Why China must buy US Treasuries with her Trade Surplus Dollars

Henry C.K. Liu

Many have suggested China is not compelled to buy US Treasuries with her trade surplus dollars. They point out that China does so voluntarily because US sovereign debt is the safest instrument as a storer of value.  This is now obviously no longer true. So why does China continue to buy US sovereign debt? The answer is China has no other options but to become a creditor to the US due to US-China trade imbalance. The following explains why.

A debt is not an independent thing. It is a designation of financial relationship between parties. For a debt to exist between parties, one party, or parties, must be the debtor, or debtors, and a counterparty or counterparties must be the creditor, or creditors. A debt cannot exist without a counterbalancing credit position.

Credit drives the economy, not debt.  Debt is the mirror reflection of credit. Even the most accurate mirror does violence to the symmetry of its reflection. Why does a mirror turn an image right to left and not upside down as the lens of a camera does? The scientific answer is that a mirror image transforms front to back rather than left to right as commonly assumed. Yet we often accept this aberrant mirror distortion as uncolored truth and we unthinkingly consider the distorted reflection in the mirror as a perfect representation.

In the language of finance economics, credit and debt are opposites but not identical.  In fact, credit and debt operate in reverse relations. Credit requires a positive net worth and debt does not. One can have good credit and no debt. High debt lowers credit rating. When one understands credit, one understands the main force behind the modern finance economy, which is driven by credit and stalled by debt.  Behaviorally, debt distorts marginal utility calculations and rearranges disposable income. Debt turns corporate shares into Giffen goods, demand for which increases when their prices go up, and creates what former Federal Reserve Board Chairman Alan Greenspan calls "irrational exuberance", the economic man gone mad.

Monetary economists view government-issued money as a sovereign debt instrument with zero maturity, historically derived from the bill of exchange in free banking.  This view is valid only for specie money, which is a debt certificate that can claim on demand a prescribed amount of gold or other specie of intrinsic value.  But fiat money issued by a sovereign government is not a sovereign debt but a sovereign credit instrument.  Sovereign government bonds are sovereign debt while local government bonds are agency debt but not sovereign debt, because local governments, while they possess limited power to tax, cannot print money, which is the exclusive authority of the Federal government or a central government.  When money buys bonds, the transaction represents sovereign credit canceling public or corporate debt.  This relationship is rather straightforward but is of fundamental importance.

Money issued by government fiat is now exclusive legal tender in all modern national economies.  The State Theory of Money (Chartalism) holds that the general acceptance of government-issued fiat currency rests fundamentally on government's authority to tax.  Government's willingness to accept the fiat currency it issues for payment of taxes gives such issuance currency within a national economy.  That currency is sovereign credit for tax liabilities, which are dischargeable by credit instruments issued by government in the form of fiat money.  When issuing fiat money, the government owes no one anything except to make good a promise to accept its money for tax payment.  A central banking regime operates on the notion of government-issued fiat money as sovereign credit.  A central bank operates essentially as a lender of last resort to a nation’s banking system, drawing on sovereign credit. A lender's position is a creditor position.

Thomas Jefferson famously prophesied: "If the American people allow the banks to control the issuance of their currency, first by inflation, and then by deflation, the banks and corporations that will grow up around them will deprive people of all property until their children will wake up homeless on the continent their fathers occupied ... The issuing power of money should be taken from the banks and restored to Congress and the people to whom it belongs."   This warning applies to all other peoples in the world as well.

Government levies taxes not to finance its operations, but to give value to its fiat money as sovereign credit instruments.  If it chooses to, government can finance its operation entirely through user fees, as some fiscal conservatives suggest.  Government needs never be indebted to the public.  It creates a government debt component to provide a benchmark interest rate to anchor the private debt market, not because it needs money.  Technically, a sovereign government needs never borrow.  It can issue tax credit in the form of fiat money to meet all its liabilities.   And only a sovereign government can issue fiat money as sovereign credit.

If fiat money is not sovereign debt, then the entire conceptual structure of finance capitalism is subject to reordering, just as physics was subject to reordering when man's worldview changed with the realization that the earth is not stationary nor is it the center of the universe.  The need for capital formation to finance socially-useful development will be exposed as a cruel hoax, as sovereign credit can finance all socially-useful development without problem.  Private savings are not necessary to finance public socio-economic development, since private savings are not required for the supply of sovereign credit.  Thus the relationship between national private savings rate and public finance is at best indirect. 

Sovereign credit can finance an economy in which unemployment is unknown, with wages constantly rising to provide consumer buying power to prevent production overcapacity.  A vibrant economy is one in which there is persistent labor shortages that push up wages to reduce overcapacity.  Private savings are needed only for private investment that has no intrinsic social purpose or value.  Savings without full employment are deflationary, as savings reduces current consumption to provide investment to increase future supply, which is not needed in an economy with overcapacity created by lack of demand, which in turn has been created by low wages and unemployment.  Say's Law of supply creating its own demand is a very special situation that is operative only under full employment with high wages.  Say's Law ignores a critical time lag between supply and demand that can be fatally problematic to the cash flow needs in a fast-moving modern economy.   Savings require interest payments, the compounding of which will regressively make any financial scheme unsustainable. The religions forbid usury for very practical reasons.

The relationship between assets and liabilities is expressed as credit and debt, with the designation determined by the flow of obligation. A flow from asset to liability is known as credit, the reverse is known as debt.  A creditor is one who reduces his liability to increase his assets, which include the right of collection on the liabilities of his debtors. Sovereign debt is a pretend game to make private monetary debts denominated in fiat money tradable.

The sovereign state, representing the people, owns all assets of a nation not assigned to the private sector.  This is true regardless whether the state operates on socialist or capitalist principles. Thus the state's assets is the national wealth less that portion of private sector wealth after tax liabilities, plus all other claims on the private sector by sovereign right.  High wages are the key determinant of national wealth.  Privatization generally reduces state assets while it may increase tax revenue.  As long as a sovereign state exists, its credit is limited only by the national wealth.  If sovereign credit is used to increase national wealth, then sovereign credit is limitless as long as the growth of national wealth keeps pace with the growth of sovereign credit. 

When a sovereign state issues money as legal tender, it issues a monetary instrument backed by its sovereign rights, which includes taxation. A sovereign state never owes domestic debts except by design voluntarily.  When a sovereign state borrows in order to avoid levying or raising taxes, it is a political expedience, not a financial necessity.  When a sovereign state borrows, through the selling of sovereign bonds denominated in its own currency, it is withdrawing previously issued sovereign credit from the financial system.  When a sovereign state borrows foreign currency, it forfeits its sovereign credit privilege and reduces itself to an ordinary debtor because no sovereign state can issue foreign currency. Dollar hegemony prevents all states beside to US to finance their domestic development with sovereign credit.

Government bonds act as absorbers of sovereign credit from the private sector.  US Government bonds, through dollar hegemony, enjoy the highest credit rating, topping a credit risk pyramid in international sovereign and institutional debt markets.  Dollar hegemony is a geopolitical phenomenon in which the US dollar, a fiat currency, assumes the status of primary reserve currency in the international finance architecture.  Architecture is an art the aesthetics of which is based on moral goodness, of which the current international finance architecture is visibly deficient.  Thus dollar hegemony is objectionable not only because the dollar, as a fiat currency, usurps a role it does not deserve, but also because its effect on the world community is devoid of moral goodness, because it destroys the ability of sovereign governments beside the US to use sovereign credit to finance the development their domestic economies, and forces them to export to earn dollar reserves to maintain the exchange value of their own currencies.

Money issued by sovereign government fiat is a sovereign monopoly while debt is not.  Anyone with acceptable credit rating can borrow or lend, but only sovereign government can issue fiat money as legal tender. When a sovereign government issues fiat money, it issues certificates of its sovereign credit good for discharging tax liabilities imposed by the sovereign government on its citizens.  Privately issued money can exist only with the grace and permission of the sovereign, and is different from sovereign government-issued money in that privately issued money is an IOU from the issuer, with the issuer owing the holder the content of the money's backing.  But sovereign government-issued fiat money is not a debt from the government because the money is backed by a potential debt from the holder in the form of tax liabilities.  Money issued by a sovereign government by fiat as legal tender is good by law for settling all debts, private and public.  Anyone refusing to accept dollars in the US for payment of debt is in violation of US law.  Instruments used for settling debts are credit instruments.

Buying up sovereign bonds with government-issued fiat money is one of the ways government releases more sovereign credit into the economy. By logic, the money supply in an economy is not government debt because, if increasing the money supply means increasing the national debt, then monetary easing would contract credit from the economy.  But empirical evidence suggests otherwise: monetary ease increases the supply of credit.  Thus if fiat money creation by sovereign government increases credit, money issued by sovereign government fiat is a credit instrument.

Economist Hyman Minsky rightly noted that whenever credit is issued, money is created.  The issuing of credit creates debt on the part of the counterparty; but debt is not money, credit is.  Debt is negative money, a form of financial antimatter.  Physicists understand the relationship between matter and antimatter.  Einstein theorized that matter results from concentration of energy and Paul Dirac conceptualized the by-product creation of antimatter through the creation of matter out of energy.  The collision of matter and antimatter produces annihilation that returns matter and antimatter to pure energy.  The same is true with credit and debt, which are related but opposite.  They are created in separate forms out of financial energy to produce matter (credit) and antimatter (debt).  The collision of credit and debt will produce annihilation and return the resultant union to pure financial energy un-harnessed for human benefit. The paying off of debt terminates financial interaction.

Monetary debt is repayable with money.  Sovereign government does not become a debtor by issuing fiat money, which, in the US, takes the form of a Federal Reserve note, not an ordinary bank note. The word "bank" does not appear on US dollars.  Zero maturity money (ZMM) in the dollar economy, is equal M2 plus all money market funds, minus time deposits. It measures the supply of financial assets redeemable at par on demand. ZMM grew from $550 billion in 1971 when President Nixon took the dollar off a gold standard, to $9.6 trillion as of December 2009, is not a federal debt.   It amounts to about 67.3% of US GDP of $14.26 trillion, slightly over the national debt of $12.33 trillion at the same point in time. Sovereign credit is what gives the US economy its inherent strength.

A holder of fiat money is a holder of sovereign credit.  The holder of fiat money is not a creditor to the state, as some monetary economists mistakenly claim.  Fiat money only entitles its holder a replacement of the same money from government, nothing more. The dollar, being a Federal Reserve note, entitles the holder to exchange the note to another identical note at a Federal Reserve Bank, and nothing else. The holder of fiat money is acting as a state agent, with the full faith and credit of the state behind the instrument, which is good for paying taxes and is legal tender for all debt public and private.  Fiat money, like a passport, entitles the holder to the protection of the state in enforcing sovereign credit.  It is a certificate of state financial power inherent in sovereignty.

The Chartalist theory of money claims that government, by virtual of its power to levy taxes payable with government-designated legal tender, does not need external financing.  Accordingly, sovereign credit enables the government to finance a full-employment economy even in a regulated market economy. The logic of Chartalism reasons that an excessively low tax rate will result in a low demand for currency and that a chronic government fiscal surplus is economically counterproductive and unsustainable because it drains credit from the economy continuously. The colonial administration in British Africa used land taxes to induce the carefree natives to use its currency and engage in financial productivity.

Thus, according to Chartalist theory, an economy can finance with sovereign credit its domestic developmental needs, to achieve full employment and maximize balanced growth with prosperity without any need for sovereign debt or foreign loans or investment, and without the penalty of hyperinflation.  But Chartalist theory is operative only in predominantly closed domestic monetary regimes. Countries participating in neo-liberal international “free trade” under the aegis of unregulated global financial and currency markets cannot operate on Chartalist principles because of the foreign-exchange dilemma.  Any government printing its own currency to finance legitimate domestic needs beyond the size of its foreign-exchange reserves will soon find its convertible currency under attack in the foreign-exchange markets, regardless of whether the currency is pegged at a fixed exchanged rate to another currency, or is free-floating.  Thus all non-dollar economies are forced to attract foreign capital denominated in dollars even to meet domestic needs.  But non-dollar economies must accumulate dollars reserves before they can attract foreign capital.  Even with capital control, foreign capital will only invest in the export sector where dollar revenue can be earned.  But the dollars that exporting economies accumulate from trade surpluses can only be invested in dollar assets, depriving the non-dollar economies of needed capital in domestic sectors. The only protection from such attacks on domestic currency is to suspend full convertibility, which then will keep foreign investment away.   Thus dollar hegemony, the subjugation of all other fiat currencies to the dollar as the key reserve currency, starves non-dollar economies of needed capital by depriving their governments of the power to issue sovereign credit for domestic development.

Under principles of Chartalism, foreign capital serves no useful domestic purpose outside of an imperialistic agenda. Dollar hegemony essentially taxes away the ability of the trading partners of the US to finance their own domestic development in their own currencies, and forces them to seek foreign loans and investment denominated in dollars, which the US, and only the US, can print at will with relative immunity.

The Mundell-Fleming thesis, for which Robert Mundell won the 1999 Nobel Prize, states that in international finance, a government has the choice among (1) stable exchange rates, (2) international capital mobility and (3) domestic policy autonomy (full employment, interest rate policies, counter-cyclical fiscal spending, etc). With unregulated global financial markets, a government can have only two of the three options.

Through dollar hegemony, the United States is the only country that can defy the Mundell-Fleming thesis.  For more than a decade since the end of the Cold War, the US has kept the fiat dollar significantly above its real economic value, attracted capital account surpluses and exercised unilateral policy autonomy within a globalized financial system dictated by dollar hegemony. The reasons for this are complex but the single most important reason is that all major commodities, most notably oil, are denominated in dollars, mostly as an extension of superpower geopolitics. This fact is the anchor for dollar hegemony which makes possible US finance hegemony, which makes possible US exceptionism and unilateralism.

When China exports real wealth to the US for fiat dollars, it is receiving US sovereign credit in exchange of material wealth in the form of goods. Thus the US trade deficit denominated in dollars is in fact US lending to China through buying Chinese goods on sovereign credit. 
China now is a  holder of US fiat money and as such is acting as a state agent of the US, with the full faith and credit of the USe behind the US sovereign credit instrument (dollar), which is good for paying US taxes and is legal tender for all debt public and private in the US.  Fiat money, like a passport, entitles the holder to the protection of the state in enforcing sovereign credit.  It is a certificate of state financial power inherent in sovereignty. Since China does not pay US taxes, the dollars that China receives  can only be used to buy US sovereign debt (Treasuries) through extinguishing the US sovereign credit instruments (dollars). Through this transaction, China changes its position from that of an agent of US sovereign credit to that of a creditor to the US. This is why China must buy Treasuries with its surplus dollar - to change it s position from that of a US agent to that of a US creditor.

The only way for China to become free of this dilemma is to require all Chinese exports to be paid in Chinese currency.

January 5, 2009