by Mario Rizzo
The U.S. Treasury, the State Department, and Larry Summers are all keen to convince the Chinese government that all they have to fear is fear itself when it comes to their investments in Treasury securities. After all, the U.S. will honor its obligations.
Frankly, I am amazed at the U.S. response. Yes, I realize that there is little else they could say. The default risk of holding U.S. securities is indeed quite low. But you don’t have to be very smart to realize that this is not the relevant risk.
As the U.S. (and other Western governments) floods the world with its bills and bonds as far as the eye can see, interest rates will surely rise. There will be at least three reasons: (1) the supply of bonds outstanding will continue to expand and sooner or later a higher rate of interest will have to be paid to get it all sold; (2) when there is economic recovery interest rates will rise generally; (3) as inflation picks up – which it will, given the huge increase in base money that the Fed will fear to withdraw from the system – the purchasing power premium in interest rates will grow. The dollars paid out as interest will be increasingly worth less.
Holders of bonds will thus experience capital losses as bond prices fall.
It is true that the Chinese export industries would benefit from economic recovery. However, that recovery in real terms will depend, in part, on the effectiveness of stimulus (and, of course, on the natural recuperative powers of the economy). If real recovery is weak and inflation accelerates in the medium-term, the Chinese will be hurt overall. Then what will Economics-Team Obama say? I guess they will say, “We didn’t default.”