Who Owns the Dollar?

Our currency and
our economy are held hostage by Asia.

The American Conservative

July 4, 2005 

China is the leading scapegoat for America`s economic
ills. On May 20, New York Times columnist Paul

blamed China
for the U.S. housing bubble. If only
China were not lending us so much money, mortgage rates
would be higher, forestalling a housing bubble. Krugman
says China is a poor country and should be investing its
capital at home, not lending it to the U.S.

Krugman could just as well have said, "If only
U.S. manufacturers produced in America instead of
outsourcing to China, the Chinese would not have any
money to lend us. Thus, no housing bubble."

Krugman is correct that if foreign lending to the
U.S. slows, interest rates will rise, putting a
speculative housing market in trouble. But the interest
of the U.S.-China relationship goes far beyond the
effect on the U.S. housing market. Economists set in
traditional ways of thinking miss the really important
aspects of the relationship.

For example, Krugman notes that China is a poor
country and is slowing its own development by lending to
the U.S. We do think of China as a Third World country
with large supplies of underemployed labor. China`s
trade relationship with the U.S., however, suggests the
opposite. The U.S. trade deficit with China is larger
than with any other country, including highly
industrialized ones such as Japan and Germany. Think of
all those Toyotas, Hondas, Nissans, office machines, and
video games that Americans buy from Japan. Yet in the
first quarter of this year, the U.S. trade deficit with
China is running 50 percent larger than the deficit with
Japan. Indeed, the U.S. trade deficit with China is
larger than the deficit with all of Europe. It is larger
than with Canada and Mexico combined, two countries in
which U.S. corporations manufacture cars, appliances,
and a variety of big-ticket items for American markets.

What are Americans buying from China? With China a
poor country and the U.S. a First World superpower, you
would think China would have a trade deficit as a result
of selling us cheap goods and importing high value-added
manufactured goods. Instead, it is the other way around.
The U.S. is dependent on China for manufactured goods,
including advanced technology products. In the first
quarter of 2005, U.S. imports from China are 5.7 times
higher than U.S. exports to China. Last year, U.S.
exports to China were $34.7 billion. Imports were $196.7
billion for a U.S. trade deficit with China of $162

It was not always this way. In 1985, U.S. trade with
China was in balance at $3.8 billion. Ten years later,
U.S. imports from China were four times U.S. exports to

The U.S.-China economic relationship is a highly
unusual one between a First World and a Third World
country. Moreover, the U.S. trade deficit with China in
manufactured goods and advanced technology products is
growing rapidly. What explains the U.S. dependence on a
poor country for First World products?

The answer, and the key to China`s rapid development,
is that corporations in First World countries—American
businesses chief among them—use China as an offshore
location where they produce for their home markets. More
than half of U.S. imports from China, and as much as 70
percent from some of China`s coastal regions, represent
offshore production by American firms for U.S. markets.

What economists overlook is that when we speak of the
Chinese economy, we are speaking in large part of the
relocation of American manufacturing to China. Those
millions of lost domestic manufacturing jobs were not
lost. They were moved. The jobs still exist, only they
are not filled by Americans.

In a world where capital and technology are highly
mobile internationally, these critical factors of
production flow to countries with the lowest cost of
labor. China has attracted manufacturing, and India has
attracted professional services. This has left the
American work force with job growth only in lower-paid
domestic services, which provide no export earnings.

The rapid transformations that have occurred in some
Indian cities, which have become high-tech centers, and
along the coast of China are unprecedented in economic
history. The changes are so rapid because they are
driven by the relocation of First World businesses
seeking the lowest labor cost.

Economics relies on automatic adjustments to rectify
trade imbalances. The trade deficit with China should
cause the Chinese currency to appreciate relative to the
dollar, raising the dollar cost of Chinese labor. In the
long run—in which, J.M. Keynes said,

"we are all dead"
—adjustments would occur until U.S.
and Chinese wage rates and living standards equalized.

Considering the disparity between American and
Chinese wage rates and living standards, the adjustment
would be extremely painful for Americans. But the
adjustment is forestalled by two factors.

China keeps its currency pegged to the dollar, so
when the dollar falls, the Chinese currency falls with
it and there is no adjustment. China does not permit its
currency to be traded, and there is not enough of it in
international markets for currency speculators to be
able to force the Chinese off the peg.

The other factor is the dollar`s role as world
reserve currency. The reserve-currency role means that
every country has a demand for dollars in order to pay
its oil bills and settle its international accounts. The
world demand means that the U.S. can run large deficits
for many years before the chickens come home to roost.

In the meantime, Asian countries are accumulating
hundreds of billions in dollar assets, making them
America`s bankers. Industrially developed countries such
as Japan, Taiwan, and South Korea have little need to
use the dollars that they earn from their trade
surpluses with the U.S. to import American capital goods
to fuel their further development. They use the dollars
that we pay them for their goods to purchase U.S.
government bonds and American companies, real estate,
and corporate bonds.

China, which has been growing at about 10 percent
annually for a number of years, could conceivably use
its export surplus with the U.S. to expand its
infrastructure more rapidly in order to develop even
more quickly. But a 10 percent annual growth rate is
probably the highest rate of change with which China
wants to contend. As First World firms are flooding
China with their capital and technology, China doesn`t
need to use its trade surplus with the U.S. to purchase
capital goods.

As a result of many years of persistent trade
surpluses with the United States, the Japanese
government holds dollar reserves of approximately $1
trillion. China`s accumulation of dollars is
approximately $600 billion. South Korea holds about $200

These sums give these countries enormous leverage
over the United States. By dumping some portion of their
reserves, these countries could put the dollar under
intense pressure and send U.S. interest rates
skyrocketing. Washington would really have to anger
Japan and Korea to provoke such action, but in a
showdown with China—over Taiwan, for example—China holds
the cards. China and Japan, and the world at large, have
more dollar reserves than they require. They would have
no problem teaching a hegemonic superpower a lesson if
the need arose.

Last year the U.S. trade deficit with the rest of the
world was $617 billion. In the first quarter of this
year, our trade deficit is $174 billion—$35 billion
higher than in the first quarter of last year. If this
figure holds for the remaining three quarters and does
not increase, the U.S. trade deficit in 2005 will be
$700 billion.

Offshore outsourcing makes it impossible for the U.S.
to rectify its trade imbalance through exports. As more
and more of the production of goods and services for
U.S. markets moves offshore, we have less capability to
boost our exports, and the trade deficit automatically
widens. Economic catastrophe at some point in the future
seems assured.

In the meantime, even a small country could pop the
U.S. housing bubble by dumping dollar reserves—which is
some fix for a superpower to be in, especially one that
is disdainful of the opinion of the rest of the world.
Comeuppance can`t be far away.

The hardest blow on Americans will fall when China
does revalue its currency. When China`s currency ceases
to be undervalued, American shoppers in Wal-Mart, where
70 percent of the goods on the shelves are made in
China, will think they are in Neiman Marcus. Price
increases will cause a dramatic reduction in American
real incomes. If this coincides with rising interest
rates and a setback in the housing market, American
consumers will experience the hardest times since the
Great Depression.

Paul Craig Roberts was Assistant Secretary of the
Treasury under President Reagan.