Wednesday, October 8, 2008

Hu's in Trouble?

The last capitalist we hang shall be the one who sold us the rope. — Karl Marx

Economists assure us that international trade is a good thing. I agree, and I think the advantages of trade are well described by the Ricardian model and comparative advantage. Yet, I worry that every dollar of debt we incur with China is a little more rope for them to use against us.

Here's an imagined conversation between Hu Jintao and George W. Bush to illustrate a repugnant possibility of China's vast holdings of US currency and debt instruments:
[Phone rings in Oval Office. Bush answers.]
W: This is W.
Hu: Howdy cowboy! Hu here.
W: The 2008 games... Great show, great show...
Hu: Let's cut to the chase. We've got some of your spare change we could loan you.
W: Right.
Hu: Furthermore, we've got a lot people to keep occupied. We can keep them occupied by either working in factories making McDonald's Happy Meal toys or we can muster them into armies. We like the Happy Meal gig and I think you do to.
W: Yup.
Hu: So how about you recognize our territorial claims to the island of Formosa?
W: Hmmm... You know I can't do that.
Hu: We'll burn $700B worth of US Government bonds and you'll recognize us as the rightful sovereign of that little island.
The above dialog reaches a spectacular low in (imagined and implied) moral turpitude. Unfortunately, this sort of option is going to remain on the table as long as China has significant holdings denominated in US dollars.

I don't know if we should do anything. Inaction is sometimes the best course of action. Nonetheless, the reality of the Templeton curve looms large before us. Politicians are oddly promising more spending during one of the greatest financial crises in American history. As a result, debt forgiveness will become more politically appealing.

I'd like to know how economists see this playing out. Are there similar examples from history that we can learn from? What policy changes should we consider?