from Follow the Money

Paul Blustein should have his own blog

November 22, 2005

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United States

Budget, Debt, and Deficits

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Or at least a column in the Washington Post!

He answered questions about the trade deficit yesterday at the Washington Post's webpage.   The questions were good, the answers were even better.

But I may be somewhat biased.   I liked (for obvious reasons) the way he answered a question about the strategic implications of relying on China, Russia and Saudi Arabia to finance US deficits.

The key quotes:

Why is China willing to hold a large part of US debt? Can they use the debt aggressively against us?

Paul Blustein: Excellent question--as were the previous ones!

The Chinese are "willing" to hold our Treasury securities for one important reason--for the past decade or so, they have rigidly linked their currency, the yuan, to the U.S. dollar, at a rate of about 8.27 per dollar. Since Chinese companies are obviously very competitive, and are earning lots of dollars, that means the Chinese central bank has to "soak up" those dollars by trading yuan for them--otherwise, the yuan would surge in value. And once the Chinese central bank has dollars, pretty much the only thing it can do with them is invest them in U.S. securities.

Sorry if that seems complicated, and it obviously raises the related question of China's currency policy, which is a whole 'nother controversy!

As for the second part of your question, if you read Saturday's story, you may have noticed the sidebar where I quoted from a Foreign Affairs article by Nouriel Roubini and Brad Setser. They pointed out that the Chinese COULD use their vast holdings of Treasury securities against us, by threatening to dump them, in some sort of foreign policy confrontation. Of course, that would hurt the Chinese a lot--perhaps more than it would hurt us; it's hard to say. But one way of thinking about this is that it's a sort of "balance of mutual terror"--a term used by former Treasury Secretary Larry Summers. It's not a very healthy situation, in other words.

And:

You wrote that it is "not a very healthy situation" that the potential for confrontation exists over China's lending to the United States. Why do you say that? It seems to me that an interlocking economic relationship that provides both parties with incentives to avoid serious conflict is a very good thing.

Paul Blustein: Fair point. The "mutually assured destruction" of the Cold War was, in a sense, highly desirable, because it gave both sides a disincentive to start a nuclear conflict.

Still, it isn't that hard to conjure up very nasty scenarios that would arise because of the large dollar holdings by central banks in countries such as China, Russia, Saudi Arabia etc. Here's just one: If foreign policy tensions with those countries really started to spiral out of control, the markets would start to worry that the central bank in question would start to dump dollars, and that alone could cause a panic to ensue. I'm not suggesting that this is a highly probable scenario, but I suspect it COULD be a constraint on U.S. policymakers.

Do read the exchange.

More on:

United States

Budget, Debt, and Deficits

Trade

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