Free Markets, Free People

foreign exchange

Our major creditor’s name also ends with a vowel

One of the irritating things about being deeply in debt is dealing with your creditors. Happily, if your creditor is, say Wells Fargo, they tend to stay within strict legal bounds when dealing with you. If you’ve been unfortunate enough to seek credit from fellows whose last names end in vowels, they tend to be more…forceful in delivering their messages to you. As it happens one of the United States’ creditors also has a name that ends with a vowel: China.

And they have a message. The more or less official organ of the Chinese Communist Party—which is to say the Chinese Government—is the newspaper People’s Daily. So, it is with much interest that I read an op/ed piece in that fine journal with the title, "China must punish US for Taiwan arm sales with ‘financial weapon’". As messages go, this one’s pretty simple.

Now is the time for China to use its "financial weapon" to teach the United States a lesson if it moves forward with a plan to sale arms to Taiwan. In fact, China has never wanted to use its holdings of U.S. debt as a weapon. It is the United States that is forcing it to do so.

The U.S. House of Representatives just passed a debt ceiling bill on Aug. 1. On the next day, a total of 181 members of the House of Representatives signed a letter sent to U.S. President Barack Obama stating that the federal government should approve the sale of F-16 C/D fighter jets to Taiwan as soon as possible to help ensure peace and stability across the Taiwan Strait…

Despite knowing that major creditor countries, especially China, would be the main buyers of its new debt, certain arrogant and disrespectful U.S. Congress members have totally ignored China’s core interests by pressuring the president to sell advanced jets and even an arms upgrade package to Taiwan.

U.S. treasuries will lose value if China stops or reduces its purchases of them on a large scale, which will also affect the value of China’s U.S. treasury holdings. However,as the situation has gotten out of hand, allowing Washington politicians to continue their game might lead to more losses.

U.S. arms sales to Taiwan can only create more jobs for the United States but cannot improve the ability of Taiwan’s military force to compete with the Chinese mainland. The essence of the problem is that some U.S. Congress members hold a contemptuous attitude toward the core interests of China, which shows that they will never respect China. China-U.S. relations will always be constrained by these people and will continue along a roller coaster pattern if China does not beat them until they feel the pain.

I am mildly amused by the claim that such sales both threaten "China’s core interests", but "cannot improve the ability of Taiwan’s military force to compete with the Chinese mainland." Both of these arguments cannot simultaneously be true.

Less amusing is the common attitude of loan sharks to their creditors displayed here using much the same language that Tony "The Shark" would use: Namely, if creditors don’t do what they’re told, you have to "beat them until they feel the pain."

With the recent rise in bond prices and drop in yields, the Chinese have a number of options. The least damaging to the US would be to sit out a few bond auctions, which would force interest rates up. But they’ve also got the nuclear option of selling off as much paper as the market could bear. Yes, they’d forego some yield payments, but they’d probably make a nice tidy premium over the original purchase price to make up for it. Rising interest rates now, at a time when the economy is weak, and short-term rates are already effectively zero, would slow the US economy. At the same time, a massive repatriation of renminbi to China would cause a steep drop in the value of the dollar in foreign exchange markets. This would raise the price of imports equally steeply. This would cause something very similar to the oil price shocks of the 1970s, that plunged the US into stagflation.

Naturally, the Chinese would be hurt by the reduction in their export capability. The question then becomes, "Which of the two political systems, China or the US, is more concerned about democratic pressure to change policy in order to improve the economy?" Who is more responsive to public pressure: our government, or the government that initiated the Tiananmen Square massacre?

I don’t know about you, but I wouldn’t expect Hu "The Kommissar" Jintao to be the one that blinks first.

Of course, if we weren’t $14 trillion in debt, we wouldn’t be very vulnerable to this sort of thing.

Dale Franks
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Now he’s done it…

It has become an article of faith in modern economics that the gold standard just isn’t suitable for modern economies.  Since the Great Depression started the movement away from the gold standard, we have moved towards a system of freely convertible fiat currencies whose values are, in the main determined by the ability of central banks to maintain control of inflation.  Any talk of returning to the gold standard, therefore, is derided as some sort of fanatical return to a failed past.

Now, to be sure, there are problems with gold as money. Some of them are perceived problems, others are real.

Ultimately, gold, as a currency, tends to be deflationary. A country’s money supply is limited by the amount of gold on hand. Absent an increase in the amount of gold, any increase in real output must cause prices to decline.

Also, any balance of payments deficit reduces the country’s gold supply. For instance, during the Depression, England had a horrific balance of payments problem. The country was paying out so much money in foreign payments, that it was literally draining all the gold out of Britain.  The only real remedy to this was to massively deflate British prices…in the midst of an already deflationary recession.

Monetary shocks are easily transmitted from one country to another via gold. Since countries who participate in the gold standard have fixed links,  inflation or depression in one country can be quickly transmitted to another.  For instance, the discovery of a large gold mine increases the supply of gold, without affecting real output.  That inflationary effect is quickly felt throughout all the countries who share the standard.

But–and this is a big “but”–the change from a gold standard to freely convertible fiat currencies has solved those old problems by introducing entirely new ones.  Governments and central banks have embarked on massive programs of public indebtedness, the inflationary–and sometimes hyperinflationary–printing of fiat currencies, and the wholesale selling of sovereign debt to foreign countries who may not have, as their primary interest, recouping the money on their investments, but rather the manipulation of an enemy’s economy, should it become necessary.

These problems bring us to Robert Zoellick, the head of the World Bank. In an Op/Ed in the Financial Times addressing our current economic woes, he suggests something that will no doubt be much discussed. In a discussion of how to create a monetary regime to succeed the clearly dying Bretton Woods II paradigm in which we’ve operated since 1971, he suggests, among other things:

This new system is likely to need to involve the dollar, the euro, the yen, the pound and a renminbi that moves towards internationalisation and then an open capital account.

The system should also consider employing gold as an international reference point of market expectations about inflation, deflation and future currency values. Although textbooks may view gold as the old money, markets are using gold as an alternative monetary asset today.

If I’m not mistaken, the head of the World bank just called for the creation of a new gold standard for international trade.

This should be interesting.