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March 8, 2010

The Myth and Realities Behind the Chinese Threat

Over the past several years, I have watched many paranoid American citizens and journalists propagate this idea that China is actively working to ruin the United States.  In 2007, Lou Dobbs said that China was buying treasuries in order to use our debt as a “bargaining chip.”  In addition to this, the Chinese Central Bank has bought dollars, and according to some, to use it to crash our currency and damage our economy.
Not only is this hysteria totally false, but the reasons behind China’s open market operations benefit both countries and have a perfectly simple economic explanation.
Let’s examine the economic relationship between China and the United States.  The U.S. is involved in heavily importing Chinese products.  About 1/6th or 17% of all Chinese exports go to the United States, and a majority of Chinese exports go to developed nations.  China’s economy is dependent on exports in order to survive, so why would they damage the single largest variable factor by conducting economic warfare?
So why does China buy treasuries and dollars?
First, China must keep its currency cheap in order to export.  If the China Yuan appreciates too much, investors will look to other countries to buy consumer and industrial goods, and they may look within their own country to get those products.  China, like all globalized countries, is competing with the world as well.
In order to keep its currency cheap, China has pegged its currency to the U.S. Dollar.  It does this by buying and selling dollars in order to offset any currency changes.  China fights Yuan appreciation by buying U.S. dollars, making the dollar stronger and keeping the Yuan at its same value.  China’s increased purchases of dollars in 2006, 2007, and 2008 were not a reflection of some sinister plan, but a result of their great economic performance.  More dollars had to be purchased during that time period because the strength of their economy was pushing their currency up at a higher rate.
So, now China has all these dollars, what do they do with them?  Some would think that they would convert them to Yuan and invest them in their country, but that’s not true either.  Doing such a swap would cause massive inflation and put even more pressure on their currency as inflation also effects currency valuations.
China must invest the dollars within the United States, the country where they are most accepted.  China buys treasuries as a form of banking in the U.S.  By buying treasuries, China gets a small return (like a savings account) and it also encourages Americans to borrow more, giving them access to more liquidity to buy their goods and encourage more trade.
What would happen if China sold all treasuries at once?  The U.S. economy would not crash, but would face a shock that would be at least as strong as the financial crisis, followed by recession.  The fears would reduce consumer spending and business investment further, decreasing business with China.  American leaders would also likely retaliate against China by passing heavy tariffs against their imports, which would hurt both countries.  The rest of the world would be pushed into recession and would likely reduce their business with China as they would not want to become like America.  This would ultimately strengthen trading between the remaining countries and leave China in the dark.  The Chinese economy would falter twice as strong as Japan’s has, and China would ultimately crumble as the populace would not appreciate being thrown back into poverty.
So, in actuality what is good for China is good for the U.S.  (Note, we will discuss the benefits of free trade from our end in more depth on Wednesday).
But, China does represent a real threat.  Before we get to that, we have to understand how large China is becoming.  They currently have about 1/3rd of the GDP as the United States, however, they are growing at a 7.5% rate over the long-term compared to 2.5% from the United States.  Over the next 50 years, many predict the Chinese economy to overrun the United States.

I do not buy this.  First, if China has a $50 trillion GDP by 2045, what is propping that up?  It can’t be the rest of the world as the U.S. and others won’t have enough money to buy those Chinese products.  It won’t be within China as the average Chinese person would have to be between 33 and 50% wealthier than the present day American in order to generate that much economic output.
I believe that China’s growth is not only temporary, but in danger.  First, China may be able to produce at lower costs than any other industrialized nation, but at what price.  History has shown that industrialized nations experience a huge spurt in growth as they enter the industrial stage, but the only countries that have successfully transitioned to developed nations are the ones that have embraced two core principles, freedom and innovation.
Freedom is sorely lacking in China.  It is lacking in the electoral system as it is in the concept of a one-party system, but one thing trumps all others in China.  In China, there is no private property.  This is critical.  Private property is the engine behind wealth creation in America.  How can leaders and owners have the drive to be better companies if they have no ownership?  Private property restrictions have made it easier for the Chinese to save as they are not investing in property, plants, or equipment, but it is quickly creating a society where only the “inner circle” can be rich and where cronyism will be exposed and revolted by the populace.
Private property directly leads into the second principle, innovation.  When has China produced the last great pharmaceutical drug or the best computer processing chip?  The answer is never.  With no ownership, there is no incentive for the Chinese individual to innovate.  With China’s obsession to copy the West and just “do it cheaper,” the Chinese way has become more of replication, not innovation.
The lack of these two proponents of long-term economic growth means that China is experiencing a bubble.  The desires of the masses could lead to revolution and years of economic depression and decades of rebuilding, or the party could retain power and the lack of innovation will cause Chinese demand to top once it reaches peak production, or the world reaches peak demand for Chinese products.
Therein is the threat to America.  Like China, we too would be damaged by a popping of the Chinese bubble.  Consumer prices would surge upwards as imports would fall and consumers would be faced with fewer options (also known as less supply).  Businesses in the U.S. that have Chinese divisions will shed employment locally and worldwide as Chinese problems bring corporate profits tumbling down.
China, like the United States, would plunge the world into recession if it too had an economic crisis. 
So what actions can be taken to prevent China from being one big bubble?
Allow the Chinese currency to float.  While the short term effects would bring chaos to the marketplace, this move would help the global economy.  China’s run-ups in the economy would be naturally cooled by less foreign investment and U.S. domestic production would once again enjoy cyclical benefits as every now and then our goods would be competitively priced with China’s.
Allow private property and private corporate ownership with no strings attached in China.  Private ownership would bring freedom and innovation to China like a torrent.  It would also increase the pace of wealth growth among Chinese citizens and this would benefit the United States.  Why?  Because as we have learned over the last few years, as the middle class has grown in China, there has been an increasing demand for luxury goods.  Who makes these luxury goods?  China can’t because they don’t have innovation.  The answer is the United States.  The demand for foreign “exotic” products by Chinese citizens will only grow by more and it will likely not be stopped by Chinese innovation.  By the way, the number one selling car in China is Buick, which goes to my point.
I believe that these two actions alone are sufficient, but a number of other steps should be considered.  Ending the one-party system is one.  The one-party system is to democracy what government is to efficiency in the United States.  With the absence of true democracy the “lid” on Chinese growth will always be below that of the United States.
By the way, if you ask me, I think China will experience a painful recession brought on by at least some of the above points within the next decade.  That, in turn, will lead to a transition to democracy in China.  In 2050, China and the United States output will be within 5% of each other and by 2100 Chinese output will have a better chance of being higher than us.  That’s just my prediction though.

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