U.S. and China: It Takes Two to Tango

For every buyer there is a seller. For every debit, there is a credit.

People often accept naive views of how the market works, perhaps considering how their own life seems to work, and not considering the other side of the trade. As an example, aside from laziness, why do market observers report a day where the market goes down on no significant news as “profit taking,” or grab at some lame smaller story which couldn’t explain the decline? For every seller, there is a buyer. No money went into or out of the market unless there was a new IPO, rights offering, company sale for cash, buyback, cash dividend, etc. People don’t run away from or run to the market; only the terms of the trade change at the margin.

The same applies to current account deficits. They have to get funded from somewhere, and on unfavorable terms to the lender if the borrower happens to be the world’s reserve currency.

Thus, when I consider arguments over whether America is to blame for its profligate ways, or whether those that funded the deficits are to blame, I simply say that the books have to balance. Neither is to blame; both are to blame.

It is not as if China has free capital markets. Given their neomercantilism (uneconomic export promotion), they had to find places where their exports would be accepted. The answer was the US. After that, what do their banks do with excess dollars? They buy fixed income dollar assets, which they foolishly think will preserve value until they need to liquidate the assets for goods or services of some sort.

That recycling of the current account deficit forced rates lower in the US while the Fed was tightening. For the Fed to have fought that influence, they should have tightened more rapidly, compared to the plodding 1/4% each FOMC meeting. How often have mortgage interest rates fallen while the Fed is tightening? Not often, which is why the Fed was impotent during the last tightening cycle. It is also why the blows hitting the global economy have fallen more lightly on the US. To the extent that foreigners buy our bonds denominated in dollars, that transfers a part of the pain to them. Thanks, but you could have avoided our pain had you opened your markets to our goods and services.

There are many efforts in play to try to replace the dollar. Most if not all will fail. At present, the US is politically secure in ways the other large currencies are not, and many invest in the US not to preserve full value, but to preserve most of the value, whatever that may be.

As with many things in life — it takes two to tango. Blame is infrequently singular. Both the US and China should own up to their shares of the current problems. Then, maybe, solutions could be found.

Comments

[Market Sniper:]

Bravo! Well stated!

Jul 05 03:34 PM

[Jordan Lindsey:]

<There are many efforts in play to try to replace the dollar. Most if not all will fail. >

USA! USA! USA! Happy 4th all!

Jul 05 04:41 PM

[Dave Wrixon:]

"At present, the US is politically secure in ways the other large currencies are not..."

I am afraid you delude yourself. I see the US as being potentially highly unstable, and the right of citizens to bear arms is not going to help one bit.

Jul 05 05:43 PM

[Steven Hansen:]

you have to expect everyone to protect themselves. when you delude yourself with dogma, and ignore its effects because your dogma is good and righteous - you are to blame.

america's leaders believe free trade is good, but ignore the consequences. nothing is totally good. water is good but you will drown in too much water.

Jul 05 10:03 PM

[conceptwizard:]

Two trillion dollars in reserves isn't really that much for a country with as many people as China has. And China long ago signaled that it was gradually moving out of dollars. The signals came in the form of (1) China moving out of long treasuries and into treasuries with a duration of 3 years or less, and (2) China using its reserves to buy commodities, instead of more dollars.
Nouriel Roubini argues:

The process that will lead - in the medium-long term - to a challenge of the US dollar as the major global reserve currency has started. The US creditors - the BRICs, the Gulf states and others - are becoming increasingly alarmed that the US will deal with its unsustainable fiscal path via inflation and debasement of the value of the dollar via depreciation. So they will not sit idly waiting for this to happen: they are already diversifying into gold, into resources (as China purchases mines and energy, mineral and commodity resources all over the world).

So, China is reducing their commitments to buying dollars. With ben Benanke's Trillions of deficit to roll over this year and next. It may become harder to find a buyer or at the very least have to pay more interest. This will not bode well for the taxpayer.

Jul 05 11:20 PM

[Moon Kil Woong:]

David Merkel your synopsis is insightful. If you frame it like a home mortgage the picture gets a bit clearer. China is at fault for writing loans to a person who is becoming less credit worthy and the US is guilty of taking out a flex rate mortgage. When interest rates rise, just like low interest zero down interest only NINJA loans the borrower implodes.

China's loans to the US were funded by cheap credit in the form of artificiallly discounted money. The US bought with no intention of paying back at present dollars assuming its fiscal health would always rise and there will never be a need to pay back the principal (the national deficit). They would be lucky if they just ceased to increase the debt (keep moving into a more expensive home).

Like the home mortgage collapse, both the borrower and the lender have been very delinquent in their responsibilities and very morally delinquent as well. Once this very unvirtuous cycle ends (despite both parties trying to continue it ad infinum) both sides are looking at a very ugly mess. There is no greater party to cover either the US' losses (mass inflation and moetization may be the only solution) or China's (a total collapse of external demand and mass depreciation of ficticious foreign reserve wealth on its books).

This should be a lesson to all parties who engage in sustained trade and deficit spending disparities. You spend or lend at greater and greater peril to your own well being. There is no real lasting substitute to internally generated wealth, productivity, or consumption. If you can not afford to borrow internally you have gone asray. If you can not generate domestic growth then your economy is ficticious and your wealth is equally fleeting. Let the world take notice and learn from the mistakes of both the US and China.

Rather than tango, both economies are now shackled together and are being forced to do real pennance.

Jul 06 03:02 AM

[Living4Divi...:]

David - I like your article, and agree with your central thesis, it takes two to tango.
I agree with your statement:
"There are many efforts in play to try to replace the dollar. Most if not all will fail."
this implies that the dollar stays as the world's leading trade currency, which adds support to the dollar. Despite the fact that the dollar remains as the global trade currency, the dollar can and will be gradually be replaced, as the world's leading reserve currency. This is easy to do by the sovereigns themselves: buy less dollars and more euro, pounds sterling and yen.

Moon Kil Wong put it succintly:
China is conflicted in that it has two unpleasant choices: 1) it can continue to finance America's growing debt and risk huge losses on it's currency reserves. -OR- 2) it can stop subsidizing the dollar and face a partial collapse of external demand and a sudden depreciation of foreign reserve wealth on its books.

Jul 06 08:09 AM

[Ferdinand E...:]

Looks to me like China might be in trouble. I see no reason at all however to believe that they will adopt the kind of pessimism pouring out of certain quarters in the US where the management of their economic problems is concerned. After all, this is going to be their century, isn't it.

Jul 06 09:49 AM

[johnbee:]

You're right in saying there is always a buyer to match a seller. The trouble in the last 12 months is that the buyer is funded by money borrowed from the unwilling taxpayer in $'s which will need be payed back twice over when inflation hits.

Jul 06 11:08 AM

[jayminho:]

the columinist probably belives US is the only nation in the planet who has a buying market.
have you ever wondered son, (damn, you are probbaly 20 years older than i am) but you probbaly grow up with the "i am american" mentality, so anyway, back to what i was saying, have you ever wondered if china develops its internal market ?
ohh boy..

Jul 06 11:19 AM

[Tony Daltorio:]

Seeing articles like this always give me a good laugh. Typical American - "Yes, I threw a rock through the window but so did Tommy down the street!"

Let's look at this - some poor farmer in western China is saving everything he can to support his family and he is equally to blame for the economic crisis with the crooks in Washington & Wall Street?? Amazing......

Look in the mirror, America..........

Jul 06 01:39 PM

[Thomas J. G...:]

David makes a good point. If China wants to be mercantilist and give us real goods and services below their cost of production, let them. We do need to get/keep our house in order though.

Jul 06 05:32 PM