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China's debt bomb

America's No. 1 creditor holds the ultimate weapon

By ARTHUR HERMAN

Last Updated: 4:28 AM, February 8, 2010

Posted: 2:06 AM, February 8, 2010

'He who pays the piper calls the tune": That old saying captures perfectly America's growing dependence on our No. 1 creditor in the world, Communist China.<p> </p><br> By their carelessness Congress and the Obama administration are steadily handing over control of America's economic and financial future to a handful of Chinese officials and generals in Beijing. Those who think the Chinese won't use that control if they feel they have to are ignoring history -- and the Chinese.<p> </p><br> The ancient military strategist Sun Tzu said that the best strategy was to render an opponent's army helpless even before the battle began. America may still have the biggest and best military in the world.<p> </p><br> But many at the Pentagon are starting to realize that, thanks to our growing fiscal irresponsibility, we may be surrendering control of America's destiny to a rival superpower -- and all without a shot being fired.<p> </p><br> Consider the scale of the problem.<p> </p><br> With President Obama's 2010 budget, 42 cents of every dollar the federal government spends will have to be borrowed. In the last decade, foreign investors have wound up lending us roughly half of all federal debt -- with just two countries, China and Japan, providing nearly half of that sum, or 44 percent, through the purchase of US Treasury securities.<p> </p><br> China now tops Japan as our biggest lender by some $30 billion a year, at $789 billion. (By comparison, our No. 3 lender, Great Britain, comes in at a measly $277 billion).<p> </p><br> But that's not all. As its booming economy becomes more global, China is also the world's largest holder of foreign-currency reserves. Most of that is in US dollars. Indeed, without most Americans realizing it, China has become the largest foreign holder of US dollars in the world. How many dollars foreign exchange traders at the Bank of China decide to sell or buy on any given day is increasingly determining whether the dollars in our purses and wallets buy a little or a lot.<p> </p><br> Seen from one angle, this dependence on China for the value of our national currency and the funding of our debt is like our dependence on inexpensive Chinese exports for our standard of living: the inevitable fruit of today's interlocking global economies -- and poor planning on our part.<p> </p><br> Seen from another, more strategic angle, it may spell disaster.<p> </p><br> History shows that nations that can't control their economic fortunes don't control much else. Debt freezes destinies -- as every credit-card holder knows.<p> </p><br> Europeans discovered that after World War II, when they lost the power to make major decisions without first checking with their lender-in-chief, the United States. At that time, we used our economic dominance to rebuild Europe, not reduce it to impotence.<p> </p><br> On the other hand, If US-China relations continue to deteriorate -- over arms sales to Taiwan, Internet freedom issues, Chinese industrial espionage and a Chinese military build-up that looks more and more like it's directed at challenging US power in Asia -- our lenders-in-chief in Beijing may not be so scrupulous.<p> </p><br> Indeed, back in 1999, the Chinese literally wrote the book on how to use economic asymmetries as a blunt instrument, entitled "Unrestricted Warfare."<p> </p><br> It draws no meaningful distinction between military, economic and political force (including using cyberspace) as means to defeat an enemy. Instead, it shows how a nation can dominate its opponents not with planes, ships and soldiers, but with foreign exchange rates, trade embargoes and armies of computer hackers.<p> </p><br> Suppose that in retaliation for some slight China decides to stop buying Treasury bonds, forcing our debt to cost us even more. A furious US Congress hits back with trade sanctions. China then responds by driving up the price of the dollar, crippling US exports -- or, alternately, it crashes the dollar by dumping its foreign reserves, even as Chinese computer hackers slow down our banks' ability to respond to the crisis.<p> </p><br> No one will call this a war. But it will certainly fit the classic definition of war as politics by other means. And the Pentagon knows it.<p> </p><br> Last March, the Pentagon held its first-ever economic-warfare war game, with China as the putative opponent and with economists and bankers (including from UBS) helping out.<p> </p><br> Details of what unfolded are still classified. However, sources told Fox Business News that the scenario played out as planned. That was the good news.<p> </p><br> The bad news is that China won.<p> </p><br> Today, some experts argue that rational self-interest will prevent China from waging this kind of economic warfare, because crippling the US would also severely wound its own economy. However, on an issue like Taiwan or Japan, rational judgment can take a backseat to national pride, and the desire to reverse old humiliations.<p> </p><br> That war game was almost a year ago, when the Federal deficit was half of what it is today. And China is moving out of its short-term debt positions -- although slowly enough not to roil the credit markets.<p> </p><br> In any case, Bracken and others argue that we need more coordination between the Treasury and the Pentagon on ways to deal with a vulnerability that seemed entirely theoretical then, but now seems all too real. Still others are pushing for rules restricting the future sales of Treasury securities to foreign buyers.<p> </p><br> All this, however, is only playing catch up. The real issue is whether we get our fiscal house in order, and realize that a $12 trillion national debt and a crippled economy could leave us as vulnerable as we once were on a December Sunday morning 69 years ago, at Pearl Harbor in 1941.<p> </p><br> Arthur Herman's most recent book, "Gandhi and Churchill," was a Pulitzer Prize finalist last year.<p> </p><br>

But many at the Pentagon are starting to realize that, thanks to our growing fiscal irresponsibility, we may be surrendering control of America's destiny to a rival superpower -- and all without a shot being fired.

Consider the scale of the problem.

With President Obama's 2010 budget, 42 cents of every dollar the federal government spends will have to be borrowed. In the last decade, foreign investors have wound up lending us roughly half of all federal debt -- with just two countries, China and Japan, providing nearly half of that sum, or 44 percent, through the purchase of US Treasury securities.

China now tops Japan as our biggest lender by some $30 billion a year, at $789 billion. (By comparison, our No. 3 lender, Great Britain, comes in at a measly $277 billion).

But that's not all. As its booming economy becomes more global, China is also the world's largest holder of foreign-currency reserves. Most of that is in US dollars. Indeed, without most Americans realizing it, China has become the largest foreign holder of US dollars in the world. How many dollars foreign exchange traders at the Bank of China decide to sell or buy on any given day is increasingly determining whether the dollars in our purses and wallets buy a little or a lot.

Seen from one angle, this dependence on China for the value of our national currency and the funding of our debt is like our dependence on inexpensive Chinese exports for our standard of living: the inevitable fruit of today's interlocking global economies -- and poor planning on our part.

Seen from another, more strategic angle, it may spell disaster.

History shows that nations that can't control their economic fortunes don't control much else. Debt freezes destinies -- as every credit-card holder knows.

Europeans discovered that after World War II, when they lost the power to make major decisions without first checking with their lender-in-chief, the United States. At that time, we used our economic dominance to rebuild Europe, not reduce it to impotence.

On the other hand, If US-China relations continue to deteriorate -- over arms sales to Taiwan, Internet freedom issues, Chinese industrial espionage and a Chinese military build-up that looks more and more like it's directed at challenging US power in Asia -- our lenders-in-chief in Beijing may not be so scrupulous.

Indeed, back in 1999, the Chinese literally wrote the book on how to use economic asymmetries as a blunt instrument, entitled "Unrestricted Warfare."

It draws no meaningful distinction between military, economic and political force (including using cyberspace) as means to defeat an enemy. Instead, it shows how a nation can dominate its opponents not with planes, ships and soldiers, but with foreign exchange rates, trade embargoes and armies of computer hackers.

-- Edited by Sanders on Monday 8th of February 2010 11:10:02 AM