Beijing bookstores would be wise to stock up on Johann Wolfgang von Goethe. His work will help Chinese officials understand the “Faustian bargain” in which they are engaged with the US.
The reference here is to a compromise of principles for fleeting gains. In literature, Goethe’s Faust is a mythic German alchemist who made a deal with the devil. And that, in a nutshell, is where China, the biggest foreign holder of US debt, finds itself as America re-inflates its economy.
Treasury Secretary Henry Paulson isn’t the devil, yet on his watch the US has morphed into a huge debt-issuing machine. The Congressional Budget Office says the US deficit will more than double this year to at least $1.18 trillion, the biggest since World War II.
Barack Obama has even bigger plans. The CBO’s estimates don’t include the cost of the president-elect’s stimulus package, which will probably add at least $750 billion to the total over the next two years. Last year’s shortfall totalled $455 billion. The US needs China’s money more than ever.
“I spent most of the first two quarters of 2008 marvelling at the pace of Chinese reserve accumulation,” Council on Foreign Relations economist Brad Setser in New York wrote on his Web log this week. “I expect to spend the first few quarters of 2009 marvelling at the size of the US fiscal deficit.”
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All that borrowing could burst what Bill Gross, co-chief investment officer of Newport Beach, California-based Pacific Investment Management Co, calls a market with “some bubble characteristics.” That isn’t escaping officials in Beijing.
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China owns $653 billion of Treasuries, and indications are that it’s losing its appetite for US debt. Expect Asia’s second-biggest economy to cut the share of dollars in its $1.9 trillion of reserves, and perhaps sharply.
The US is, after all, acting at the expense of its best customer. Just as shareholders abhor companies diluting their stock with new offerings, China’s debt managers can’t be happy with the Treasury’s plans.
Along with its Faustian bargain, one wonders if China risks a Madoffian one, too.
No, the Treasury isn’t engaged in a massive fraud of the kind allegedly perpetrated by financier Bernard Madoff. Yet the US’s $5.3 trillion government debt arena is looking more like a Ponzi scheme than a market.
MADOFF’S SCHEME
Madoff personifies the greed, lack of transparency and lost trust that has accompanied the US’s fall from grace. Even though sceptics raised concerns about the veracity of Madoff’s performance over the years, regulators failed to act. They believed Madoff’s assertions and figures.
The reason credit-rating companies aren’t swarming around and threatening to downgrade the US is trust. It’s a deep belief that the issuer of the reserve currency and one without foreign-currency debt will always make its payments. That doesn’t mean critics who say the market has become the world’s biggest pyramid scheme are wrong.
Holding the whole thing together is the idea that there will always be fresh money flowing in to save investors already there. A pyramid-scheme dynamic is very much at play. Treasury holders won’t lose everything the way Madoff’s investors might. Yet China will suffer when foreigners sell Treasuries and yields surge.
SUCKER’S BET
The question is how aggressively China will shield itself from what increasingly looks like a sucker’s bet. Economists at Deutsche Bank AG in Frankfurt, for example, estimate China will trim the share of dollars to about 45 per cent this year from more than 70 per cent in 2003.
Of course, having entered into this arrangement, China is hard-pressed to get out of it. Its economy is largely about selling manufactured goods overseas.
“I am not suggesting this model is irrevocable,” says David Gilmore, partner at Foreign Exchange Analytics in Essex, Connecticut. “Like anything in economics, situations evolve. But in the midst of a global slowdown the world has not seen since World War II, now is not the time for China to throw out the existing economic model for a new one.”
Relying on domestic demand is a long-term goal that will require deft policy making and a high level of tolerance for disruptions in the short run. It’s not clear 2009 is the year to make that transition.
The best scenario for China is for American consumers to resume buying its goods. China has a vested interest in not doing anything to complicate things for the biggest economy. Pulling the plug on Treasuries would make headlines, precipitate a run on the dollar and hurt U S growth.
That doesn’t mean China wants to risk more money on a Ponzi scheme in its last throes. The world is littered with examples of how that can turn out. And China’s 1.3 billion people could sure use some of that cash back home as their own economy falters.