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Mutually Assured Economic Destruction

One of the many arguments I hear about a growing deficit is the power other countries begin to wield over America. I’m talking specifically about China and the substantial dollar reserves they are building up from an imbalance of trade. It is estimated that China holds $1.3 trillion dollars of foreign reserves and that at least $800billion of that is made up of U.S. government bonds. The bonds are sold by the U.S. government to make up for their budget deficit and eaten up by fiscally responsible Asian nations who believe in national savings.

This isn’t new. Japan has accumulated over a trillion dollars in reserves over the past half century and has kept the dollar strong in times of weakness by buying up extra reserves. The difference is, Japan is a major ally and friend of the U.S., and it’s in the interest of the Japanese to ensure the dollar is considerably strong because of close links to the American economy.

China’s different. Historical mistrust and our friendship with Asian rivals assures us that the Chinese view the USA as a potential enemy and not a competitor. China is accumulating dollar assets not just to gain wealth but to gain a bargaining chip over the world’s lone superpower. In China it’s called their economic “Nuclear option“. Essentially, the Chinese know that they are increasingly in control of the dollar’s value and that the moves they make can alter the value of it drastically.

How would this work? Let’s pretend that China disagrees with global U.S. policy and decides it wants to act. With military options off the table it decides to wage economic warfare. It starts a massive sale of U.S. bonds. This causes a drastic spike in treasury yields, pounds the housing market, and throws the economy into a guaranteed recession. The USA, which has run a budget deficit for 35 of the last 40 years, would have trouble finding buyers for its U.S. bonds since the dollar’s value is volatile and decreasing. In addition, the price of gold and oil would skyrocket and the rest of the world would become unstable.

Sound far-fetched? Well, its happened before. The United States pulled the same stunt on Britain during the Suez crisis in order to get the British to withdraw from the region in 1956. As written in Wikipedia: “Part of the pressure that the United States used against Britain was financial, as President Eisenhower threatened to sell the United States reserves of the British pound and thereby precipitate a collapse of the British currency. ”

The situation is rather similar today: A world superpower (Britain) is heavily indebted to an emerging superpower (USA) due to war (World war two). Fast forward to 2008: A world superpower (USA) is heavily indebted to an emerging superpower (China) due to war (Iraq & Afghanistan). When another nation controls you physically or economically your sovereignty is threatened, at risk, and exploitable.

This isn’t a doomsday post and I’m not a conspiracy theorist. I am merely concerned as a citizen of this country. Having looked into this a lot, I’ve reached some conclusions about this and I like to think that times are different and the risk isn’t there for a number of reasons. First, China’s wealth is entirely Dependant on the price of the dollar and the overall state of the U.S. economy. A recession (or depression) in the USA threatens the trade imbalance China enjoys with the USA and possibly prevents it from accumulating more wealth through its exports. Second, and more importantly, China’s wealth exists because of the price of the dollar. A massive sell of dollars would take time as there simply isn’t a buyer for $1trillion in greenbacks. That means as China begins to sell off its reserves, the value of the unsold reserves will decrease. A 20% drop in the value of the dollar means that $1trillion China holds is now worth $800billion in purchasing power. It is in China’s best interest to ensure a strong dollar in order to preserve its new-found wealth. Any sudden moves to destabilize the dollar would inadvertently wreck China’s gains over the last 15 years.

Rather than using its “Nuclear option”, I would expect China to do two things going forward. First, it diversifies its reserves into two other currencies: The Euro & the Pound. It then uses its vast pool of reserves to buy up key assets in western nations. The Chinese Sovereign wealth fund, which is actually controlled by the government, will buy up ports, energy assets, and technologically important assets in western nations to continue its long standing tradition of economic espionage. Western nations will continue the upward trend of having foreign-owned businesses. Lastly, economic influence will be more evenly spread out between traditional superpowers and emerging nations like China and Russia.