The defining feature of the global economy right now is the $660 billion US current account deficit...
The defining feature of the current international financial and monetary system is that it finances the United States' enormous external deficit...
--Roubini & Setser (big pdf!) link from Billmon
The lion's share has been paid for by China, which has purchased a staggering amount of dollars to keep their currency cheap and sales brisk. There is momentary stability here, but it can only last for so long. Some say 2 decades, others say 2 years.
Will China and the other Asian nations keep financing us? Will they force us to get fiscal responsiblity? Or will we go down the path of Mutually Assured Financial Destruction?
The United States and China are playing a dangerous game of prisoner's dilemma: stay on the boat and risk getting screwed by your companion, or jump off now, but risk immediate negative consequences for everyone. [More, with poll...]
Roubini's blog has a smaller important
companion piece to the one above:
US-China "Balance of Financial Terror" Game. A Prisoners Dilemma Game: hard landing MAD or Chinese pre-emption as the likely solution?
Prisoner's Dilemma, the text-book concept: Two players have to decide whether to cooperate or defect, without knowing what the other player will do. If both sides cooperate, everything ends up pretty good for everyone. But if one player defects while the other cooperates, the defector gets even more and the other loses badly. If both sides defect, everyone loses pretty badly, but not as bad as a cooperator does when only the other guy defects.
End result: each side is much better off if both sides cooperate than if both defect. But look at the decisionmaking: if the other player cooperates, you're better off defecting, but if the other player defects, you're also better off defecting. So the natural outcome is that both sides defect and take a bad blow.
(look at the link if this is confusing)
So... here's Roubini:
The cooperative solution - beneficial both to the US and to the world at large is for the US to agree on a serious fiscal adjustment (reverse some tax cuts for the rich and and give up on social security privatization and/or fix social security without financially reckless privatization) and for China to agree on adjusting its peg, say by 20% plus. Then, the other Asian will follow China... Then you get cooperative orderly global rebalancing of current accounts with sustained global growth.
The non-cooperative game is one where the US sticks with its train-wreck fiscal policy that leads to a twin wreck of unsustainable current account while China not only refuses to revalue but also gets tired of financing cheaply the US. Usually it is argued that China has no interest of pulling the plug on the US as this would hurt China a lot: stopping the US financing is risky and costly as: a) the renmimbi would appreciate and slow down Chinese growth; b) hard landing of US dollar and US bond market would lead to a US and thus global recession that is not in China's interest. So, according to the three smart BW2 Deutsche Bank musketeers, [this] is a stable cooperative equilibrium of another sort: the Summers balance of financial terror ensures that the US current account deficit and the rest of the world surplus is maintained for two decades with easy Chinese and Asian financing of it.
The US is using [the threat of global recession] to convince China not to defect. Ideally, US would want to fool China twice: have them appreciate once now and take a big capital loss and then keep on accumulating more reserves and get more losses down the lines as lack of US adjustment means further need for foreign accumulation of US - by now junk - treasury bonds. In the absence of full Chinese twice masochism, the US is comfortable for now with China not appreciating as long as they keep on intervening at faster rates and thus keep the 10 year Treasury bond close to a 4% yield; a not so bad second best for the US that is a lousy deal for China and the rest of the world.
[...]
Will this US threat work? It has so far and it has maintained the US-does-not-cooperate while China-cooperates-to-finance-the-US threat equilibrium. But it is a really lousy deal for China and the world as they export goods to the US and they get in exchange promises to pay - bonds - that will be wiped out in real value via the eventual real devaluation of the US dollar.
And anyway, even if they do this, it's only going to last for so long:
currently accepting supinely the US pre-emption game forces China and the world to keep on financing the US and just pospone the eventual hard landing in time; it does not prevent it, it pospones it and creates greater imbalances that will make the hard landing nastier when it does occur..and be assured that hard landing would eventually occur...
What is the solution? According to Roubini, there's only one which avoids a hard global landing: If China, Japan, and Europe act now to show that they're not going to accept this fiscally irresponsible bullshit. Roubini throws out a strong entreaty to these powers to do just that:
[T]hreaten to stop financing the US... stop intervening for a month, desert a couple of Treasury auctions and signal with actions, rather than just token words, your displeasure with the US... It is a dangerous game... but it may be the only way...
The only thing I can add is this: as usual, it's important to look inside these "entities" (China, the US, etc) and see the players within them, because the entities aren't unified. Obviously, within the US, we've got the Bushies at the helm. Seems like they're going to "defect" no matter what (can you imagine them buckling to world pressure and raising taxes? I mean... maaaaaybe... but it feels like a long shot. Might China and the rest keep funding the deficit? I've wondered why they have until now, and my idea is this: it's not in the interest of the whole nation of China, but if you're a business man and can convince the government to use the people's money to buy dollars, keeping your goods cheap so American's buy them, that's a good idea. I think this is how it may have worked until now. But signs are that this won't last...