Real money

by Russ Roberts on March 13, 2009

in Politics

China is worried:

The Chinese prime minister, Wen Jiabao, expressed unusually blunt concern on Friday about the safety of China’s
$1 trillion investment in American government debt, the world’s largest
such holding, and urged the Obama administration to provide assurances
that the securities would maintain their value in the face of a global financial crisis.

They probably should have gotten the guarantees before they bought the securities.

Interesting to know that China has a trillion dollars of our debt. That's it? What are they so worried about? They have a billion or so people. That's only $1000 per capita.

Of course if you think of the Chinese system as a bit of a kleptocracy benefiting the top echelon of the political class disproportionately and assume that class has maybe 1000 influential people, that's $1 billion per relevant person. That would be real money. No wonder they're worked up.

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MnM March 13, 2009 at 4:50 pm

They probably should have gotten the guarantees before they bought the securities.

They probably should have understood that there are no such guarantees when making investments.

vikingvista March 13, 2009 at 5:24 pm

But just wait. Obama will make some special deal with the Chinese to encourage them to finance more US debt. It may be special terms on the debt that the rest of us cannot get, or may be something far more dangerous.

The danger for us is not the debt that China has, but the fact that our government is so desperate to get them to finance more of it. China knows this, and that is why they are posturing.

murigeo March 13, 2009 at 5:38 pm

Maybe we should just give them some of the triple A rated CDO's we now jointly own and assure them that they are good as cash….really!

Mike Farmer March 13, 2009 at 5:55 pm

China may put spending limits on the US and demand we not use Air Force One, and quit ordering expensive steaks.

Randy March 13, 2009 at 5:56 pm

Vikingvista,

Agreed. Its posturing.

Martin Brock March 13, 2009 at 6:10 pm

Of course if you think …

Halfway through your post, I was already thinking the same thing. The real question for Chinese statesmen and everyone else in the world holding U.S. securities is simple. What can you buy from the United States with those dollars? If you expect everything on Earth to hold its value in dollars, you're probably delusional. Even if you expect goods produced in the U.S. to keep their dollar value as well as they have in recent decades, you're still delusional. We've gotta pump up other prices until they make our housing prices sustainable. That's just how the monetary system works.

Methinks March 13, 2009 at 6:14 pm

Somebody, please check the temperature in hell and also look outside and see if you can spot flying swine. Even though Muirdiot doesn't know the difference between a marshmallow and a CDO, if you think about it, that's sort of what's already happened.

Bret March 13, 2009 at 6:18 pm

China has over 1.3 billion people so a mere $750 a head.

Bob D March 13, 2009 at 6:23 pm

No Tickie, No Shirtie! Translation: You put your money up and if your ticket doesn't say you are indexed to inflation, you are SOL!
I guess the paper that the Chinese are holding is about as good as that crap they sell at the 99 cent store once Uncle Ben and Tiny Tim start up the money printing press!

maximus March 13, 2009 at 6:52 pm

They'll demand defense toys to build up their military technology. They also hold the N Korean card. And you just know the messiah will give em what they want. Just send Old Joe hairplug VP out there to tell everybody it's ok. Oh yeah and Holbrooke too. Those two have never been snookered before, right?

Mesa Econoguy March 13, 2009 at 7:20 pm

What China should do is 1) hire a good attorney, or any attorney, 2) tell them they were misled at the time of purchase of these securities, and that they entailed way more risk than was thought, and 3) tell Andrew Cuomo, who will require the US government to repurchase those securities at the original purchase price (and he’ll probably throw in some punitive damages just so the Chinese don’t think we’re stingy and limit absurdly inflated monetary awards to US residents only).

Problem solved.

Crusader March 13, 2009 at 7:20 pm

Methinks – if muirgeo wandered onto the trading floor, would you have security deal with him?

Lee Kelly March 13, 2009 at 7:55 pm

Martin,

What are the Chinese going to buy with all their dollars? Perhaps a derelict shopping mall, statue of Obama the Great, or sports merchandise, or perhaps not. But what about food? What happens to the price of food in the U.S. if the Chinese start buying? What happens when all those trillions of dollars of fresh bank reserves find their way onto the market?

Martin Brock March 13, 2009 at 7:58 pm

… require the US government to repurchase those securities …

But an obligation of the U.S. government to repurchase the securities with dollars is exactly what the Chinese have already.

Crusader March 13, 2009 at 7:58 pm

Lee Kelly – last I heard China is facing such a severe drought that a huge crop shortage is imminent. Who cares about trade-fueled prosperity when you can't even feed your own people?

Martin Brock March 13, 2009 at 8:07 pm

What happens to the price of food in the U.S. if the Chinese start buying?

Good question. Food prices rise faster than other prices. Per capita U.S. food consumption drops. More U.S. land and labor shift into food production.

Something like 20% of Chinese labor still works in agriculture, compared with something like two percent of U.S. labor. U.S. agriculture is far more efficient, and obesity is a national epidemic here. I suppose these changes could be a plus for everyone.

Mesa Econoguy March 13, 2009 at 8:10 pm

Not at the original purchase price, Martin. And there is no “guarantee,” tho everybody knows that the full faith & credit of the US government is golden, because it’s never defaulted before. Don’t look now, but there’s a major disaster looming in about 10-20 years with things like socialist security bills coming due.

What Cuomo did in the auction rate securities market (which no longer exists, because of him) was just that.

So, why not try that here? Here you go, sorry to have taken your money, and here’s a little extra for your trouble.

Yes, I'm being slightly facetious.

LowcountryJoe March 13, 2009 at 9:00 pm

Of course if you think of the Chinese system as a bit of a kleptocracy benefiting the top echelon of the political class disproportionately and assume that class has maybe 1000 influential people, that's $1 billion per relevant person. That would be real money. No wonder they're worked up.

The Left just doesn't get how something like this could happen. All the talk about equalizing incomes and all the centralization of power required to pull it off, it's no wonder how government becomes a very small group of 'elites' who live large and reign for lifetime periods while the rest live in equal misery. All the Leftist that come onto this message board and spout their big-government nonsense have got to reconcile the tendancy for the bureaucrats to become tyrants before you'll gain any kind of traction with your forced altruism/compassion bullshit.

Andrew_M_Garland March 13, 2009 at 9:08 pm

China should be worried, because they are being demonized by Alan Greenspan for making too much capital available! They enticed "us" into taking out bad loans. They are predatory lenders. (I think that is what he is saying.)

The Fed Didn't Cause the Housing Bubble
WSJ by Alan Greenspan
http://online.wsj.com/article/SB123672965066989281.html

"The result was a surge in growth in China and a large number of other emerging market economies that led to an excess of global intended savings relative to intended capital investment. That ex ante excess of savings propelled global long-term interest rates progressively lower between early 2000 and 2005.

That decline in long-term interest rates across a wide spectrum of countries statistically explains, and is the most likely major cause of, real-estate capitalization rates that declined and converged across the globe, resulting in the global housing price bubble.
"

Martin Brock March 13, 2009 at 9:49 pm

Not at the original purchase price, Martin.

The bonds, other than TIPS and the like like, promise the original purchase price, in dollars, plus interest over time. That's all they promise. Buyers understand that they're buying this promise from the same authority entitled to create dollars.

Don’t look now, but there’s a major disaster looming in about 10-20 years with things like socialist security bills coming due.

Looming? Seems like the financial disaster is already here.

The projected deficit in the Social Security system over 75 years is only a bit more than the bailouts of the last year. The Bushniks forgot that a three trillion dollar deficit over 75 years is catastrophic when they decided to hand Henry Paulson a trillion bucks in one fell swoop. You'll never convince anyone that Social Security is a problem now.

Bush, Paulson, McCain, Obama and all the other bailers out have destroyed the argument for Social Security reform based on the system's "insolvency". Everyone knows that when a system's insolvent, we just authorize the Treasury to bail it out.

Gil March 14, 2009 at 1:37 am

"What China should do is hire a good attorney, or any attorney . . ."

I'm sure the attorney would then say "tough cheese" or something like that. He also probably say why invest in that which U.S. government could honour through umpteen goods&services or that the U.S. government could give up and fire up the printing presses? It'd be akin to Bill Gates all of a sudden saying he's wanting to give 1,000,000 Microsoft shares, I initially think I'm rich when I get ownership of the shares, only to watch the news saying Microsoft is defunct and Bill Gates has disappeared into South America. I can't say I get cheated in any way, regardless if the shares were a a payment for my sevices because I got what he offered – 1 million shares of Microsoft. Likewise the Chinese would have to consider whether the U.S. would actually engage in hyperinflation to pay them back. If China feels cheated then next time they should ask for gold or silver as payment.

Mesa Econoguy March 14, 2009 at 11:27 am

The bonds, other than TIPS and the like like, promise the original purchase price, in dollars, plus interest over time. That's all they promise.
Posted by: Martin Brock

No Martin, they don’t. Bonds promise repayment of principal only, along with a stated periodic interest rate.

In case you haven’t noticed, the Chinese are massive consumers of US Treasuries (as are the Japanese), and this consistent demand has driven up the price of these instruments, keeping yields low for some time (some economists have pointed to this as a problem). So it is very likely that the Chinese paid a premium for these bonds (i.e. greater than par), and would be disadvantaged should they be refunded only at par, which is the source of your confusion.

As for socialist security, probably right, especially if the "reforms" Obama is proposing are enacted, and we have a "lost decade" like the Japanese did in the 1990s.

Mesa Econoguy March 14, 2009 at 11:30 am

I'm sure the attorney would then say "tough cheese" or something like that.
Posted by: Gil | Mar 14, 2009 1:37:42 AM

No Gil, that’s precisely the problem, and one of the wondrous features of the US legal “system.” See the ARS link above.

Martin Brock March 14, 2009 at 2:50 pm

No Martin, they don’t. Bonds promise repayment of principal only, along with a stated periodic interest rate.

What is "the principal", from an investor's perspective, if not original purchase price? I may pay you more for a bond than you paid for it, but on my books, my purchase price is still my "principal".

In case you haven’t noticed, the Chinese are massive consumers of US Treasuries (as are the Japanese), and this consistent demand has driven up the price of these instruments, keeping yields low for some time (some economists have pointed to this as a problem).

I've noticed.

So it is very likely that the Chinese paid a premium for these bonds (i.e. greater than par), and would be disadvantaged should they be refunded only at par, which is the source of your confusion.

Regardless of face value, the Chinese know what they paid for the bonds, and they know the effective interest rate implied by this price if they hold the bonds to maturity. This is what I meant by "original purchase price", not the face value of the bonds. They presumably did not pay more dollars for the bonds than the dollars they expect in return.

What the Treasury perceives as "principal" and what the Chinese perceive as "principal" may be different, but this fact is beside the point I was making. If the Chinese hold the bonds to maturity, they'll get the dollars they expect, regardless of which dollars you label "principal" and "interest".

When the Chinese sought "assurances that the securities would maintain their value", they were worried about inflation, not default. That's my point. We'll never default on the bonds, because we can create dollars to repay them.

Martin Brock March 14, 2009 at 2:55 pm

In fact, if Bernanke starts buying long term Treasury notes in open market operations, rather than the short term bills, as he's suggested he might, he'll drive the price of China's bonds up, so they could get receive more dollars they expected based on their original purchase price, but of course, this Fed policy could be inflationary, so they might expect to purchase less, even with more dollars.

Kevin March 14, 2009 at 2:55 pm

No Martin, they don’t. Bonds promise repayment of principal only, along with a stated periodic interest rate.

You guys can argue about what the promise is if you want, but the broader point is that the Chinese currently hold promises from the US Treasury to pay dollars. What more assurance could they have? Another promise just as likely to be kept/broken? They're not talking about collateral yet, are they?

Martin Brock March 14, 2009 at 3:01 pm

As for socialist security, probably right, especially if the "reforms" Obama is proposing are enacted, and we have a "lost decade" like the Japanese did in the 1990s.

You mean "another lost decade". We lost the last one too. That's why we're in this fix right now.

Martin Brock March 14, 2009 at 3:05 pm

What more assurance could they have?

Well, like Gil said, they could have demanded repayment in gold, but then they wouldn't be holding U.S. Treasury securities, because the Treasury doesn't sell promises to pay gold. They bought the promise of dollars, so that's what they have.

Bill March 14, 2009 at 4:35 pm

Martin: What is this "lost decade" nonsense? I made a lot of money personally in the 2000s and still have most of it. I would also note that the Obamas did quite well financially over the last 10 years. It has been a rags to riches by way of corruption story for them.

BTW, I find it amusing how leftists only believe economic downturns are "real" and prosperous times are all "false". This is probably due to some psychiatric condition, I would imagine.

Mesa Econoguy March 14, 2009 at 4:36 pm

Martin, principle is the face value of the bond, i.e. $1000 (I think they’re down to increments of $100 now). Premium is the amount above $1000 you paid for said bond. At maturity, bonds repay $1000, and that’s it. If you paid greater than $1000, as the Chinese probably did, you won’t get that back, and it reduces the bond’s yield (bond yield and price are inversely related).

The guarantee that they’re looking for here is guarantee of the repayment of the $1000, not the interest, and not any overage paid to acquire the bond.

Correct, if the price of the bond goes up, their holdings would increase in value, though to capture that, they would have to sell at least part of their holdings, and because that holding is so large, they would likely drive down the price.

Mesa Econoguy March 14, 2009 at 4:39 pm

Actually, they’re probably looking for assurance on the interest, too, as our ability to pay that is similar to repayment of the principle.

Zachary Kurtz March 14, 2009 at 4:43 pm

isn't the annual income per capita in China about $1000?

Mesa Econoguy March 14, 2009 at 11:22 pm

China:

GDP – per capita (PPP):
$6,100 (2008 est.)

GDP – composition by sector:
agriculture: 10.6%
industry: 49.2%
services: 40.2% (2008 est.)

Labor force:
807.7 million (2008 est.)

Source: CIA World Factbook

Gil March 15, 2009 at 2:29 am

*slaps forehead*

Martin – I said China should next time try and make a contract where the U.S. would have to repay China in the form of silver or gold as to avoid hyperinflation (barring some miracle in mining). Earlier in the post I said China risks getting what they asked when they contract for fancy American printed paper which could either derived from actual trading or plain hyperinflation. Hence my Microsoft analogy.

vikingvista March 15, 2009 at 6:21 am

"Bonds promise repayment of principal only, along with a stated periodic interest rate."

I always thought it funny that TIPS, by being inflation-adjusted, were supposed to be the government's way of protecting you from (government-created) inflation, by preserving the real value of your principle investment.

But if there is inflation (and there always is, by design), the government taxes you on the inflation adjustment. The greater the inflation, the greater the tax. It is essentially a property tax.

And of course who controls both inflation and calculation of the CPI?

Those who recently bought TIPS in response to (the government's) cries of deflation, are going to sweat a few bricks when the banks suddenly rain onto the economy all that funny money the Fed has been pumping into them.

Oh, I forgot. Bernanke told Congress he was going to stay on top of inflation. And the Fed has a stellar record of staying on top of things the last 95 years.

Martin Brock March 16, 2009 at 4:55 pm

Martin: What is this "lost decade" nonsense? I made a lot of money personally in the 2000s and still have most of it.

Me too. I have most of it largely because I held entitlement to tax revenue rather than real productive assets through the end of last year. Hypocritical? Yes. Beneficial to me under the circumstances? Yes. Productive? No. The extra cash in my pocket as a consequence of holding entitlement to tax revenue is no evidence of productivity, mine or anyone elses.

But money in my taxpayer backed bank account is what I suppose was "lost". People made money last year too, and people will make money this year.

I would also note that the Obamas did quite well financially over the last 10 years. It has been a rags to riches by way of corruption story for them.

But not for you?

BTW, I find it amusing how leftists only believe economic downturns are "real" and prosperous times are all "false". This is probably due to some psychiatric condition, I would imagine.

We spent trillions on the warfare state and the ill-conceived "war on terror", as well as the Medicare expansion and other programs, in the last decade. Apparently, the "right" has come to its senses and now embraces the leviathan enthusiastically.

Everything we could have produced with all of these resources is what we lost.

Martin Brock March 16, 2009 at 4:55 pm

But money in my taxpayer backed bank account is not what I suppose was "lost".

Martin Brock March 16, 2009 at 6:02 pm

Martin, principle is the face value of the bond, i.e. $1000 (I think they’re down to increments of $100 now). Premium is the amount above $1000 you paid for said bond.

I'm not a financial professional and don't know the specialized nomenclature well, but I'm thinking of the twelfth sense of "principal" here.

"Finance. a capital sum, as distinguished from interest or profit."

If you pay $1000 for a bond promising you $1100 interest a year from now, $1000 is your "principal", and you expect a 10% "interest rate".

If I then pay you $1050 for the same bond, my "principal" is $1050, and I expect a 5% interest rate. In this sense, "interest rate" goes down as "bond price" goes up, and vice versa.

I know you understand this already. I'm only explaining my point for the sake of others.

At maturity, bonds repay $1000, and that’s it.

They pay this principal plus the promised interest, and Treasury bonds are nominally riskless. The Chinese have little doubt of this nominal return, i.e. they'll get the $1000 at maturity, and they'll get the promised payments in the meantime. If they paid $1050 for the bond, they expect only a 5% interest rate, but they get just what they expect.

If you paid greater than $1000, as the Chinese probably did, you won’t get that back, and it reduces the bond’s yield (bond yield and price are inversely related).

I understand you, but from my perspective, I paid $1050 for the bond and perceive this amount as "my principal" or the capital I've invested, in the sense above. I'll consider my investment nominally "profitable" if I get $1050 and a bit more back.

I'm not disputing your nomenclature here. I'm only explaining what I meant.

Even if the Chinese pay $1000 for a bond with a face value of $1000, they can still receive less than $1000 for this bond in the bond market if they sell it before maturity, if interest rates later rise, because people will not pay them $1000 for their bond paying 3% interest when they can pay the Treasury $1000 for a bond paying 4% interest. Again, I know you already understand this.

The guarantee that they’re looking for here is guarantee of the repayment of the $1000, not the interest, and not any overage paid to acquire the bond.

I don't think so. They already have the only guarantee they can expect. They know what they paid for the bonds, and they know the face value and promised interest, and they have little doubt that they'll get both, so they have little doubt that they'll get back what they paid plus a bit more if they hold the bonds to maturity.

The Chinese have considerable reason to believe that the dollars they'll receive years from now will buy less than the dollars they paid. They've made some calculation of a real interest rate based upon their expectation of inflation. Their fear now is that they assumed too little dollar inflation.

Correct, if the price of the bond goes up, their holdings would increase in value, though to capture that, they would have to sell at least part of their holdings, and because that holding is so large, they would likely drive down the price.

I don't think they'd drive down the price, because the Fed can pay anything it likes for the bonds. The Federal government's holdings of its own bonds (including Federal Reserve holdings) is estimated to rise by $1.7 trillion this year alone. That's an extraordinarily high number, of course, but it's nearly twice the value of all bonds held by the Chinese.

Markets set long Treasury rates ordinarily, because the Fed doesn't ordinarily buy and sell them, but Bernanke has suggested that he might in the future. Investors presumably are speculating on this possibility now.

As an imperial power, the U.S. will not permit the Chinese state to believe that it holds too much leverage.

Methinks March 16, 2009 at 8:59 pm

I have most of it largely because I held entitlement to tax revenue rather than real productive assets through the end of last year.

WHAT???? And this after you yelled at me to put my gun down and invest in something else after I told you all of my investments were in productive ventures? Behold the power of self interest. I claim moral high ground, darn it all!

We spent trillions on the warfare state and the ill-conceived "war on terror",

How dare you? That war created jobs! In fact, I don't know why the Obamessiah is so eager to shut this war down when so many jobs would be lost. He should really start another one to grow jobs.

I don't think they'd drive down the price, because the Fed can pay anything it likes for the bonds.

I don't think this is even the biggest concern. If the Chinese decide to reduce their U.S. Treasury holdings and that is perceived as a bad sign by other creditors, creditors will all stampede for the door in order to not be the last one out of U.S. Treasuries. When that happens, the currency will collapse and inflation will become astronomical overnight.

The goal for the U.S. government here is not to simply buy back the debt, but to convince China to keep holding it. Even that may not be enough. We'll see.

Martin Brock March 17, 2009 at 8:10 am

WHAT???? And this after you yelled at me to put my gun down and invest in something else after I told you all of my investments were in productive ventures?

The context was different, but like I said, holding the Treasuries was hypocritical. I don't deny it. The truth is: if my options were limited enough, I'd probably kick puppies for a buck, maybe even guard Gypsies in concentration camps.

I'm not saying that's a good thing. I'm only saying that I'd probably do it. I don't allow myself the luxury of self-serving delusions of heroism in imaginary scenarios.

Behold the power of self interest. I claim moral high ground, darn it all!

Granted, my noble lady.

He should really start another one to grow jobs.

He seems to be starting another one already, in Pakistan.

When that happens, the currency will collapse and inflation will become astronomical overnight.

Inflation of what? What will the Chinese buy with the dollars the Fed gives them for their Treasury notes? Corn? They need grains in the future, but they can't store it long enough. I suppose they'll buy U.S. stocks, real estate and other assets that have fallen precipitously in value over the last couple of years.

So we'll have astronomical inflation in these assets, prices doubling in a very short time? Yeah. I guess so. But they'll only rise to a level closer to their price a year or two ago. The inflation is a reflation.

From a domestic inflation perspective, I worry more that the Chinese will stop buying the notes as they stop selling us goods and consume more of their produce domestically. The withdrawal of these goods from our domestic markets will raise prices here, and we'll produce more of the same goods domestically.

Fortunately, our economy is highly developed, and we're well able to make this adjustment.

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