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Wednesday, May 27, 2009

What if China "Calls In" its Debt?

Click here - this article begs the question:
What if China "Calls in" its Debt?

We hear this question resonate throughout the American debate. The great fallacy is that we simply don’t owe China all that much money, relatively speaking. This question is a misnomer, a fallacy - a distraction.

The United States federal government owes China about 7 ½ billion dollars – which is a lot by itself. However, the United States federal government owes the Federal Reserve Bank well over 4 trillion dollars – which makes the debt to China look small.

To put the whole debt in perspective, think of this. Our federal government owes a little more than it makes every year – it makes around 7-8 trillion a year. The debt side is likely to increase substantially under President Obama’s recent spending binge. Half that debt is owed to the Federal Reserve. About 1/8 or 1/9 of that debt is owed to China.

For the Chinese – this is a lot of money. But to the U.S., it is payable. If China “called in” this debt, the U.S. could simply pay it off. This would be temporarily difficult, but doable. Simultaneously, China would lose all its financial leverage with the U.S. as the debt gets paid off. The Chinese are highly unlikely to give up this leverage any time soon.

Furthermore, the U.S. can always pay off its debt with its own currency, a luxury not afforded to most countries. This means that the U.S. can simply print money to pay off any institution that “calls in” its debt. This would create massive inflation, meaning that a dollar would buy less because it is worth less. This is because more paper money means that money already in circulation loses its real value. In other words, China would get their 7 ½ billion, but it would be in the form of inflated (less valuable) currency.

This has occurred several times in history, and is attributed to the fall of many “great powers.” Famously, this is what happened to Germany in the 1920’s, and contributed greatly to the rise of Adolph Hitler.

The Real Problem in the U.S.

The real issue to worry about is this: what will the U.S. do if the Federal Reserve “calls in” its debt?

Here is what could actually happen:

The Fed is a "quasi-government/quasi-private bank" and has real balance sheets to worry about. (Although nobody has access to these records. Congress often complains that it has more access to the CIA than the Fed. However, the "Audit the Fed Bill," HR 1207, now has over 150 co-sponsors in the House). The Fed could start to realize that it is becoming insolvent because its assets are being paid in its own increasingly worthless currency.

The Fed would then have only two choices: either 1) continue to finance debt till there is an inflation crisis, or 2) refuse to finance any more debt.

So, what will happen given these two choices? The answer is that there would be what economists call a “correction,” aka: a crisis. The U.S. has spent its paper money with reckless abandon, often building up long-term liabilities in the process. Because the U.S. refused to allow spending cuts for several years, it will be forced to pay the piper later.

Technically, this is inevitable, because:
1) if the Fed continues to finance debt, inflation will take over and the money will become worthless. In other words, all our employees, allies, hospitals and retirees would still get their checks – but the checks would not buy much.
2) if the Fed stops financing debt, the U.S. federal government would have to cut about 25% of its spending overnight. All this “stimulus spending” would have to stop. Probably half the federal workforce would have to be laid off (and the federal government is the country’s largest employer). Medical and retirement spending would have to be slashed.

Either way, Milton Friedman’s classic saying still holds true: “There is no such thing as a free lunch.”

1 comment:

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