In the game of chicken that the US is playing with its creditors/dependent trade partners, this move by the Bush administration has to be chalked up as a giant "F*** you".
The federal budget deficit is expected to reach $368 billion this fiscal year, the non-partisan Congressional Budget Office projected today . . .Well, at least Bush will continue issuing mountains of T-bills so as to float a dozen more $60bn monthly trade deficits.
If the deficit reached $368 billion this year, it would be the third highest deficit on record, in dollar terms, topped only by last year's $412 billion and the $377 billion gap in 2003. Add another $80 billion [to fund the wars in Iraq and Afghanistan] and close to $1 billion in promised relief for the Asian tsunami and the deficit could reach a record $449 billion.
With these kinds of numbers, the Bush administration is flat out daring the Asian central banks to not buy US debt. One could even see it as an incredibly reckless attempt to throw China off its dollar peg. With the US federal government issuing more and more debt, our best customers need to consumer more and more of it to keep the dollar up and thus their exports flowing (and in China's case, their banks afloat). If China refuses to keep buying, the pressure on the dollar to fall will grow incredibly, venting first on the yen and the euro, and then Japan and the EU venting politically on China. Hot money would presumably start flooding China and Hong Kong, stepping up the pressure on the People's Bank of China to adjust the peg.
Would Japan and Europe let it go this far? Can China resist this pressure on their 8.28 ft. dike? Would the Bushies really hope to provoke the chaos that would ensue?
For my $0.02, China keeps on eating US debt, and eating, and eating . . . but as we know from Monty Python, if you eat enough, even a wafer thin mint can cause you to explode.
UPDATE: If you like a lot of game theory jargon, Nouriel Roubini has a good post on the same topic today. Suffice to say that Nouriel thinks China is much closer to being fed up with the US than do I. Why? Certainly not because I'm a believer in Bretton Woods II. It's because I have real reservations concerning the key reasons for China calling the US bluff.
China may tire of financing the US for lots of reasons: eventual capital losses on holding of forex reserves are massive; partially sterilized intervention causes dangerous credit and asset bubble, excessive real investment and even larger NPLs with risk of China hard landing down the line; it also causes higher inflation as if you repress fundamental real appreciation driven by relative productivity growth by avoiding nominal appreciation, you will get that real appreciation via higher and socially dangerous higher inflation; and everyone in Asia is free riding on China that is thus overfinancing the US deficit.Let's take these one at a time.
First, massive losses on forex reserves. China is already eating real losses due to open market operations as I mentioned yesterday. 15-20bn renminbi is hardly peanuts, but even these losses have not yet caused the PBOC to shy away from dollar assets. Massive losses, moreover, only result if dollars are exchanged for renminbi. China can avoid all losses by keeping their financial assets in dollars and then buying real US assets down the line -- natural resources, real estate, IBM, whatever.
Second, excessive real investment. Well, so far China is convinced that administrative controls and higher interest rates will keep the lid on investment. Fourth quarter GDP figures suggest that they're having real success on this score: industrial production rose at the slowest pace in more than a year in December and Chinese officials say there will be no let-up on administrative restrictions plus there will be higher interest rates as 2005 progresses.
Third, higher inflation. But China is keeping inflation under control so far, with consumer prices up 2.4% in December, the smallest gain in 10 months.
Certainly China will tire of consuming an ever-increasing amount of dollar denominated financial assets, but in the short term at least, this just seems to be an unpleasant cost of maintaining the peg which is clearly delivering a lot of valuable services to the Chinese leadership.
Moreover, don't forget the Bank of Japan or the European Central Bank. I've said many times that as long as Japan is in deflation, it's ability to consume US debt is practically infinite. It's willingness to do so over the past three years seems to match its ability. The Europeans have not yet moved into supporting the dollar, but could be forced to if the euro sails above $1.40. This is particularly the case in light of the ever-fading export-dependent German economy.
The world is addicted to cheap money, and addicts aren't usually known for the prudence, planning and foresight.