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There are a flock of Chicken Littles, not all of them on the right, predicting that China will -- unless we follow their advice -- sell all their treasury bonds and reduce the US to bankruptcy. Now, any change beyond the resiliency of the market would be disastrous, but such change isn't going to happen. (One reason that it isn't is that, were China to dump its holdings of treasuries on the market, they would get only a fraction of what they paid for them.)

Let's consider, though, what the results would be for a much smaller change, China stops net buying of US treasuries, and no other country takes up the slack. (I say net borrowing because China holds millions of bonds which come due each month.)

Well, why is it necessary for the US Treasury to sell so many bonds?

The primary reason, as Lord Keynes taught us, is that in a closed economy, savings = investment. (By a closed economy, I mean one that has no foreign trade and investment. Most economies operate almost like that, and the Earth as a whole operates precisely like that.) This is sometimes taught as if it were some esoteric discovery, but it is the logical consequence of two other simple equations:
Production = consumption + investment. (Everything produced is either consumed -- including waste -- or invested in either inventory change or in plant and equipment.)
AND
Claims on production = savings + consumption.
Now, whenever anything is produced, equal claims on production are produced along with it. Some of those claims go to workers, some to suppliers of materials, some in taxes, and the remainder to owners. Now since the dollar value of claims on production is the dollar value of production, and consumption is consumption, the remaining terms must be equal.

Now, at any level of economic activity, there is an intention to save and an intention (mostly of other people than those who intend to save) to invest. If the intentions to save total greater than the intentions to invest, the result is an increase in investment in inventory greater than was intended. The obvious response is to manufacture less. So, when the intention to save is greater than the intention at any level of economic activity to invest, then economic activity falls until it reaches a level at which the intention to save at that level equals the intention to invest at that level. That means a recession.

Now that is total savings, including government savings. So, when intended private savings exceeds intended private investment at a healthy level of the economy, the task of the government is to run negative savings (aka borrowing) until total savings matches total intended investment at a healthy level of economic activity. That's the reason we need to run a deficit these days.

The problem is that we are not only soaking up the excess savings of domestic private actors, we are soaking up the savings of foreign actors, including the PRC government. If those foreign actors declined to buy our bonds we could return to a healthy economic level rapidly and at with much less federal borrowing.

Now, I repeat. A precipitous change would lead to catastrophe. But a gradual change foreseen by the US government and a sensible response to that change would be in our best interests.

Of course, the Chinese government is not operating on their opinion of what would be in our best interests, but on their perception of their best interests -- a mixture of varied opinions within the government of what would be best for China, of what would be best for the Chinese government, and of what would be best for the individual politicians. (Just like here at home.)
 

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Comment Preferences

  •  Wouldn't matter, the Feds would buy (1+ / 0-)
    Recommended by:
    wu ming

    the bonds up with newly created fiat money.  We'd hardly notice.

    This is all part of the austerity theme, a pig in a poke being sold to the public.

    Much more worrisome are the fears of currency wars, a la 1930s.  Could tank the German economy, and take down the rest of the world.   Little Hitlers could pop up all over Europe, fanning the fires of nationalism with screeds on the benefits of autarchy and dumping the Euro.

    Anyway, its not going to happen.  PRC needs those dollar assets to buy oil and other stuff they don't produce domestically.  Not to mention the stability it provides their central bank.

    •  Read the whole thing. (0+ / 0-)

      The Fed wouldn't have to buy the bonds.

      One major reason for selling bonds is to absorb excess szavings (I call it, and as far as I know nobody else does, being the "borrower of last resort.")

      If China didn't buy the bonds, Yanks would buy enough to abosrb our excess savings without the Treasury selling as many.

  •  Our bonds are denominated in US dollars (7+ / 0-)

    The Chinese have the dollars to buy the bonds because they traded their products for those dollars - all those iPads and flatscreen tv's and kitchen stuff and all the rest. They were paid in dollars and they have limited choices what to do with all those dollars - they can spend them, save them or invest them.

    They do spend some dollars on US products and services, but to simply save them is non productive. They can trade them for other currency - driving up the price of the other currency and driving down the relative value of the dollar. That would be costly, it would be wiser to invest them, but to do so they must invest in dollar based assets. The safest such assets are US Treasury certificates because being denominated in dollars the government can always make the obligated payments since they issue the currency. The only bondholder risk is inflation.

    The main point is, it is not the Chinese purchase of bonds that is the problem, it is the American public's purchase of Chinese goods that produces the economic leakage. So long as we run a trade deficit, we NEED federal budget deficits or the private sector will take on intolerable levels of debt as happened in the late 90's. The private sector cannot sustain persistent deficits, the public sector can and must.

    Federal deficits are a relatively unimportant parameter - the parameters most important for long term stability are the relative rates of interest on the debt and GDP growth. As long as the fed maintains interest rates below the GDP growth rate, the debt service to GDP ratio has an upper bound. For most of the post WWII period the economy has grown faster than the interest rate on the debt. However, in the 80's and 90's we were in a high interest rate regime and the debt service ratio was growing without bound. After 2000 we returned to interest rates below GDP growth except for the massive contraction of the great recession.

    •  Krugman; Chinese dictatorship. (2+ / 0-)
      Recommended by:
      Seneca Doane, fuzzyguy

      1. Google "krugman china" and you get a lot of informative stuff, including these two columns in which Krugman explains China needs us more than we need them, and in fact we'd be better off if China bought fewer of our bonds:

      http://krugman.blogs.nytimes.com/...

      http://krugman.blogs.nytimes.com/...

      2. Recall that the average Chinese person is much poorer than the average American. So why are they sending a lot of wealth to America (by buying American bonds) instead of buying stuff for themselves with it? Stuff like consumer goods, education, clean air, rural plumbing? Because sending it to America keeps the Chinese currency cheap, which keeps their wages low, which creates more Chinese manufacturing jobs, which allows more rural Chinese to move to the cities, where even sweatshop workers live much better than rural peasants. So if they don't allow rural Chinese to move to the cities, they're going to have a revolution on their hands. So the Chinese purchases of American bonds are as much about the Chinese dictatorship trying to pacify the Chinese people as about anything else.

      This can't go on forever. The Chinese people are waking up to the fact that their dirty manufacturing methods are a public health disaster. They're going to have to divert some of their revenue to cleaning up their factories and related enviro problems. And Chinese factory workers are starting to demand higher wages, and must to a certain extent be accommodated; that will also absorb some revenue that used to go to US bond purchases.

      "The true strength of our nation comes not from the might of our arms or the scale of our wealth, but from the enduring power of our ideals." - Barack Obama

      by HeyMikey on Tue Feb 12, 2013 at 06:49:29 PM PST

      [ Parent ]

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