Monday, July 27, 2009

The US China Relationship

Although this article from MSN Money may be a bit too simplistic and a little more gloom and doom than I like, I think it does a awesome job explaining China and the United States' interdependency. It is very interesting to read a simplified history of how we came to depend on each other and how our relationship poses some problems for the future.

Imagine becoming so successful at your job that you stack up $2 trillion in income, which you conservatively place in short-term U.S. Treasury bonds for safekeeping.

Now imagine that when you try to cash in those bonds to buy a few things for your kids, the clerk at the bank abruptly shuts her window and tells you to go away.

That is essentially the situation faced by China these days as it wonders whether its plan to manufacture goods for U.S. consumers over the past two decades in exchange for a pile of credit slips was really such a hot idea.

I have heard little political tidbits and people's random remarks about how China basically owns us. I always had a gut feeling this was exaggerated paranoia, however my ignorance on the topic had me refraining from commenting. The one positive I took away from this article is that as scared as many Americans are about China having such a large possession of US bonds, the Chinese may be just as scared to have such a large position in US bonds.

Well, now think about this in the context of a Ponzi scheme such as the one perpetrated by disgraced financier Bernie Madoff.
Madoff's clients for years thought they were rich because he sent them brokerage statements that said so. But that scheme worked only as long as new money kept coming in. When international money flows seized up last year and too many people wanted to redeem their accounts at once, Madoff's $50 billion game fell apart. Then his victims suddenly discovered that their brokerage statements were worthless pieces of paper. Madoff clients' households crashed, and now one-time millionaires are broke. The reality is that they were always broke; they just didn't know it yet.

The credit that has kept American families afloat for the past 10 years is similar to those Madoff-produced brokerage statements. The credit is good only so long as China keeps recycling funds through the Ponzi scheme. But if Beijing leaders ever decide that it's just too risky to own U.S. dollars and debt, then the system is going to come crashing down. Of course, it is not really in China's interest to stop the scheme, even if it wanted to, because its own economy would likewise blow up. Satyajit Das, a credit derivatives expert in Australia, likens this to stepping on one of those land mines that are activated by the weight of a victim's body. As soon as the weight is lifted, the mine explodes, and the person's leg is blown off.

China is thus frozen in place, damned if it does and damned if it doesn't. It's a classic Catch-22. China's cache of U.S. bonds isn't worth anything unless the bonds are sold. But selling them on any kind of scale will gut their value.

"People need to realize that China doesn't actually have any real U.S. money," Das says. "Unless they can turn in their bonds and exchange them for something else, they're only paper assets. Yet if they try to exit the position, they'll destabilize the dollar, and the value of the rest of their assets will plunge. And that's not even their biggest problem. It's that they also need to keep buying Treasurys, or interest rates will go up and their capital losses will be terrible."

I don't really know if the situation is 'mutually assured destruction' like author Jon Markman claims, yet I don't really know the path to changing it either. Hopefully the recession has served as a wake up call that we cannot as a nation merely borrow our way to 'wealth'. Couple the wake up call with access to more information (financial education information) than ever via the Internet and maybe the US will begin to start living the Badskiblog definition of being rich.

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