China must help itself ... for the US' sake
A growing number of United States policy advisers are arguing that as the government borrows and spends money to make up for lower spending by the nation's households, only China, with its huge hoard of central bank reserves, can supply the US Treasury with the new funding it needs.
But the Chinese government, they say, has an alternate use for its resources. It must pay for its own domestic spending to fight off a sharp economic slowdown at home. The US, they conclude, must convince China, with its huge foreign currency reserves, to choose to fund US government debt rather than domestic expansion, or else it will face an inability to revive the US economy.
The argument is wrong for several reasons. First, it is highly unlikely that the US will need to turn to China or any other country to fund the US fiscal deficit. It will easily be financed domestically.
Why? Because the purpose of US government spending is to offset the decline in US household spending that will occur as these households increase their savings in response to the financial crisis. US households have consumed too much and saved too little for nearly a decade, and one consequence of the crisis must be that they begin to save more. These higher savings must be invested, and as they are likely to be larger than the fiscal expansion plan, the US Treasury will have no problem obtaining financing domestically.
But even if the US needed Chinese help, China's US$2 trillion in reserves cannot be lent to the US. The money held by the People's Bank of China has already been lent to the American, European and Japanese governments. That is how reserves are held. Only new reserves can be lent, and the only way for China to accumulate new reserves is by continuing to run large trade surpluses with the US.
If China runs a trade surplus with the US, and wants to continue doing so, it has no choice but to recycle the money back into the US. A current account deficit cannot exist without a capital account surplus to fund it. If China were to stop lending money to the US, its trade surplus with the US would disappear, something China is desperate to avoid.
Anyway Chinese government spending at home can only be funded by domestic borrowing, not by reserves. If China wants to spend its dollar reserves at home, it can only do so by taking dollars from the People's Bank of China and selling them for yuan. But in order to control the value of the yuan, the central bank must buy dollars. It cannot also sell dollars without giving up control of the yuan, and letting it surge. This would destroy the Chinese export industry.
Any domestic fiscal expansion must be financed by borrowing domestically, while reserves can only be invested abroad. But even if China could choose between funding domestic spending and the US fiscal deficit, it wouldn't make sense for American policymakers to hope that China is generous enough to choose the US Treasury rather than fund spending in China.
On the contrary. They should prefer that China spend the money at home. This is because the fundamental imbalance in the global economy has been the balance of payments between the US and China. China, which produces far more than it consumes, must export its overcapacity to the US, which consumes much more than it produces. With US households cutting back sharply on consumption, the world is now facing a serious imbalance between production and consumption.
There are, broadly speaking, three ways to resolve this imbalance. One way, which everyone hopes to avoid, would be a sharp contraction in global production - closing factories and firing workers. A second way is for the US to expand fiscally, so that US debt-financed household consumption is replaced by US debt-financed government consumption.
A far better solution is for Chinese demand to expand sufficiently to enable it to absorb its own excess capacity. The more China spends to create domestic demand, the less the US must spend to replace declining household consumption. There is no trade-off.
The root of the economic and financial crisis has been the capital and trade relationship between the US and China. Any adjustment in one part of the relationship must automatically force adjustments elsewhere. If policymakers try to design policy without understanding the links and their necessary adjustments, the outcome will be misguided policy, collapsing trade, and a worse economic outcome for everyone.
Michael Pettis is professor of finance at Peking University