Thursday, July 28, 2011

Spooky Debt to China

We tend to be spooked by the amount of our debt held by China. It makes good late-night comedy and cartoons abound. 
"Chinese President Hu Jintao was hinting that China may not loan the U.S. any more money. President Obama is now talking to him about a reverse mortgage." –Jay Leno

"The President of China is in Washington. It's a bit like when you're into your bookie for more than you can afford, and he stops by the house to say hello." –Jimmy Kimmel
We seem sure that China finances our profligate spending and resulting trade deficit. Nothing could be farther from the truth. Our spending shows up in our own loan balances.

The myth is that foreign investment funds our trade deficit. To be sure, we typically have imported more than we export for the last four decades.
Suppose we want to buy a Japanese car, many of us have done that. First we go to a bank and get a loan on reasonable terms, we draw on that loan to pay for the car and drive happily away. There is more happiness all around. The bank is happy to have the loan as an asset, and the car company is glad to have the money in trade for the car. 
Big deals work the same way. Walmart gets a boatload of Chinese stuff that it buys with a loan and the intent of making a profit when it sells the stuff to us. In neither case is there any foreign capital involved; there is just our private credit.
However the foreign country, Japan, China, or another trading partner has some dollars after the trade and can buy with those dollars any dollar denominated assets or convert to another currency. If they choose to buy safe US Treasury assets and we wish to sell them, it can be done. It is a matter of making a transfer from their checking (reserve) account at the Fed to a time deposit.
Our credit has funded their desire to acquire US dollar assets. Yes, it is that simple.

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