In Part 1 of this series, I outlined why austerity (ie government spending cuts or tax increases) won’t solve our debt problem. Critics of my view tend to see the US as a big Argentina. If we spend too much and get into too much debt, our currency will become worthless and will fall victim to spiraling inflation. Go buy gold or crypto! The US dollar is trash.
Could the something like this happen to the US? It’s certainly possible but highly unlikely. Why? Three main reasons.
Reason 1: We Can Blow Things Up:
The US has a navy, an air force, and lots of nuclear weapons. If it really came down to it, I don’t see Argentina refusing to accept dollars with US warships ready to bomb the coast and marines ready to land. Of course that seems silly to us today but Britain did it to China during the Opium War and in the American colonies, Africa, India, etc. Part of what I’m seeing as I write this blog is the re-emergence of behaviors you only read about in history books.
We aren’t used to a world where trade and military power are so explicitly linked. The reality is those two have always been link but the US’s overwhelming power protected the international trading system has lulled us into complacency. In the end countries like Argentina would have no choice but to take US dollars.
Reason 2: Export Driven Countries Have to Buy Dollars
Ok, so Argentina couldn’t refuse to accept dollars but what about China? They have nukes too. That’s true. I don’t think we’ll be replaying the Opium War but does that mean China is going to stop buying US assets? If you say yes, you have to think through the consequences.
China’s economy essentially depends on exporting things to the US and Europe. It’s own people don’t have enough money to buy what the country produces and there are no other countries with enough people and wealth to make up for US consumption. India? Their GDP is $3 trillion spread across 1.3 billion people. US GDP is $25 trillion spread across 330 million people. Obviously, Americans have a bit more disposable income to spend on iphones and vacuum cleaners.
If you depend on exports, the way China does, then you need to find ways to keep your currency weak. This is why China has to recycle the dollars we send them back into US and Western assets (including our Treasury debt). This is also true of South Korea, Japan, and Germany. They have no choice. If they didn’t, the demand and therefor value of US dollars would fall even while Americans used more and more of them to buy things in Yuan, Euro, and Won. That would push up the value of those currencies against the dollar and make buying their stuff more expensive. Eventually US customers would say, “I’m good with the vacuum I have,” and then an American entrepreneur would think, “You know, I can make vacuums here a lot cheaper than the price those Chinese companies sell it for.”
If export driven nations like China didn’t recycle their dollars then their currencies would appreciate and that would make their exports more expensive for Americans. The only way to keep exporting is for countries like China to take the profits they earn from selling to the West and send them back to the US and Europe.
Ok so that’s why they need to buy dollars but why do we let them? In theory, we should want to protect our own manufacturers even at the cost of not being able to deficit spend the way we have. The main reason we allow this to happen is that we have free and open markets. We did this post WW2 to facilitate world trade. At that point we were subsidizing our allies to help with the fight against global communism. We won that fight so the question now is why are we letting countries still do this.
Unfortunately any system creates winners and losers. The winners tend to get entrenched and fight to preserve the system. The winners in our system are rich people, Wall Street, and our foreign policy/military elites.
When the Chinese buy US assets it increases the price of those assets. People who own those assets (the rich) want them to stay high. Wall Street in turn gets rich off of trading the assets so it wants to see Chinese money continue to pour in. Finally our military and foreign policy elites see the power that controlling the world’s reserve currency gives you. You can use it to punish your enemies and reward your friends.
So that’s why the winners in our society want this situation to continue but what about in China? If China were smart, it would stop focusing on exporting everything it can make to other countries and focus on serving the needs of their own people. This is what the US did as it transitioned from an export led to a consumption driven economy through the Great Depression and WW2. It’s a more balanced way to grow your economy. But remember the system creates winners who get entrenched.
If China stopped exporting things to the US it would be a massive change to their economic model and guess who would lose? All the powerful rich people in China today. If you are going to change from export driven to consumption led, you have to have workers/citizens with money. They can’t consume without buying things. Currently China suppresses their workers’ wages to invest in export led projects. If it were to readjust, it would have to reduce investment in export led projects and turn the money over to regular people. The companies getting the export led investments don’t like that.
We effectively did something like this in the 1930s with the New Deal and later with the Great Society. It was a massive redistribution. Businessmen howled at the injustice and we went through a massive fiscal adjustment with 25% unemployment. It’s unlikely China could survive a similar adjustment. And, at this point, China’s economy is so unbalanced that the adjustment would most likely be worse than the one we went through, making it an even more unattractive option.
That’s why China has been talking about making the adjustment from export-driven to consumption-led for 15 years and has made essentially zero progress. When everyone with money and power want something, they usually get it-even if it isn’t really sustainable.1
In the end we’ve built a system where the US specializes in creating safe financial assets that other countries buy to fund exporting TVs to the US. We’re like a big bank and China and Germany are the factories. Essentially the manufacturing company owners in China and Wall Street capitalists in the US propagate a system where they profit at the expense of workers in both countries2.
Reason 3: There Is No Alternative (TINA)
As we discussed in Reason 2, people use the dollar because the US has large and open capital markets. But why not use the Chinese Yuan and Chinese capital markets? Ask yourself this question: do you want your money in a Chinese bank? I didn’t think so and neither does any one else, including Chinese people. China imposes all sorts of capital controls preventing people from taking their money out of the country. When the government loosened capital controls in 2015 massive amounts of money poured out of China into countries like the US, Canada, and Australia3. That was great for people selling condos in Sydney but not great for China’s export-driven model. The value of the Yuan to dollar plunged and China quickly clamped back down.
The other issue is the rule of law. What’s stopping Chairman Xi from deciding that your money in that Chinese bank is really his? Not much so I don’t think many people are going to trust that their assets are safe.4
No other country in the world has a large economy, open capital markets, and the rule of law. The UK, Canada, and Australia have the last two but they lack the large part. There is simply no alternative to using the dollar as your currency for trade.
Even if people trusted China with their reserves, China doesn’t want them. Remember, when you open your capital markets and act as a reserve currency, lots of money floods in. That raises the value of your assets and makes your exports more expensive. That is not what China wants.
In Part 3 of this series, I’m going to discuss what would happen if we followed Calacanis and Friedberg’s advice. Let me give you a preview: it’s not good.
Michael Pettis and Matthew Klein lay out how this system works in their excellent book, Trade Wars Are Class Wars.
Sorry if this sounds like Bernie Bro warmed over communism. I’m a capitalist through and through but this is how the system works.
This caused a rapid devaluation of China’s currency. While China doesn’t want its currency appreciating too much, it also doesn’t want it falling through the floor. The key for them is stable but slight devalution.
Of course you can argue that the US isn’t safe as Russia found out when it invaded Ukraine. If there were an alternative, the Putin’s of the world would put their money somewhere else but there isn’t.