Tax Analysts Blog

The Slow Road to Hell

Posted on Apr 1, 2009

The Prime Minister of the Czech Republic is like my brother-in-law Vinny. He’s loud and even in polite company he argues like he’s in a barroom brawl. He (the prime minister) once said in a newspaper interview that the European constitution was “shit.” And at a meeting of his country’s parliament he gave the opposition party the finger. So no one should have been too surprised when Mr. Mirek Topolanek declared Obama’s budget policies were putting the world on “the road to hell.”

Most of Europe’s other leaders would not disagree much with the substance of Topolanek’s comment, but they know better than to say it out loud. Maybe we should cut old Mirek some slack. He was having a tough week (and who hasn’t lately?) The day before his “road to hell” remark his government lost a no-confidence vote and the day after he had to submit his resignation (to take effect as soon as new elections are held).

Czech leader does not like Obama budget
Normally nobody cares what the Czechs think of U.S. policy. But it so happens that from January through June Topolanek is in effect the temporary head of the European Union. The EU presidency is rotated between the 27 member countries every 6 months. And his remarks came in that official capacity in a speech before the EU parliament.

China's Problem with the US

What the Chinese think is another story. They hold about $1 trillion of U.S government bonds and government-backed securities (compared to a measly $4 billion held by the Czechs). And over the last few weeks the world’s biggest lender sent a couple of stinging messages to the world’s larger borrower.

First were the remarks of Chinese Premier Wen Jiabao on March 13 at his annual press conference. “We have lent a huge amount of money to the United States,” said the leader of 1.3 billion people. “Of course, we are concerned about the safety of our assets. To be honest, I am definitely a little bit worried. I request the U.S. to maintain its good credit, to honor its promises and to guarantee the safety of China’s assets.”

China's leader worries about his $1 trillion investment.
Then to drive home the point the head of China’s central bank last week floated a proposal to replace the dollar as the world’s premier currency with money issued an by international body. (In U.S. newspapers the significance of this proposal was overshadowed out by a related story about the troubles of Timothy Geithner. In a momentary lapse of judgment the beleaguered Treasury Secretary responded favorably to the Chinese proposal and sent the currency markets into 15 minutes of turmoil.)

You will often hear scary statements from talking heads and politicians that we should avoid deficits because the Chinese will pull the plug on us and throw us into financial collapse. But the Chinese are too shrewd to make a dumb move like that. Are here are three reasons why:

(1) If the Chinese stop buying U.S. Treasuries (with dollars) the demand for the U.S. dollar would decline and so would its value. That makes Chinese goods more expensive for U.S. buyers and would reduce China’s money-machine trade surplus with the U.S. This would close factories and reduce commodity prices in China. The Chinese could have a peasant revolt of untold proportions on their hands,

(2) Any ensuing market turmoil from a disruptive withdrawal from the U.S. Treasury market would drive down the price of China’s existing $1 trillion portfolio of U.S. bonds.

(3) The hardship to the U.S and other western economies from Chinese avoiding U.S. debt would wreak havoc on the Chinese export markets because U.S. consumers could no longer afford Chinese products. If (1) didn’t already spark a revolt, (3) will.

And besides, as any loan shark or credit card company executive will privately tell you, the most profitable customers are those who have trouble making payments.

The Inflation Solution

The Chinese are not afraid of America going bankrupt. What the Chinese really fear is U.S. inflation.

How can we say that when inflation rates are at historical lows?

The Chinese watch CNN and C-SPAN on their satellite dishes. They see that even U.S. politicians who say they are devoted to reducing the deficit (e.g., Barack Obama) are not serious. They see a Congress that is dysfunctional when it comes to dealing with its own fiscal profligacy. Tax increases cannot be mentioned. Social Security reform is just a topic for academic discussions and blue ribbon panels. To top it all off, the party in control is now hell bent on expanding government support for healthcare. Congressional scorekeepers say the Obama budget plan would more than triple the already humongous government debt — from $5.8 trillion in 2008 to $17.2 trillion in 2019.

For any government that issues debt in its own currency the neatest trick of all is inflation. There is no embarrassing or awkward write down of the debt as there would be with a loan delinquency or default. The value of the Chinese investment in America would just slowly fade away. The Chinese understand this, and they know someday Americans will figure it out too. Just 7 percent inflation for ten years and your debt is cut in half. Of course, any government in its right mind wants to avoid inflation like the devil. But what’s the alternative solution to the debt problem for the U.S.? Can you imagine a Congress like the one we have raising taxes and cutting spending to shrink a ten trillion dollar debt to half its size?

Given the choice between inflation and cutting the deficit any rational government should choose cutting the deficit. But the U.S. government is giving off whiffs of irrationality. Even the House and Senate budget resolutions that pared back Obama’s budget are setting the ratio of government debt to GDP to ever higher levels with no plans to bring it down. There’s a word for that: unsustainable.



So, the Chinese sent a few shots across the bow. There is no serious proposal from the Chinese. Nobody, not even the Chinese, believes the U.S. or other big countries would agree to give up their privileged positions in world financial markets. But they do want the U.S. to get serious about its finances. Their warnings were subtle ways of letting us know without throwing the markets into chaos. We should probably be thanking them.

What the United States should be fearing is higher interest rates.

How can we say that when interest rates are at historic lows?

First of all, current near-zero interest rates are an illusion caused by the worldwide flight to safety from equity and corporate bonds into government bonds. Second, and this is the main point, the Chinese understand that skyrocketing debt and an out-of-order budget process is a lethal combination for bond investors. As the Chinese grow increasingly apprehensive of U.S. inflation they will simply start charging higher interest rates to make up for expected inflation. If we inflate at 7 percent, they’ll charge 10 percent. That was easy — for the Chinese. But if interest rates rose to those heights, the needed tax increases and spending cuts in the United States would be epic. And it is through that channel — and not any sort of national bankruptcy -- our children will pay for the sins of their parents.

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