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Some light reading:

Easy to confuse the commitment of one nation to another for an act of friendship. As mid-19th century British Prime Minister Lord Palmerston once commented, nations don’t have friends; nations have interests. The mutual interests of China and the U.S. are the kind that kept the U.S. and the Soviet Union from going at each other with nukes during the Cold War.

China and the U.S. are running inter-dependent bubble economies, relying on the economic equivalent of Mutually Assured Destruction (M.A.D.) to keep one from blowing up the other’s economy. Whether by intent or accident, sooner or later market forces will assert themselves and both economies will go through tough transitions. How will the world look after that?

The Set-Up

The U.S. and China are have distinctly different bubble economies. The Chinese bubble economy runs mostly on credit and corruption, like the Japanese bubble economy of the late 1990s except more extreme.

Although the PRC has made some progress toward achieving other characteristics of successful market economies, the PRC retains many of the detrimental characteristics of command economies. In particular, the PRC’s four major state owned banks and other depository institutions have extended too many questionable loans to the state-owned enterprises and the state-influenced enterprises based on industrial policy, guanxi (i.e., connections) with government officials, or outright corruption. Along with below-market interest rates and distorted prices, non-market lending has sustained the PRC’s unusually high rate of investment in capital assets (i.e., equipment, software, and structures) of 43.6 percent of GDP in 2004. In turn, this high investment rate has boosted the PRC’s real GDP growth rate to 9.5 percent in 2004. However, many state-owned enterprises and state-influenced enterprises are unprofitable. Protected through guanxi from bankruptcy and foreclosure, many state-owned enterprises and state-influenced enterprises are either unable or unwilling to service their debts. Consequently, non-market lending has saddled the PRC’s four major state-owned banks and other depository institutions with enormous portfolios of non-performing loans. Private economists estimate that the cost of resolving the PRC’s bad loan problem would be about 40 percent of the PRC’s GDP. Non-market lending encouraged the state-owned enterprises and the state-influenced enterprises to invest in too many capital assets and the wrong types of capital assets to produce goods and services to satisfy market demand. The eventual liquidation of the resulting overinvestment or malinvestment poses a significant long-term risk to the continuation of the PRC’s economic growth. Given the PRC’s integration with the global economy, a significant slowdown or recession in the PRC could diminish the prospects for economic growth in the United States and other countries around the world.

Chairman Jim Saxton (R-NJ)
Overview of the Chinese Economy
Joint Economic Committee, United States Congress, July 2005

The U.S. bubble economy, as explained in The Big Bet is heavily dependent on speculation in financial assets.

The U.S.-centric global speculative financial system continues to operate as a kind of perpetual motion machine, propped up by the "moral hazard" of central bank policies and the willingness of foreign lenders to support U.S. consumption on credit, in order to fund their own economic expansion at home via export income and domestic savings.

As long as the global system works this way, profit incentives, asset markets, and resource allocation will remain distorted. The system will continue to reward speculators with great wealth while it offers scraps to the inventors. The U.S. educational system will cater to speculators, who pay the endowments, and ignore the inventors, who can’t give them as much money.

After more than 25 years of this, is it any wonder that the entire U.S. economy has organized itself to conform to this financial model: a gigantic, risky, one-way bet that uses trillions of dollars of credit and massive leverage, relying on the savings of foreign workers to fund the bet and foreign central banks to cover the risks?

To keep its credit-corruption economy going, China’s ruling party, the CCP, needs the U.S. to buy Chinese exports at a rate that keeps its economy growing fast enough to keep its new entrepreneur class growing and supporting the regime. If they fail, the CCP loses their core political support base.

Meanwhile, the U.S. needs cheap imports from China to balance out the inflation created by its asset-speculation based economy. Lacking cash savings, U.S. consumers cannot buy Chinese exports except with credit. To get access to credit, U.S. consumers need low interest rates. Thanks primarily to China now, and Japan and the UK in the recent past, purchases of U.S. treasury debt keeps U.S. interest rates low, allowing North Americans to re-finance their homes to free up cash to pay for hammers and nails at Made in PRC.

Low cost labor is one reason why Chinese exports are cheap. The wage rate for the average GM factory worker is about $74 per hour versus $3.50 for a factory worker in China, where they are are more than 100 auto companies in operation. When Chinese cars start to hit the U.S. market in volume in a couple of years, they will be comparable to Korean cars today but at two thirds to half the price if the current exchange rate between the Chinese currency, the Renminbi (RMB), and the U.S dollar hold. This is the most important factor keeping Chinese exports cheap for North Americans; an exchange rate that favors Chinese exports. U.S. officials say the RMB is too cheap. The Chinese say the problem is not enough saving in the U.S. Both assertions are true. Fact is, that in addition to indirectly supplying U.S. consumers with the cash and credit needed to buy Chinese stuff, the CCP’s purchases of U.S. treasury debt also strengthens the dollar because every time the CCP buys U.S. treasuries they need to convert RMB into dollars. This help keeps demand for dollars high and the dollar strong. That helps keep Chinese goods inexpensive priced in dollars.

The Stand Off

As the political heat over jobs due to Chinese imports rises in Congress, the U.S. threatens China with trade sanctions and tariffs if the CCP does not let the RMB increase in value to make U.S. exports more competitive. It’s generally believed by members of Congress that the RMB is undervalued by about 40%. But if China actually does as the U.S. asks, U.S. interest rates will increase, the U.S. housing market will decline in earnest and the asset-speculation based U.S. economy may go into a tailspin. China counters by threatening to stop buying U.S. treasuries at the same torrid pace if the U.S. slaps tariffs on Chinese goods. But if the CCP actually carries out this counter-threat then exports to the U.S. decrease and China’s credit-corruption bubble economy may go the way of the Japanese bubble economy in 1991.

An economic version of M.A.D. keeps the two co-dependent bubble economies “in balance.” Will economic M.A.D. work as well as the nuclear version?

The Chinese government is a totalitarian capitalist regime that has over the past several decades evolved from a communist into a capitalist totalitarian state. With the notable exception of perennial hawk Michael A. Ledeen, writing for the Wall Street Journal in 2002, few have stated this in public, and you will never hear it out of a member of the U.S. Congress for two reasons.

The first is obvious: the U.S. counts heavily on China for purchases of U.S. treasury debt to fund outrages fiscal deficits (PDF File) and for cheap imports to balance out strong inflationary forces within the U.S. asset-speculation economy that show up dramatically in commodities like oil that must be imported and in non traded goods and services, such as health care and education. To enable politically popular “Something for everyone!” government spending and support the “Every ticket is a winner!” asset-speculation economy, the U.S. relies on a country that increasingly puts political dissenters in concentration camps, shoots villagers who dare stand up to corrupt local politicians who confiscate their land, and jails anyone who offers even mild criticism of the government. This dependency eliminates the incentive for the U.S to get its fiscal house in order, put an end to reliance on asset-speculation for economic growth, and make a principled choice to not finance a totalitarian regime that continues to move away from the principles of liberty and freedom on which the U.S. was founded.

The second reason given for engaging versus shunning the CCP is that a policy of engagement is expected to lead to greater democratization of China. By doing business with the CCP, the U.S. is encouraging capitalism and trade. This will eventually lead to greater democracy in China. If the CCP does not increase personal freedoms to meet the demands of the nation’s burgeoning entrepreneur class, growing political instability will force the change. All these newly minted capitalists will press for personal liberties to match their economic liberties. The old – literally -- leadership will die off to be replaced by younger, more democratic minded leaders who grew up immersed in Western ideas of democracy and freedom. This line of reasoning is justified with research that shows that the more a country is involved in trade, the more likely that country is to address human rights and other social issues.

This is a politically convenient confusion of correlation with causation. Capitalism and trade may correlate to greater political freedom but does not necessarily cause it. The institutions of democracy do not grow naturally from the mechanisms of trade. A strong political class has to build them with outside help. How about China's new middle class and wealthy capitalists? Not likely. The credit-corruption system is making them rich. They are not motivated to rock the boat, especially when doing so can land you in prison.

As Ledeen pointed out in his WSJ piece, “It is… wrong to think of contemporary China as an intensely unstable system, riven by the democratic impulses of capitalism on the one hand, and the repressive instincts of communism on the other. Fascism may well have been a potentially stable system, despite the frenzied energies of Hitler's Germany and Mussolini's Italy. After all, fascism did not fall as the result of internal crisis; it was destroyed by superior force of arms. Fascism was alarmingly popular; Hitler and Mussolini swept to power atop genuine mass movements, and neither Italians nor Germans produced more than token resistance until the war began to be lost.”

How does it end?

Dangerous as it was, M.A.D. nuclear policy worked. There were a couple of close calls, but no nuclear war between the U.S. and the Soviet Union. The U.S. and the Soviet Union developed communications methods and checks and balances to help prevent accidents. Luck played a big part. The U.S. applied the economic screws on the U.S.S.R., raising the costs of military confrontation until the Soviet economic system failed, which was inevitable in any case.

The current economic version of M.A.D. between the CCP and the U.S. may turn out to be as lasting and positive for the U.S. as nuclear M.A.D. was between the U.S. and the U.S.S.R. but for three major differences. Capitalism has made the CCP wealthy and powerful, supported by a large and growing capitalist class, whereas socialism brought the Soviet Union’s leadership to ruin, a lesson not lost on the CCP. Maybe free trade makes democracy more likely in China but shoveling U.S. capital assets and productive capacity into China and increasing dependency on China’s capital and labor to fund America’s fiscal profligacy and economic dysfunction takes away U.S. leverage to press the CCP for social reforms. Either bubble economy may go through a crisis for reasons neither country either expects or desires, but that doesn’t mean such a crisis might not be instigated by one that foresees an end-game advantage.

If the brewing confrontation between Iran and the U.S. breaks out into open hostilities the result will be a spike in oil prices and interest rates in the U.S. The asset-speculation economy will take a major hit. How will China’s credit-corruption economy fare? China has oil and gas deals with Iran and it has been credibly asserted that the CCP played a role in the election of Iran’s current anti-U.S. leadership. The CCP also has oil deals with an increasingly dictatorial Russia and overtly anti-American Venezuela. When the dust settles after a possible a U.S./Iran crisis, China winds up with oil, enormous productive capacity and trade partners across Asia, South America and Europe. And what does the U.S. have?