STAFF NEWS & ANALYSIS
Paulson Placates China and Russia for Now
By Staff News & Analysis - September 10, 2008

For a nation that has basically accepted the contention that Alaska Governor Palin is a foreign policy expert on the level of Henry Kissinger or Metternich just on the basis of Alaska's proximity to Siberia, it might be a surprise to be told that, "yes, America, there is a world out there." Last Thursday, September 4, the New York Times published probably the closest thing to journalism's apocryphal "man bites dog" story, in that it reported, referring to the People's Bank of China, the country's central bank, that the "Main Bank of China Is in Need of Capital". For a world accustomed to stories about the quantity of China's foreign exchange reserves spinning always ever upward like slot machine jackpots, this was a surprise; had the human race, or, more specifically that large subsection of it that shops at Wal-Mart, finally weaned itself from it's addiction to cheap microwaves and plasma TVs? By now, the problems attendant to China's recent economic success are fairly well known. China is running a roughly $25 billion a month trade surplus with the US. Standard floating exchange rate theory states that countries experiencing large trade surpluses see their currencies appreciate, with the flip side of that being the deficit countries' currencies depreciating. Eventually, the deficit country finds that the rising prices caused by its currency's depreciation means it can't import as much as it used to, and the surplus country finds it can buy more, now cheaper, imports. Over time, if the system works the way the free market theorists say it should, the combination of increased imports to the surplus country and increased exports from out of the deficit country should whittle away the deficit to a manageable level – well, someday it might. But China has not wanted to play this game. Fewer exports from out of Chinese factories means fewer paychecks earned by Chinese factory workers, and, for all the gleam and beauty on display at the Olympic Bird's Nest stadium, China's Communist rulers apparently still fear that there's just not enough distance between the two to keep an unemployed factory worker of the Pearl River Delta from showing up as a protester in Tiananmen Square. They don't want their currency, the yuan, to rise too fast against the US dollar. A rising yuan is the same thing as a falling dollar, and the dollar, just like anything else, will fall if there are more sellers of it than buyers, if supply exceeds demand. Therefore, the People's Bank of China has been acting to buy lots of those loose dollars on the markets, attempting to keep the yuan's rise at least orderly. And what are they doing with all the dollars accrued with their currency market interventions? Well, mostly, they're buying US government-guaranteed notes and bonds; that includes, according to Marketwatch, $376 billion of Fannie and Freddie Mortgage Backed Securities (MBSs). – Asia Times

Dominant Social Theme: It's a big world out there, and you don't understand it.

Free-Market Analysis: Sorry to return to the Fannie and Freddie bailout once again, but the totality of mortgages held by these two monsters is in excess of $6 trillion. The United States, in taking over these "companies" has basically socialized a major portion of its internal marketplace with the stroke of a pen. The reverberations will be felt for years to come – and the analyses will run deep and reveal in doing so, more about how the world really works, as well as America's place in it.

The Asia Times article shows just how far from reality much of the current commentary is about the government takeover. Internal factors may not have played nearly as much of a role as external ones. What is clear is that the funding of the United States' debt was of paramount importance when it came to determining whether the United States would fully back Fannie and Freddie.

The "cold war": was always a fairly artificial construct but today's version is odder still. Bound together by shared debt and a need to sustain certain economic realities, China and America may have a closer relationship in some ways than America and Europe. And despite talk of a renewed Cold War with Russia, there is this from the same article explaining about Russia's holdings of American mortgage securities.

The extent to which China's and other Asian central banks have tied themselves to US MBS debt is fairly well known; what is less well known is that Russia has been tempted into the game as well. According to the US government's monthly Treasury International Capital report, the Russian central bank held about $100 billion in MBS debt as of July.

After Thoughts

In searching for the bottom line significance of the Fannie and Freddie bailout, we can turn once more to the Asia Times article excerpted above. It ends as follows:

It can't be pleasant to be at the PBoC and receive the type of flaying they received from the MoF over buying US mortgage-backed securities. .. The world's money will undoubtedly eventually learn not to make itself vulnerable to America's profligacy with uncontrolled debt and leverage, especially if that same policy continues with a new president. What happened with the rescue of Fannie and Freddie only delayed that day of reckoning.

Interesting. The philosophers among us may indeed decry the takeover as a watershed moment for the American marketplace, the day when the Libertarian impulse of the country's domestic elite took a back seat to immediate monetary concerns. But another ramification, just as important is that overseas entities that have funded the imperial American overreach of the last 50 years may finally have to rethink their investments.

It is not America's wars, the belligerence of its leaders or even the increasing chaos of its political structure that is causing the gradual eclipsing of American power. What will be responsible ultimately is America's difficulty in balancing its books. The dollar will continue to decline as the world's inevitable reserve currency and Americans themselves will wake up one day to find that their deficit has grown so large as to be unmanageable – in the sense that other countries will not fund it anymore. That may be the ultimate significance of the Fannie/Freddie bailout, that it marks the beginning of the end of the American empire – and also the value of its notes.

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