The Chinese are not likely to be concerned about default; they are probably more interested in what the Fed intends to do with interest rates. They are not getting much interest on short-term bonds, and are probably reluctant to buy or hold long-term just now if the Fed will be raising rates. Short- or long-term is a decision always facing bond investors and the media give it almost no attention.

Where is the evidence that China is more concerned about the U.S. trade deficit over the budget deficit?

Listen to Treasury Secretary Geithner's interview of June of 2009.

http://www.chinadaily.com.cn/video/2009-06/03/content_8065601.htm

China has no flexibility on the trade deficit. If they don't finance it, they get massive unemployment.

So either Mr Orszag was the unnamed source or there is a second source:

"And yet, there was budget director Peter Orszag rushing to a lunch with Chinese bureaucrats on a Monday in late July. To his surprise, when Orszag arrived at the site of the annual U.S.-China Strategic and Economic Dialogue (S&ED), the Chinese didn't dwell on the Wall Street meltdown or the global recession. The bureaucrats at his table mostly wanted to know about health care reform, which Orszag has helped shepherd. "They were intrigued by the most recent legislative developments," Orszag says. "It was like, 'You're fresh from the field, what can you tell us?' "

http://www.tnr.com/article/economy/peking-over-our-shoulder

The ChinaDaily interviewer in the story referred to by AndrewDover expressed concern about inflation, as well he might - China would not like to see her bond holdings devalued. This is not the same as fear of default. With large deficits and very low interest rates there will probably be inflation if the economy turns around. As Dean and some other economists have argued, moderate inflation might be good for the U.S. The Chinese can sell their U.S. bonds if they want, but they will would lose on this because of their own policy of tying their currency to the dollar. They would like to see smaller deficits in the U.S. and try to sound tough, but whether they would actually sell off is another matter.

The IMF estimates that a dollar's purchasing power -- its true value -- is about equal to that of two Chinese yuan. But since the mid-1990s the Chinese government has pegged the yuan:dollar exchange rate at (on average) more than seven yuan per dollar, by standing ready to pay out to its exporters that many yuan for every dollar they bring in.

It seems to me that if you pay seven yuan for something whose real value is less than two, you've lost five or more yuan -- and not at some time in the future, but at the instant you do that. And if you put the dollars on your books as worth seven, rather than what they're really worth, you're just committing an accounting fraud.

Since to buy up the more than $2 trillion they've accumulated the Chinese government has paid out about 15,000 billion yuan in return for dollars worth less than 4,000 billion yuan, it has already lost its citizens at least 11,000 billion yuan of purchasing power.

Assuming a labor force of 0.8 billion workers, that's more than a year's income for an average worker.

If the people running the Chinese government were really concerned about their citizens being paid back, they'd have stayed out of the dollar-buying business and let the market set the exchange rate, which would undoubtedly have settled near two to the dollar.

For the Chinese to really be paid back what they've lent us, we would have to at some time in the future run a trade surplus with them of sufficient scale to send them 15,000 billion yuan worth of goods and services, $7.5+ trillion worth at purchasing power parity. Since the total value added by US manufacturing industries comes to only about $1.6 trillion per year, it would take a lonnnggg time to really pay them back.

But fortunately, since we only owe them $2 trillion thanks to their exchange rate fraud, if they ever do decide to let the rate adjust to where US-made products might seem worth buying, we won't have to sell them even a third as much stuff as it would take to really pay them back.

Why have the leaders of China persisted in such a stupid policy, lending 15 trillion yuan worth of buying power to the US in return for dollars with only 4 trillion yuan of buying power? Because as long as they can preserve the accounting fiction that those dollars are worth 15 trillion yuan, they and their business buddies can claim the economy is doing great. And since their buddies in the export businesses can sell seven yuan worth of Chinese value-added for a dollar worth less than a third that and still make a profit, no one else in the world can possibly compete with them in any business where they can offer a useable product. Imagine how great business would be in the US midwest if it seceded from the Union and set up as its currency a "Midwest Dollar", pledging to pay MW$ for every US$ its businesses could bring in.

So the politicians and businessmen make out like bandits, as long as they can keep the citizenry believing that $2 trillion in foreign reserves is really worth 15 trillion yen.

When they can't maintain that fraud any longer, they'll be about as popular as Bernie Madoff, and there'll be hell to pay.

Dean,

Do you find it at all plausible that high level Chinese officials actually believe this? I know for a fact that you're right (it's not a matter of belief, but simple economics), but lately, I've become more cynical with regards to people's basic understanding of economics. I've listened to well-respected Ivy league professors rail against the deficit and inflation, whilst ignoring deflation.

To be quite honest, I wouldn't be surprised to find officials in different countries make the same fallible mistake.

What do you think?

Jim,

I think it is possible that the Chinese leaders actually are this confused about economics that they care about the U.S. budget deficit, but not the trade deficit. However, if I had to place a bet, I would want 5 to 1 odds.

Our enormous trade deficit is rightly of growing concern to Americans. Since leading the global drive toward trade liberalization by signing the Global Agreement on Tariffs and Trade in 1947, America has been transformed from the wealthiest nation on earth - its preeminent industrial power - into a skid row bum, literally begging the rest of the world for cash to keep us afloat. It's a disgusting spectacle. Our cumulative trade deficit since 1976, financed by a sell-off of American assets, exceeds $9.5 trillion. What will happen when those assets are depleted? Today's recession is the answer.

Why? The American work force is the most productive on earth. Our product quality, though it may have fallen short at one time, is now on a par with the Japanese. Our workers have labored tirelessly to improve our competitiveness. Yet our deficit continues to grow. Our median wages and net worth have declined for decades. Our debt has soared.

Clearly, there is something amiss with "free trade." The concept of free trade is rooted in Ricardo's principle of comparative advantage. In 1817 Ricardo hypothesized that every nation benefits when it trades what it makes best for products made best by other nations. On the surface, it seems to make sense. But is it possible that this theory is flawed in some way? Is there something that Ricardo didn't consider?

At this point, I should introduce myself. I am author of a book titled "Five Short Blasts: A New Economic Theory Exposes The Fatal Flaw in Globalization and Its Consequences for America." My theory is that, as population density rises beyond some optimum level, per capita consumption begins to decline. This occurs because, as people are forced to crowd together and conserve space, it becomes ever more impractical to own many products. Falling per capita consumption, in the face of rising productivity (per capita output, which always rises), inevitably yields rising unemployment and poverty.

This theory has huge ramifications for U.S. policy toward population management (especially immigration policy) and trade. The implications for population policy may be obvious, but why trade? It's because these effects of an excessive population density - rising unemployment and poverty - are actually imported when we attempt to engage in free trade in manufactured goods with a nation that is much more densely populated. Our economies combine. The work of manufacturing is spread evenly across the combined labor force. But, while the more densely populated nation gets free access to a healthy market, all we get in return is access to a market emaciated by over-crowding and low per capita consumption. The result is an automatic, irreversible trade deficit and loss of jobs, tantamount to economic suicide.

One need look no further than the U.S.'s trade data for proof of this effect. Using 2006 data, an in-depth analysis reveals that, of our top twenty per capita trade deficits in manufactured goods (the trade deficit divided by the population of the country in question), eighteen are with nations much more densely populated than our own. Even more revealing, if the nations of the world are divided equally around the median population density, the U.S. had a trade surplus in manufactured goods of $17 billion with the half of nations below the median population density. With the half above the median, we had a $480 billion deficit!

Our trade deficit with China is getting all of the attention these days. But, when expressed in per capita terms, our deficit with China in manufactured goods is rather unremarkable - nineteenth on the list. Our per capita deficit with other nations such as Japan, Germany, Mexico, Korea and others (all much more densely populated than the U.S.) is worse. My point is not that our deficit with China isn't a problem, but rather that it's exactly what we should have expected when we suddenly applied a trade policy that was a proven failure around the world to a country with one fifth of the world's population.

Ricardo's principle of comparative advantage is overly simplistic and flawed because it does not take into consideration this population density effect and what happens when two nations grossly disparate in population density attempt to trade freely in manufactured goods. While free trade in natural resources and free trade in manufactured goods between nations of roughly equal population density is indeed beneficial, just as Ricardo predicts, it’s a sure-fire loser when attempting to trade freely in manufactured goods with a nation with an excessive population density.

If you‘re interested in learning more about this important new economic theory, then I invite you to visit either of my web sites at OpenWindowPublishingCo.com or PeteMurphy.wordpress.com where you can read the preface, join in the blog discussion and, of course, buy the book if you like. (It's also available at Amazon.com.)

Pete Murphy
Author, "Five Short Blasts"

The reason why Ricardo's theory of comparative advantage isn't working is that it implicitly assumes that prices in the trading nations accurately reflect the values of the economic inputs to production, as they did in Ricardo's day because it could be asumed that trade accounts would be settled in hard currency, preventing the kind of exchange rate manipulation practiced today by the Asian mercantilists.

In Ricardo's day, had a nation run the kind of trade deficits the US has run over the last decade, it would have been completely drained of specie. And long before reaching that point its domestic price and wage levels would have been forced down by the monetary deflation to where lowered export prices and import-buying-power would have rectified the trade deficit.

It is only the Fed's ability and proclivity to keep printing money in sufficiently vast quantities to prevent such deflation, and Asian governments' ability and proclivity to keep buying up those printed dollars -- despite their lack of real value -- that keeps the game going.

No new theories are required to understand what's going on.

To understand Ricardo's theory of comparative advantage, and why it's not working now though it's still valid:

Suppose you are trying to put together a brass quartet, and have available to you a truly virtuoso French horn player who also plays the trumpet fairly well, and a couple of other French hornists who are only fairly good, but truly lousy on trumpet. The optimal assignments are to put the French horn virtuoso not on French horn but on trumpet, and have one of the mediocre hornists play the French horn.

What would it take for you to not use the French horn virtuoso on trumpet, and employ both the other fellows instead, one on trumpet and the other on horn?

Suppose they were brothers, and their dad offered you a bribe so large it would more than compensate you for the loss of audience ...

That's basically what's going on in the world today. If the Chinese government were to cease its fraud of paying seven yuan for dollars worth less than two, the trade deficit would go away quite quickly.

With respect to the trade deficit and the US$-Yuan exchange rates, I was curious about the impact of the fact that China maintains two currency systems, one for internal use and (the yuan) for foreign use. Since the Chinese government can "mitigate" the effect of a cheaper U.S. dollar on prices paid by Chinese consumers, how much can the Chinese government manipulate the trade deficit ? At what point does the dual-currency system break down ?