar and the
French franc, in addition to the pound sterling, as reserve assets, and
encouraging non-belligerent countries to inflate their monies, instead of
belligerent countries deflating theirs.
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