There's a crescendo of worry regarding the question of whether or not China, one day, will stop buying our debt. Last week, famed hedge fund manager Julian Robertson said the U.S. will experience economic "Armegeddon" if China stops buying. (Proving that you don't have to be smart to make a lot of money as a trader.) And now Paul Volker is in the news alluding the same thing. (Proving that he knows shockingly little about macroeconomics.)
Let's try to break this whole problem down and see if we can understand it piece by piece, shall we?
The first thing you should say to someone who says, "What if China (or anybody) stops buying our debt?" is...
"Okay...can you tell me how China or anybody else pays for our debt?"
If they're halfway on the ball they'll say, "They pay in dollars," or something like that. If you get that answer, that's good enough. (You'll find that some people will even be stumped by your question.)
To be more precise, they pay in reserves. When somebody buys a Treasury, that person's checking account is debited and their bank's reserve account at the Fed is debited in the amount of the purchase.
The reserves balances are lower, but the buyer gets a Treasury.
So far, so good.
But here is the problem with the worry warts' arguments: Reserves are a monopoly of the state, i.e. of the government. Only the government can create reserves!
Therefore, if reserves are a monopoly of the government and buyers of Treasuries can ONLY pay in reserves, then in order for anyone to have the reserves to pay, the government MUST HAVE SPENT THOSE RESERVES INTO EXISTENCE IN THE FIRST PLACE!!
Do you follow me??
When you or the Chinese or the Japanese or your Uncle Frank or ANYONE buys Treasuries, you can only buy them with the government's own money. And the government has a monopoly on the creation of its own money.
How, then, does that equate to a loan from the Chinese??
The answer is, IT DOESN'T!!
Our government, in some way shape or form, MUST GIVE THE CHINESE U.S. DOLLAR RESERVES IN ORDER FOR THEM TO BE ABLE TO BUY TREASURIES!!!
How does that happen?
It happens when the governemnt spends. More precisely, it happens when the government defict spends because that is how more reesrves are credited to the banking system. Some of those reserves are held by accounts of foreign banks at the Fed.
When the government spends it increases aggregate demand, which adds to GDP and national income and that gives buying power to American consumers, who then spend on imports and that spending results in an increase in reserve balances for Chinese and other foreign entities' bank accounts.
Then those foreigners simply exchange those reserves (which pay little or no interest) for a savings account of the U.S. government that earns interest, which is called a Treasury. That's all a Treasury is...a savings account of the U.S. government.
THERE IS NO BORROWING!!!
Anyway, ask your friend or colleague this: Why in the world would the government need to borrow what it can create without limit???
This whole, "borrowing from the Chinese, thing" is a complete fallacy yet it is going to end up destroying our country.