Mutually Assured Destruction v. 2.0

Much has been made in recent weeks about what I like to call MAD 2.0–this time between the U.S. and China.

Of course, the new MAD is not nearly as vindictive as the previous phase of international relations between the U.S. and the S.U.  It involves no bombs, posturing, or division of the world into spheres of influence (yet).  No, the new MAD is predicated on a simple fact: each country controls the other country’s financial system.

The Financial Times synthesized the situation rather succinctly.  China has made a policy of holding substantial currency reserves while keeping its currency artificially low.  This will, in theory, allow it to weather economic downturns while promoting its exports, because if the currency remains low it is easier for other countries to buy Chinese products.

These substantial currency reserves have to sit somewhere, and must be of a different currency (since to hold a potential flood of yuan would pose a potential problem to the currency’s value should it have to be spent).  Up to this point and continuing at least until the near future, the reserves have been held primarily in United States’ assets.

In the process, China has become the largest creditor to the United States, with this debt growing by 25% per year.

If the U.S. were to falter, China would lose its currency reserves, revaluing the yuan and cutting its growth massively.  If China were to draw down its reserves, the U.S. would have to call in mountains of debt to begin to pay it back and would lose the status of reserve currency that has allowed outrageous deficit spending for many years.

From the U.S. perspective, this is quite a precarious situation at first glance: to depend solely on a country that is not exactly the friendliest of allies on many issues for economic security does not top the list of desirable positions to be in.  Yet there are several factors that make this relationship much more complicated and not so evidently negative.

Primarily, the U.S. has the advantageous position at the moment of being the world’s reserve currency, which means for this application that it is still one of the safest investments in terms of long-term stability that exists.  If the Chinese choose to continue their policy of holding huge currency reserves, then their best investment option is still the dollar.

For China, to even begin to move away from its stake in the dollar would collapse all of the value that that remains in their reserves.  This is why they are so cautious to assure the world’s investors that this is precisely what they are not going to do.  Furthermore, to liquidate its reserves would lead to a valuation of the yuan.

Clearly, neither country can afford to have the other make any drastic moves.  A very precarious balance pervades the system, and any sway in either direction could bring both economies to a grinding halt.

Still, China realizes that it has the relative upper hand in the sitaution, and, as the Financial Times report, are beginning to move the issue of debt obligation into the realm of foreign policy.  The U.S. is going to have to tread very lightly into the future–especially because, in this case, it cannot deficit spend the enemy into oblivion.

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For further information, here is an interesting podcast published by the Economist on China’s downturn and how it plays into this financial crisis:

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