When Treasury yields on the 10 year note were climbing to 4.0% in the late spring bond traders fears were centered on the Federal Reserve's extraordinary liquidity provisions, the Obama administration's unprecedented ten year deficit projections and the potential for inflation. The collapse in Treasury prices prompted the Fed's entry into the Treasury market. Its $300 billon program to purchase government debt led to suspicions that the US Government had embarked on direct monetization of its debt, printing dollars to make up for the revenues it no longer had. As the Treasury began to auction the massive amounts of debt these fears undermined confidence that the credit markets would accept the new issuance.
The currency market reaction was perhaps the greatest weakness for the government debt plans. When the Fed announced its Treasury purchase program in March the dollar suffered one of its largest falls against the euro since the beginning of the financial crisis. The threat of overt monetization of US debt to the dollar was not one that the Federal Reserve could ignore.
A rapidly devaluing dollar, as seemed to be indicated by the March slide, could severely limit the appeal of the Treasury bonds. Why buy low yielding notes that paid in a depreciating currency?
China and Russian were the most vocal about the danger to their American investments from a collapsing dollar but risk applied to all holders of US notes. The Chinese and the Russians underlined the seriousness of the risks in clear and unsusually plain terms. Chinese officials warned the US government to be mindful of its status as the world's largest holder of US debts and warned the Washington to act as a careful custodian of the dollar. The Russian were blunter, calling for anew world reserve currency to replace the dollar.
If the debt markets did not buy American debt because of worries about the US dollar, American bond rates would be forced higher dragging mortgage and other US economic rates with them. The US government's efforts to limit the economic damage of the financial crisis and recession would be far less effective with higher mortgage and credit card rates. Few economists and officials then thought the American economy could tolerate a substantial rise in rates.
But rhetoric aside the Chinese, had reasons of their own to abjure what would have been a dangerous fall in the Treasury markets and the consequent rise in American interest rates.
China depends on the world's economy to buy her exports. If the US Treasury markets had cratered in the spring the effect on the US economy and the world could have been catastrophic. In the frightened atmosphere last spring that risk was very high.
At the least it would have heightened the sense of disaster that was just beginning to ebb, seriously deepened the recession and escalated the collapse in world trade. In that febrile atmosphere a Chinese withdrawal from the US Treasury markets would have had global effects.
As it was, Chinese exports contracted dramatically in the late fall, winter and early spring. Factories closed, millions of migrant workers to the cities were thrown out of work bring with them the specter of civil unrest which is never far from the minds of the rulers in Beijing,
As the US began its Treasury auctions China's immediate self interest kept her actively involved. As the most visible of the world's governments involved in the Treasury market any sign of actual withdrawal, as opposed to theoretical comments, would have had a dire effect on the worldwide appetite for US debt.
China clearly has a present interest in keeping the US Treasury market from sliding further and in keeping US rates low and the US economy on track for the strongest recovery possible. But there is also a long term Chinese interest in fostering the US debt binge.
The Obama administration has embarked on the largest expansion of US debt in history. Its legislative plans include the greatest addition to government services since the Depression. Such a program cannot be accomplished without the cooperation of the world's credit markets and the leading buyers of US debt are other governments with China paramount. If China does not acquiesce to the increase in US debt the administration will have a much harder time enacting its plans. The most likely political result would be a curtailment of US Government spending and a drop in the amount of debt that the Treasury would have to issue.
But if the administration is able to complete its economic agenda the result will be an enormous increase of US debt and higher taxes to pay for those programs and the debt. The exaction that this debt will take from the US economy in lower productivity and economic growth will permanently alter the position of the US economy in the world. If the administration completes its agenda then the dollar will decline, slowly but inevitably, as the US economy slips from its position as the most vibrant mature industrial economy and eventually loses it position as the world's largest national economy.
The possibility for devaluation of Chinese dollar holding is very real but perhaps Beijing may consider it just a lease on the future. Would it not be a worthy price to pay for assisting the self-imposed crippling of her greatest economic competitor?