President Obama Takes a Bow

The ferocious criticism of the now notorious bow with which Barack Obama greeted his counterpart Wen Jiabao during Obama’s recent Asia trip is a further demonstration (as if we really needed one) of how some on the Right will do or say almost anything, no matter how silly, to try to discredit the President. Unfortunately the episode also demonstrates how both the President’s critics and supporters, as well as our terminally dumbed-down national media, are missing the real issue.

Many politicians on the Right were quick to denounce the bow – one of several Obama made on his Asia trip - as an unprecedented sign of “weakness” by an American President. Their cronies at Fox News, who apparently would view anything even approaching journalistic integrity and objectivity as similarly unprecedented signs of weakness, rolled out the usual array of pundits to analyze the bows – even attempting to calculate, with the aid of multiple slow-motion replays, its exact angle. Across the great media divide, MSNBC predictably scoured its film vault for footage of former Republican Presidents bowing to foreign heads of state and gloatingly aired the images as yet another example of right wing political hypocrisy.

Poor Obama. The Asia trip in general, and his time in China in particular, seem to have been an unmitigated public relations debacle that has done nothing to reverse the slow but steady erosion in his job approval ratings. Even the New York Times editorial pages uncharacteristically chided him – for allowing the Chinese to manage his schedule, and for his failure to speak out as strongly as George W. Bush on issues like human rights, the undervalued renminbi, the Iranian and North Korean nuclear programs, etc. But all of the overblown commentary on the bow begs more serious questions about the economic relationship between China and the United States.

Both political parties need to acknowledge that the United States has made itself beholden to China – not just as our principal source of cheap clothing, shoes and the endless array of electronics and consumer goods that Americans seem unable to do without, but as the principal source of financing for the Federal government. The Chinese now own roughly $800 billion in U.S. government securities, and the American economy is increasingly dependent on the Biejing’s willingness to roll this debt over month after month, year after year.

How did we find ourselves in this situation? It’s not complicated. It was in large measure the Chinese who financed George Bush’s reckless military adventures in Iraq and Afghanistan, his irresponsible tax cut for the rich, the “no strings attached” Wall Street bailout and eight straight years of budget deficits. It was the Chinese in large measure who helped Bush and his economic team – probably the most inept in modern American history - maintain an illusion of domestic prosperity while turning Bill Clinton's budget surplus into the deficit of over $600 billion that was dumped on Obama’s doorstep.

Given all of this, one can only wonder why Republicans strategists think it’s smart politics to portray Barack Obama as looking “weak” in his dealings with the Chinese. Like it or not, the position of the U.S. China has weakened over the last decade, and the irresponsible “borrow and spend” policies of the Bush era are the principal cause.

Statistics about the Federal deficit and public debt lend themselves to manipulation, so it’s important to understand what we’re talking about here. The U.S. public debt is currently a whopping $12 trillion. Some argue that even though the total debt may be a problem, the fact that we owe the Chinese “only” $800 billion, less than 7 percent of the total, isn’t such a big deal. They’re dead wrong, and the reason lies in what the public debt represents.  It is made up of a number of separate components, the largest (roughly 50 percent) being the surpluses in governmental trust funds (such as the Social Security Trust Fund), which are required by law to be invested in Treasury Securities. More on the trust funds in a future commentary. Suffice it to say that to the extent the trust funds are in surplus, the government has to borrow less money on the open market to finance its operations than the size of the public debt and annual budget deficit would imply.  That might seem like good news, but it really isn’t, at least in the long term, because as the trust fund surpluses diminish, the securities held in the trust fund have to be sold, thereby increasing the public borrowing requirement beyond the amounts that the annual budget would indnicate.

The Federal Reserve also buys and sells government securities in the market to regulate supply and demand and control interest rates.  In addition, many securities are owned by domestic entities The balance, roughly $3.5 trillion (as of September 30, 2009) is held by foreign governments and institutions And that is what we need to focus on.

Of the $3.5 trillion in foreign-held government securities, China’s share accounts for roughly 23 percent. Japan, the second biggest holder, owns roughly $750 billion, or 21 percent. But of equal or greater concern is the trend that has emerged over the last decade. When George W. Bush took the oath of office for the first time, the portion of the public debt in foreign hands was, in round numbers, $1 trillion.  Of that amount, China held only 6 percent, or $60 billion.  Under Bush, the total foreign-held debt increased by over 200 percent, but Chinese holdings rose over the same period by over 1,000 percent. Though the President will fault the economic policies of his predecessor, the trend has continued unabated under Obama and China continues to absorb a disproportionate amount of the net increase in foreign-held U.S. public debt.

The ballooning public debt is bad in and of itself.  We should recall that the Soviet empire was brought down not by force of arms, but by the collapse of its domestic economy.  Fans of Ronald Reagan credit his policies for reducing the USSR to economic ruin. Unfortunately it’s little exaggeration to say that the policies of his ideological successor, George W. Bush, have done much the same for the United States.   Economic power ultimately begets political power, and the continued concentration of the U.S. public debt in the hands of China has implications for China’s pretensions as a world super-power.

A May, 2009 report by the Congressional Research Office (CRO) downplays the risks of financial dependence on China. If China were to reduce its dollar holdings significantly over a short period of time, the report acknowledges, interest rates would rise, also significantly, domestic investment would decline and growth rates would fall, triggering potential recession. However, the report argues, China is unlikely to take such action because it would hurt itself in the process. The value of its remaining dollar-denominated assets would decline and its trade relationship with the U.S. would be placed in jeopardy, in part because of reduced U.S. demand in general, and in part because any precipitous action by China would likely lead to a "protectionist backlash" against Chinese products. On the other hand, a gradual reduction in China’s Dollar holdings could actually have a net beneficial effect on the U.S. economy, because the reduction in the trade deficit that would accompany a depreciation of the dollar could offset the adverse economic effects of higher interest rates.

I think this is muddled, complacent and dangerous thinking.

First, the report fails to recognize that the issue is not simply whether and how China would reduce its portfolio of Treasury securities; if China simply were to stop increasing its holdings to match the growth in the public debt, interest rates are likely to rise and this could adversely affect whatever fragile recovery may be beginning. But I don’t rule out a move by the Chinese to start making net reductions in their Dollar exposure, at least until they have a higher level of confidence in the U.S. government’s willingness and ability to manage the economy. I also don’t buy the CRO’s conclusion that the resulting interest rate increase would be accompanied by a decrease in the value of the Dollar, thereby improving the trade deficit.  That’s the muddled thinking.  It’s also at odds with a study by the same CRO only 5 years ago that reached exactly the opposite, and generally accepted view: that a rise in interest rates tends to make Dollar-denominated assets more attractive, thereby increasing the value of the Dollar, which negatively impacts the balance of payments (except in the worst case scenario where huge numbers of Dollars are dumped on the market within a short period of time).

According to the Treasury, China is restructuring its portfolio of Dollar holdings and moving toward shorter-term maturities. The CRO believes this is simply because shorter-term securities are viewed as “safer”.  That's the complacent thinking. One can equally speculate that the move towards shorter maturities is designed to enable China to reduce its portfolio more rapidly, less disruptively and with less risk to the value of its remaining holdings. Only time will tell.

The dangerous thinking is to assume that China is so afraid to jeopardize its trade relationship with the United States that it will dutifully keep piling up IOUs as long as Uncle Sam can keep printing them. China has responded to the global recession by stimulating national demand and recent events must have demonstrated to China’s leaders the danger of over-dependence on export markets, especially in the developed world. Over time, and perhaps not too much time, the U.S. market will become less critical for Chinese manufacturers.  And you can be sure the Chinese won’t be scared by the prospect of a hypothetical “protectionist backlash”. At the end of the day, U.S. consumers vote with their pocketbooks and everyone, with the possible exception of the CRO, knows it. The likes of Walmart, who these days seem to stock their shelves almost entirely with Chinese products, certainly do.

The Chinese have repeatedly and publicly made clear their concerns about the long-term stability and value of the Dollar.  According to recent press reports, Chinese Treasury officials have been consulting at length with their U.S. counterparts about the long-term budgetary implications of health reform, stimulus spending and other “big ticket” government programs.  The United States is starting to take on the appearance of a free-spending but impecunious rake, repeatedly begging a stingy rich uncle for money with the promise that “things will be different this time”.  It’s little surprise that the Chinese have questioned the continued reliance on the Dollar as a reserve currency and the fact is that we are likely to see a gradual (or perhaps not so gradual) movement toward use of currency “baskets” such as the SDR in international commerce.  This will also have serious implications for U.S. fiscal policy, but in the interim, given China’s continued importance as a purchaser of U.S. government securities, this is hardly the most appropriate time for Obama to publicly bash the Chinese on exchange rate policy.  It is in part Chinese purchase of Dollar-denominated securities that prevents slows growth in the value of the remninbi; in addition, the exchange rate is a concern not just for the U.S. but for the West in general and is best addressed on a multinational level. I think Obama understands this, and on his recent trip he set precisely the right public tone.

Back at home, the President’s critics, and the American public, need to understand that the best way to restore strength to the U.S. relationship with China is not through public posturing on contentious issues, but by getting control of the Federal budget deficit.   Both Democrats and Republicans need to play a constructive role in that process.  The Democrats need to freeze further wasteful “stimulus” spending that is not targeted specifically at investments in productive capacity and infrastructure.  Republicans must play their part by accepting health care reform proposals that lower the deficit, by agreeing to roll back George Bush’s tax handout for the wealthy and by supporting responsible efforts to curb the ruinously expensive military operations in Afghanistan.  That will require from our politicians a lot more intellectual effort and political courage than making silly cheap shots about Obama’s “bow” to the Chinese – but if they don’t they will only have themselves to blame if future American Presidents have to bow even lower, and with cap firmly in hand, to their bankers in Beijing.