U.S. kid: "Get out of my room and keep your hands off my stuff! And you'd better let the yuan appreciate against the dollar, too."
Chinese kid: "Oh, yeah, what makes you think you can make me?"
U.S. kid: "If you don't, we'll just start putting tariffs on all those goods you produce and sell here in the United States."
Chinese kid: "Well, if you do that, we'll just sell some of the debt we've taken from you, and your Greenback will sink like a stone."
U.S. kid: "Oh, sure, right. If you do that, then we couldn't buy as much of your stuff as we've been buying. So what good would that do you?"
Chinese kid: "Not much good at all, but if you keep bugging me, I'm going to do it anyway just to get back at you…."
And so goes the level of trade "dialogue" between those two powerful nations, the United States and China. What's important to remember is that China holds more than a trillion dollars of U.S. debt and buys more of it every day. That's a large part of the credit-market support here in the United States that keeps our interest rates low.
This was a week for bickering. The U.S. Senate pushed our Treasury Department to tell China to let its currency float higher against the dollar so that we won't pay as much for the huge amount of goods we buy from China. But China snapped back with its own argument that's the equivalent of a nuclear deterrent. It goes like this: If you try to cut back on your trade deficit with us, then we can just start selling (and stop buying) some of that debt of yours that we hold. Once this argument gets going, it becomes a game of chicken to see who will blink first.
On this side of the Pacific, Americans figure China wouldn't do that because it would only be cutting off its nose to spite its face. After all, if the dollar loses value because China starts dumping it, then China's investments lose value, too. But on the other side of the Pacific, the Chinese can't figure out why Americans ignore the fact that foreign purchases of U.S. debt are what have kept the U.S. dollar strong, so that U.S. citizens can actually afford all their fancy cars and HDTVs.
This week, a Chinese government researcher wrote an article in the state-run China Daily in response to the protectionist noises being made by U.S. Senators. "The Chinese central bank will be forced to sell U.S. dollars once the [yuan] appreciates dramatically, which might lead to a mass depreciation of the U.S dollar against other currencies," wrote He Fan, as reported in The Washington Post on August 8, 2007.
The Post quotes a professor of economics at the University of Wisconsin as saying, "There would be turmoil in the financial markets. It's not really a credible threat."
Well, credible or not, just because nations may know that the policies they pursue are wrongheaded or stupid doesn't mean they won't follow them. After all, Prohibition was a bad idea, but look what happened in the United States in the 1920s. The Smoot-Hawley Tariff Act was an equally bad idea that got enacted. Anybody care to weigh in on warrantless wire-tapping, while we're at it?
And the larger lesson behind the increasing tensions between the U.S. and China has to do with how fear is creeping into the credit markets. As Bob Prechter writes in his business best-seller, Conquer the Crash, when optimism changes to pessimism, "creditors and debtors change their primary orientation from expansion to conservation. As creditors become more conservative, they slow their lending. As debtors and potential debtors become more conservative, they borrow less or not at all. These behaviors reduce the "velocity" of money, i.e., the speed with which it circulates to make purchases, thus putting downside pressure on prices."
Tension between creditor and debtor is exactly what this argument between China and the United States is all about. Whether that tension happens internationally or domestically, Elliott Wave International's analysts have been warning about the credit bubble and its potential for disaster for years now. Most recently, Steve Hochberg and Pete Kendall wrote a special section for the August issue of The Elliott Wave Financial Forecast, called "The Credit Bubble Bursts."