China's Pursuit of Galactic Finance

China is looking for an extra-terrestrial currency. Not really, but they're clearly unhappy with the existing offerings here on Earth.

This week the governor of the People's Bank of China called for a new IMF currency reserve system as an alternative to the dollar. Russia is much less dependent on the value of the dollar, but they're thinking along the same lines. China's problem is that it has accumulated roughly $2 trillion in reserves and has no good place to stash them. Chinese leaders have been vocally concerned about the safety of their dollar holdings. They have begun to realize how reliant they are on the fiscal responsibility of the United States, and that scares them.

The Congressional Budget Office just forecast on Friday that, under an optimistic reading of President Obama's budget, the U.S. federal budget deficit will soar, then dip, then start climbing out of control. The optimism comes from assuming short-term spending programs actually end, new revenue measures will be passed, the economy revives soon, and the financial sector can be fixed on the cheap. But under the budget, publicly-held debt in the United States is predicted to climb from 41 percent of GDP in 2008 to about 82 percent of GDP in 2019, without any stabilization in sight.

It's always a challenge to put large budget numbers in perspective, but Europe has a benchmark for when a country is going astray: a budget deficit of 3 percent of GDP and debt/GDP of 60 percent of GDP. Under the Obama budget, the U.S. deficit never dips below 4 percent of GDP. The standard prediction for a country with uncontrolled borrowing would be a bout of inflation, rising interest rates, and currency depreciation. None of these would be good for foreigners holding U.S. debt.

Under an optimistic reading of President Obama's budget, the U.S. federal budget deficit will soar, then dip, then start climbing out of control.

The Obama administration's reaction to the CBO report was that things would look better under rosier assumptions, and all this borrowing is necessary so as not to pass problems on to our children. This seems not to have reassured the Chinese.

The difficulty foreign investors face is that if they don't like the dollar, they need to go somewhere else. The Euro and Yen have problems of their own. There already is an "international currency" created amid the financial turmoil of the 1960s--the IMF's Special Drawing Rights--but it's eminently terrestrial. Like the dollar, it used to be pegged to gold. Now it's pegged to a basket of earth-bound currencies: the dollar (44 percent), the Euro (34 percent), the Yen (11 percent), and the British Pound (11 percent).

The only real alternative would be for the Chinese to rebalance their economy and try to spend down their massive reserves. That would require a lot of painful adjustment in their export sector, however, and this is now a lot more difficult than it would have been a couple years back. So whether China likes it or not, there's no escaping the current financial system for now, and it's stuck with our worldly woes.

Philip I. Levy is a resident scholar at AEI.

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