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The tone of U.S.-China relations, as evidenced by General Electric CEO Jeff Immelt's provocative 'colonization' blast, is deteriorating rapidly and signaling trouble ahead. Given the importance of this relationship it would be very helpful to understand what's at stake and how events will play out.

Chimerica: The World's Most Crucial Relationship

The most important bilateral economic and political relationship in the world today is arguably the one between the Chinese and the Americans. London School of Economics Professor Niall Ferguson coined the term "Chimerica" to characterize its interdependent nature.

The U.S. currently has the world's largest economy and most powerful military, and the U.S. dollar is the world's reserve currency. China is the fastest growing large economy, and the holder of approximately $1 trillion -- or about 50% -- of all foreign held U.S. Treasury debt. Depending upon how you measure GDP, China's economy has already-- or should soon-- pass Japan's to become the world's second largest. The Chinese economy is projected to pass the U.S.'s to become #1 in the not too distant future.

A significant part of China's rapid growth has been driven by its ability to export its goods to countries such as the United States. In turn, the U.S.'s ability to continue to finance its massive $13 trillion federal deficit has been substantially underwritten by China's ongoing purchase of U.S. Treasury debt.

While each side has gained from this relationship it is charting an unsustainable trajectory that could lead to severe problems. This is particularly troubling because Chimerica tension is rising over China's currency policy just as many countries -- including the U.S. with its high unemployment and China with its property bubble and inflation concerns -- appear to be struggling to emerge from the 'Great Recession'.

The Who and Why Behind Deeming China's Currency Policy as 'Harmful'

China's currency is confusingly referred to both as the renminbi and the yuan. The Chinese government has historically fixed the renminbi's exchange rate to the U.S. dollar. The working economic assumption in the U.S. is that if the renminbi were allowed to fluctuate that it would appreciate vs. the U.S. dollar.

Many have been very critical of the Chinese policy of suppressing the value of the renminbi, perhaps none more loudly and persistently than Nobel Laureate, Princeton Economics Professor, and NY Times columnist Paul Krugman. He has stated again and again that China's currency policy provides an economic advantage that -- while good for China in the immediate term -- is harmful towards the goal of achieving a balanced global economy. The European Union has also been critical in the past of China's currency policy.

What is the effect of a low renminbi? There are several, but one is that a low renminbi makes Chinese goods relatively less expensive in America. Consumers bear witness by observing that a vast number of the manufactured products at Wal-Mart (NYSE:WMT), Home Depot (NYSE:HD), etc. are made in China. Obviously most consumers prefer to pay less, and if given the choice between nearly identical products the consumer will choose the less expensive of the two.

China's ability to export comparatively less expensive products, which is aided by the renminbi's managed exchange rate, is a key element in China's economic growth story.

China is Playing Games

Headlines were made following the recent move by the Chinese to de-peg their currency to the U.S. Dollar. The move, however, was greeted by China critics as lacking in substantive change.

Professor Krugman was among the many who characterized the Chinese move as "playing games" to prolong their current policy. In the time since the Chinese allowed the renminbi to float it has moved both up and down vs. the U.S. Dollar within a very narrow range of approximately 0.5%.

An Imminent Showdown

There are a number of simultaneous forces coming to a head that indicate some type of Chimerica fracture may be on the not too distant horizon.

Politicians throughout history have consistently created scapegoats when problems arise. The U.S. is in the throes of a very serious economic challenge. Professor Krugman is not alone in thinking that the U.S. is in the early stages of what he's calling "The Third Depression". As depressions are relatively infrequent economic phenomena, we don't have a substantial body of history from which to base predictions. However, the increased political pressure that has occurred during history's depressions has led to radical and destructive policies.

The Chinese will make a convenient scapegoat during an election season characterized by high unemployment and deteriorating confidence. This is already happening, but expect even more China bashing (a la 1980s Japan bashing) from U.S. politicians, labor groups, etc. through this November's mid-term elections and the next U.S. Presidential election in 2012.

Unemployment has and will continue to be blamed on unfair Chinese competition due to the renminbi's low exchange rate. Look for more fear mongering over China's massive U.S. treasury holdings. And expect trade sanctions and barriers against Chinese goods. Simply discussing trade barriers or currency values publicly can be seismic in their impact to China's attitude towards the U.S. In addition, other efforts are underway that will further compound the schism.

Crossing the Debt Rubicon

The U.S. Federal debt level is around $13 trillion, which equates to approximately 90% of annual U.S. GDP. That's in line with Greece's Debt-to-GDP level. While the U.S. is not in the same economic boat as Greece, the 90% debt-to-GDP threshold is the level that research conducted by Reinhart and Rogoff has shown to be problematic. Have the Chinese and other holders of U.S. debt fallen victim to history's reoccurring "This Time is Different" thinking with respect to U.S. government debt?

Throughout history sovereigns have 'debased' their currencies for a variety of reasons. One common reason is to retire debt to foreign creditors. I've written previously about why the Federal Reserve will engage in another round of massive money printing to try and combat deflation and kickstart an economic rebound. Monetizing debt is another powerful incentive that could drive such a move.

The Option to Go Bankrupt Can Be a Very Valuable Option

Thinking about the future of Chinese-U.S. relations I'm reminded of a comment my uncle made to me when I was a kid about the sometimes conflicted relationship between a farmer and his bank:

"The Bank has a lot power over most Farmers. If the Farmer runs into financial trouble then the Bank can seize the Farmer's land, putting the Farmer out of business. This power dynamic is reversed, however, when it comes to the case of The Really Big Farmer. If The Really Big Farmer has financial trouble he can put the Bank out of business."

While it's tempting to reduce the complex U.S.-China relationship to that of The Really Big Farmer and the Bank, respectively, I don't believe it's that simple. Having said that, the U.S.'s option to effectively go bankrupt by monetizing its debt is a very powerful card that can be played.

It is entirely possible that the U.S. has in effect already crossed its debt 'Rubicon'. At this point the U.S. may either be unable, or unwilling, to pay back its debt without printing substantial quantities of money to do so. If this is in fact the case, then the U.S. government may have an incentive to just keep on borrowing for as long as creditors will lend it money.

Massive money printing could reduce the U.S.'s debt burden. But it would damage, if not destroy, the value of the U.S. dollar and topple it from its reserve currency status. However, it's unclear who would lose more -- The Big Farmer or The Bank -- were such a event to occur. As an example, Iceland -- which experienced one of the greatest financial disasters ever -- when compared to countries such as Ireland, Estonia and Latvia is doing better on a GDP and Employment basis. Professor Krugman's takeaway: "if you’re going to have a crisis, it’s better to have a really, really bad one."

Just How Likely is Openly Waged U.S.-China Economic War?

There is a huge incentive for both the U.S. and China to avoid a path as destructive as the one described here. The economic disruption and cost would be widespread, devastating and perhaps permanent. However, we know that it is human nature to underestimate the probability of severe events like a U.S.-China economic war. I believe this is a mistake.

What would be the trigger? A U.S. Treasury auction, a WTO complaint, U.S. Congressional action, or perhaps even a geopolitical event are all possible candidates. For example, the U.S.'s failure to enact fiscal austerity in a timely enough fashion for the Chinese, or concerns about massive money printing, could lead the Chinese to reduce their U.S. debt purchases. If the Chinese fail to show up for a U.S. debt auction, then the U.S. will have a much lower incentive to hold back on efforts to combat Chinese currency and trade manipulation.

If the U.S. responds with trade and monetary policies of sufficient scale, China would likely consider these moves to be openly hostile and retaliate.

Two keys to determining China's likely response: a) the speed at which events unfold and b) the size of U.S. actions (e.g, how much money will the Fed print). If political and economic pressures do not overwhelm U.S. policymakers and force them to move too quickly, then the U.S. may be able to phase implement its policies so that they do not provoke a rapid, complete breakdown in relations. However, recent history is not encouraging as policymakers have struggled to accurately diagnose and get out in front of big problems (e.g., inaccurate calls that the subprime problem was "contained" prior to the near collapse of the global financial system).

Closing Thoughts

The Chinese have been driving a very hard bargain with the rest of the world with their managed currency policy. China has benefitted tremendously from joining the open world economy. However, free trade is not an inalienable sovereign right.

China's growing economic power comes with the role of being a responsible global actor by playing by the same rules as its trading partners. The U.S. has grown weary of waiting for the Chinese government to come around at a time when it is also economically weakened. In short, the time has come for the renminbi to be revalued upward or U.S. action will occur.

What is China's realpolitik calculation?

China's leadership, emboldened for example by the failure of the U.S. to navigate the world away from a near financial collapse and Google's recent blink, is growing more confident. It is reasonable to assume that China will increasingly flex its economic muscles and may reject the U.S.'s request for a change in its currency policy.

The Chinese government stubbornly detests public pressure from foreign government officials. Yet the Chinese leadership appears to only move when they are forced to do so. And often when they do finally make a change, as with the most recent renminbi move, they barely budge.

At the same time, it is highly unlikely the U.S. will quietly surrender its role as the world's dominant superpower. And the pressure is growing to take swift, assertive action on the renminbi as calls to "do something" grow louder in the face of a deteriorating domestic economy.

China -- similar to Japan in the 1980s -- is directly in the U.S.'s economic crosshairs. The inescapable conclusion is that an escalating U.S.-China economic war is not only underestimated in terms of its likelihood, but probable.

Disclosure: Long Gold and Silver

Source: Is a U.S.- China Economic War on Its Way?