The flow of money in the U.S. for the last several years has been as follows. Somebody in the U.S. buys something made in China. The dollars are aggregated and sent back to the Chinese manufacturer. The manufacturer converts them to Chinese renminbi at a Chinese bank at the government mandated exchange rate. The Chinese bank is required by the Chinese government to send the dollars to a couple of government controlled institutions. Those institutions wind up with a lot of dollars–a million dollars a day, or something like that. They take most of those dollars and use them to buy U.S. Treasury bonds. I may have some details wrong, but that is the general trend.
The Chinese goverment keeps this flow running smoothly by controlling the exchange rate. The exchange rate is lower than one would normally expect. This has the effect of keeping prices in the U.S. low: the dollars we send buy more renminbi than one would expect, which multiplies the effect of the relatively low wages in China. Conversely, it means that Chinese workers get less renminbi than one would expect, which means they have less ability to buy things made outside of China. Thus the policy encourages the U.S. to import goods from China.
However, most of the money actually winds up back in the U.S. By consistently buying U.S. Treasury bonds, the Chinese government is holding down interest rates in the U.S. This makes it easier for people in the U.S. to borrow money and buy more things, many of which are made in China. Without this money flow, the interest rates on Treasury bonds would rise. The U.S. government can not stop issuing bonds because it is so deeply in debt. If the money flow stopped, he effect would be that money in the U.S. would be diverted from productive investment into investment in Treasury bonds. It would be more expensive to borrow money. Of course, on the Chinese side, money in China is being forced into investment in U.S. Treasury bonds, rather than being used as productive investment in China.
So this flow of money is good for the U.S.–interest rates stay low, money is invested productively, the government can run a large debt without pain–and bad for the U.S.–goods are imported from China, discouraging local manufacture, effectively exporting manufacturing jobs to China. And the flow of money is good for China–lots of exports to the U.S. mean lots of local jobs–and bad for China–the money being made by Chinese workers is not being invested in China, Chinese workers can not afford to buy imported goods.
As a steady state, this is workable. Since workers in China are starting from such a low base, even the share of money and investment that they do receive is a significant improvement. It will take a long time for them to get up to the level of the U.S., when some adjustment would have to be made.
However, it’s not a steady state. The Chinese goverment is getting more and more dollars, and using them to buy more and more U.S. Treasury bonds. That process can not go on forever. Therefore, it must stop.
One good way for it to stop would be for the U.S. government to stop running a deficit. This is not silly–until the early ’80s the U.S. was the largest creditor rather than the largest debtor, and even recently the U.S. ran a surplus in the late ’90s. If the U.S. started to run a surplus it would stop selling Treasury bonds, and the Chinese goverment would find new things to do with their dollars. They could invest them locally in China, or, if they wanted to avoid the resulting inflation, they could invest them back in the U.S. in some more productive way. The accumulation of dollars in China would stop, and the bonds which the Chinese government currently holds would be paid off over many years.
That does not seem to be a particularly likely scenario at the moment. However, it is not impossible. If the next president is a Democrat, it is likely that the Bush administration tax cuts for the very wealthy will expire, and it is likely that spending on Iraq will decrease. These steps could move the U.S. economy back toward a surplus without significant harmful effects.
Another likely scenario is that the Chinese goverment stops buying U.S. Treasury bonds, and instead starts investing their dollars elsewhere. The U.S. government will still be running a deficit, and will still have to sell bonds. Interest rates will go up significantly. It will be harder to borrow money in the U.S. Investment will go down. The economy will slow down. People will have less money to spend on Chinese goods. The Chinese govermnent will accumulate fewer dollars.
A responsible U.S. government will break this money flow in a way which is advantageous, or at least not harmful, for the U.S. Unfortunately the current government is not responsible, and none of the candidates are talking about how they would handle this issue. The problem only gets larger over time. The sooner it is tackled, the better.