Action at the Auction?

When the U.S. government needs money to fund the deficit, they hold open auctions to place their debt instruments – generally 30-year Treasury bonds (different from the shorter-term notes) – and bidders set the effective interest rates in a basic application of the law of supply and demand. If there are insufficient bidders and the auction is not otherwise terminated, the Federal Reserve buys the excess inventory (which looks a whole lot like the government is simply printing more money). The feds tend to put out some sizeable numbers at these auctions, particularly as the stimulus package and the federal budget are generating trillion dollar deficits. $200 billion is not an uncommon amount these days.

One of the biggest buyers of these Treasuries (about $1.5 trillion to date), as we all know, has been China . After all the years the U.S. has pressed China for economic reform (to revalue the Chinese currency, for example), the shoe is on the other foot these days. China is deeply concerned about Washington ’s deficit policies, a combination of reckless spending and exorbitant stimulus packages that, in their eyes, threaten the underlying value of the massive U.S. currency reserves and Treasuries that China has accumulated over the years; the threat of dollar inflation is a genuine and major concern.

An official delegation from Beijing , visiting the United States in late July, had a very serious mission: evaluate the risks of China ’s huge investment in Treasuries. The U.S. in turn had the challenge of convincing the delegation to make more purchases of future bonds in support of the American deficit. “We are concerned about the security of our financial assets,’ China’s assistant finance minister, Zhu Guangyao, said with uncharacteristic bluntness during a briefing for reporters covering the ‘U.S.-China Strategic and Economic Dialogue’ on [July 27^th].” July 28^th NY Times.

The Chinese are buried pretty deeply in the dollar, and the fears that they will dump their dollar holdings on the open market (which would devalue the U.S. dollar so much as to create a serious depression) are probably unjustified: “There is little real danger, despite the periodic warnings from cable-television doomsayers, that the Chinese will sell off their huge holdings in American debt. As one senior Chinese official involved in the country’s investment strategy put it several weeks ago, ‘As the biggest holder of Treasuries, we would suffer the most from starting a panic.’ The euro and the yen do not seem especially attractive — China ’s most expensive import is oil, and oil is still priced in dollars.” NY Times.

But the writing is on the wall. As President Obama figures out how to reignite the U.S. economy with his budget-busting stimulus package, and as we are now facing a second wave of recessionary numbers through commercial real estate defaults (part one was the subprime residential mortgage collapse) with lingering and excessive levels of core unemployment, he also has to convince China and his own Congress that budget deficits will be reduced on a manageable basis in future years. Continuing stimulus spending is seen by many bond-buyers as unsustainable. Add the cost of the project healthcare plan before Congress, and the magnitude of the challenges is huge. But if Obama yields to pressure from our buyers of Treasuries and trims the spending stimulus, thus cutting the deficit before the economy reverses, the damage to our long-term prospects could be devastating.

The new economic world order clearly places the power in the hands of the creditor nations, making the United States the supplicant and China the financial master. It’s awkward, there is shame in the effort, but the unregulated excess, the unjustified levels of borrowing across every segment of the American economy, all carried a price. We are paying and will continue to pay that price for the foreseeable future.

I’m Peter Dekom, and I approve this message.