Niall Ferguson: Let the Chinese Keep Financing American Debt

... In effect, the Bush administration's combination of tax cuts for the Republican ''base'' and a Global War on Terror is being financed with a multibillion dollar overdraft facility at the People's Bank of China. Without East Asia, your mortgage might well be costing you more. The toys you buy for your kids certainly would.

Why are the Chinese monetary authorities so willing to underwrite American profligacy? Not out of altruism. The principal reason is that if they don't keep on buying dollars and dollar-based securities as fast as the Federal Reserve and the U.S. Treasury can print them, the dollar could slide substantially against the Chinese renminbi, much as it has declined against the euro over the past three years. Knowing the importance of the U.S. market to their export industries, the Chinese authorities dread such a dollar slide. The effect would be to raise the price, and hence reduce the appeal, of Chinese goods to American consumers -- and that includes everything from my snowproof hiking boots to the modem on my desk. A fall in exports would almost certainly translate into job losses in China at a time when millions of migrants from the countryside are pouring into the country's manufacturing sector.

So when Treasury Secretary John Snow insists that the United States has a ''strong dollar'' policy, what he really means is that the People's Republic of China has a ''weak renminbi'' policy....

Sadly, according to a growing number of eminent economists, this arrangement simply cannot last. The dollar pessimists argue that the Asian central banks are already dangerously overexposed both to the dollar and the U.S. bond market. Sooner or later, they have to get out -- at which point the dollar could plunge relative to Asian currencies by as much as a third or two-fifths, and U.S. interest rates could leap upward. (When the South Korean central bank recently appeared to indicate that it was shifting out of dollars, there was indeed a brief run on the U.S. currency -- until the Koreans hastily issued a denial.)

Are the pessimists right? The U.S. current account deficit is now within sight of 6 percent of G.D.P., and net external debt stands at around 30 percent. The precipitous economic history of Latin America shows that an external-debt burden in excess of 20 percent of G.D.P. is potentially dangerous....

During the Second World War, Britain financed its wartime deficits partly by borrowing substantial amounts of sterling from the colonies and dominions within her empire. And yet by the mid-1950's, these very substantial debts had largely disappeared. Unfortunately, this was partly because the value of sterling itself fell significantly. Moreover, sterling's decline and fall did not reduce the U.K.'s chronic trade deficit, least of all with respect to manufacturing. On the contrary, British industry declined in tandem with the pound's status as a global currency. And, needless to say, the decline of sterling coincided with Britain's decline as an empire.

From an American perspective, all this might seem to suggest worrying parallels. Could our own obligations to foreigners presage not just devaluation but also industrial and imperial decline?

Possibly. Yet there are some pretty important differences between 2005 and 1945. The United States is not in nearly as bad an economic mess as postwar Britain, which also owed large sums in dollars to the United States. The American empire is also in much better shape than the British empire was back in 1945.

Though neither side wants to admit it, today's Sino-American economic relationship has an imperial character. Empires, remember, traditionally collect ''tributes'' from subject peoples. That is how their costs -- in terms of blood and treasure -- can best be justified to the populace back in the imperial capital. Today's ''tribute'' is effectively paid to the American empire by China and other East Asian economies in the form of underpriced exports and low-interest, high-risk loans.

How long can the Chinese go on financing America's twin deficits? The answer may be a lot longer than the dollar pessimists expect....