Treasury Secretary Timothy Geithner heads for China for talks with officials there early next week. In January, Geithner angered the Chinese government by accusing China of manipulating its currency and undermining free trade. China shot back, blaming the U.S. for sparking the financial crisis.
Certainly, the U.S. bears a large share of the blame for the meltdown, but many economists believe China's currency policy paved the way for the worldwide crisis.
Here's the short argument that China is partly to blame for the crisis: In its rush to industrialize, China ran up huge trade surpluses. It saved too much of the money it made selling its products. Then, it lent too much of that money to America, says Peter Morici, an economics professor at the University of Maryland.
"They accumulated dollars and they invested those dollars in the New York bond market," he says. "That made it inexpensive for banks to lend us money through our homes on mortgages and second mortgages and to loan us money on credit cards and to buy cars."
China, along with some other Asian nations and oil producers, flooded the U.S. financial markets with so much excess cash that it drove interest rates down, providing an irresistible temptation for Americans to take on more debt, Morici says.
"And it meant that the Federal Reserve couldn't pull in the mortgage frenzy when it wanted to," he says. "There was not much the Fed could do. It raised short-term rates, but long-term rates didn't go up with them. Mortgage rates didn't go up. And the terms got easier and easier and people borrowed more and more."
Economist and China expert Nicholas Lardy agrees that Chinese money provided the fuel for the financial crisis.
"The Chinese gave us the rope, but we didn't have to hang ourselves," he says. "If we had had tougher regulation, the inflow of capital from China would not have led to the crisis that emerged over the last year or so."
Lardy says the lack of regulation allowed U.S. investment firms to develop riskier financial products. And they did so with abandon as they tried to boost profits in the low interest rate environment created by the flood of cash from China.
So why did China build up such large and destabilizing surpluses? Lardy and Morici disagree on China's motives. Morici thinks China made a deliberate decision to build its economy and its global power through exports.
"Quite simply, China wants to have a very large trade surplus with the United States as a development tool to employ [people from rural China] in the cities making things to sell here," Morici says. "So what it does is, it keeps its currency cheap."
But Lardy, a fellow at the Peterson Institute for International Economics, says China sort of stumbled into the situation.
Back in the 1990s, China decided to peg its currency to the dollar, a move that was viewed as positive back then. For a while it worked fine. The dollar appreciated and so did China's currency, the yuan. That meant Chinese exports were more expensive. So, despite its increasing productivity, China's trade surplus was manageable.
But early in this decade, the dollar began to fall, and with its currency still pegged to the dollar, China's exports became cheaper. China sold mountains of goods, and its trade surplus soared, Lardy says.
"Their goods became massively more competitive on international markets and they developed large trade surpluses without any precedent in recorded history," he says.
Lardy says some Chinese leaders want a more balanced economy. But he says others, with economic interests in export production, have gotten addicted to the huge profits that exports generate. They're resisting the calls from the U.S. government and others to allow the value of the yuan to rise.
Geithner will raise the issue during his talks next week, but Lardy says that with China holding $1.5 trillion in U.S. debt, the U.S. doesn't have a lot of leverage. Just last month, the Treasury blinked when it declined to officially call out China for manipulating its currency.
"Certainly one of the reasons they probably didn't raise it to that threshold is the very commonsense idea that maybe you shouldn't pick a fight with your banker," Lardy says. "If you need to borrow a lot of money from somebody, you have to treat them, perhaps, with greater deference than you would if you didn't have that dependency."
Morici argues it's the other way around. The fact that China has lent the U.S. so much money actually gives the U.S. leverage. That's because China needs a strong U.S. economy if it wants to be paid back in full.
And, of course, China is still dependent on the U.S. consumer. A Treasury official says Geithner will urge China to seek more balanced growth by boosting domestic consumption and depending less on exports.
In IMF Bonds, A Possible Rival For The U.S. Dollar
hide captionIn March, Chinese Premier Wen Jiabao warned the United States to guard the value of its currency.
Liu Jin/AFP/Getty Images
In March, Chinese Premier Wen Jiabao warned the United States to guard the value of its currency.
Liu Jin/AFP/Getty Images
In times of global economic crisis, the International Monetary Fund lends money to nations in trouble. But in the current recession, the IMF has found that it, too, is running out of money.
"We have made quite a large number of commitments of our resources in the last year," says Craig Beaumont, division chief of the IMF's finance department. The organization has loaned out about $150 billion, leaving it with just another $50 billion on hand.
Now the IMF has decided to raise an additional $70 billion the same way large companies do — by issuing bonds (a first for the IMF).
That part of the story is simple enough, but the IMF bonds touch on a far more profound topic: namely, what the world's reserve currency should be. Reserve currency acts as an anchor and a safe haven. It's the currency everyone measures their own against, and the one everyone reaches for in times of trouble. Right now, the world uses the U.S. dollar.
But emerging players like China and Russia have said they wouldn't mind if that changed.
And that's where this story gets more complicated. The IMF's new bonds aren't denominated in U.S. dollars. Instead, they'll be issued in a kind of hybrid called Special Drawing Rights. SDRs are a mixture of the U.S. dollar, the British pound, the euro and the Japanese yen.
The IMF uses SDRs internally, to calculate the money it lends to various nations. A few months ago, the head of China's central bank suggested that SDRs could become the basis for a new kind of global currency.
"The emerging markets are hoping, and China in particular is hoping, that this will start the debate," says Eswar Prasad, a Cornell University professor who once led the China division at the IMF. The bonds could "also start some real progress toward challenging the U.S. dollar's dominance in international financial markets. The Chinese would dearly like to break free of the embrace they have of the U.S. dollar, because they have no alternative, and they would desperately like to have an alternative."
The Problem Of Dollars
Beaumont, of the IMF, is quick to point out that Special Drawing Rights are absolutely not a currency. They're more of an accounting tool, a way to track where the IMF's money is going.
"No one ever carries SDRs around in their pocket," he says.
The problem for China is that it has more money coming in than it knows what to do with. It sells tons of stuff to the U.S. and gets billions of American dollars in return. Where should it put those dollars? Often, China buys U.S. Treasury bonds, because they're the safest investment around.
The IMF bonds will also be very safe, because they're essentially backed by the entire world.
China has pledged to buy what amounts to $50 billion of the new bonds. Russia has pledged to buy up to $10 billion, and so has Brazil.
Against the scale of the global economy, Prasad says, these amounts are relatively small. But if countries decided they didn't trust Treasury bonds so much anymore and began moving a lot of money elsewhere — say, to IMF bonds — that could be a big deal. It could spook the U.S. bond and currency markets, he says, and they are in a fragile mood.
There are a lot of reasons to think China, for all its trash-talking about the dollar, doesn't want to knock it too much. Brad Setser, an economist at the Council on Foreign Relations and an expert on the relationship between the Chinese and American economies, says Beijing would hurt its own cause by moving away from the greenback. "I don't think this is a step toward a new currency that is going to rival the dollar," Setser says.
That's because China needs the dollar to remain strong. It happens to hold more than $700 billion in U.S. Treasury bonds. And it's still buying more.