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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.

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, 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.

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.

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 – 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.

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

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.

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.

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.

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.

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?

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.

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