Margareto Pagano, real interest rates, and 'the balance of financial terror'

Looking through recent back articles online Margareta Pagano had a good piece in The Independent on the interrelation between economic events in the US, and other countries, and China. She understands that all the borrowing being carried out to fund bank bailouts and Keynesian reflationary measures will have to be repaid over time and therefore a critical factor for economic developments will be the real interest rate at which it will have to be repaid? That depends not only on the situation in the US, Europe, Japan and other advanced countries but on the worlds largest saver China - and to a lesser degree Japan and the Middle Eastern oil producers.
She writes: 'The former US Treasury Secretary, Larry Summers, calls it the "the balance of financial terror". A noted academic, Summers, who served under President Bill Clinton, was referring to the relationship between the US and its newer creditors, such as China, the Middle East and Russia. Foreign countries now own nearly a quarter, some $2.6 trillion, of the total US debt. They also own more than $14 trillion in US assets – that's more than the total US national output.
'By far the biggest chunk of this debt is still owned by the Japanese, with US Treasuries worth $593.4bn. But soaring up the debt table is China, which now controls $518.7bn, more than 8 per cent higher over the past year, and equal to about half of the total $1.2 trillion it holds in reserve assets. Oil-rich states are also snapping up T-bills as though they are going out of fashion – up 29 per cent on the year to $173bn. On top of this, the US has a trade deficit with China in the first six months of this year of $142bn – and it is still growing.
'Behind all the figures lurks some intriguing realpolitik. The success of the US rescue package depends as much on the support of China and the Middle East as it does on the American taxpayer. Ultimately, it is the Chinese and Middle Eastern governments – and their taxpayers, which will decide the fate of the biggest financial rescue plan in history. Indeed, one of the reasons the US authorities say they had to rescue Fannie Mae and Freddie Mac was to reassure the Chinese government that US securities really were secure.
'They are going to have to do so again for this latest bail-out. Apparently one of the first things Hank Paulson, the US Treasury Secretary, plans now the package has gone through is a "road show" in Beijing to explain the rescue and why the US is not going to explode. As the ex-chairman of Goldman Sachs, Paulson has had good relations with China – visiting the country more than 70 times, chairing Tsinghua University's business school and helping the former Chinese president save an area of outstanding environmental importance.
'But Paulson will need to do more than go down on one knee to persuade the more sceptical Chinese – and there are many – that this rescue will work. There are some signs that the Chinese are being co-operative, and this may explain why the dollar has been strengthening during this recent crisis despite such low interest rates.
If they decide not to buy any more of the new debt, or dump existing debt, then the outlook for the US is truly dire. Interest rates will have to be pushed up again to attract new investors. It is a zero sum game: if the foreign holders do pull out then they would only be hurting their own investments.
'We've known for some time that the growth of the emerging economies such as Russia, China and India through globalisation would eventually dilute the power of the US. Philosopher John Gray thinks American political leaders are oblivious to what is really going on. He believes the present crisis is pushing the US into a fall as catastrophic and swift as that of the Soviet Union when the Berlin Wall came down. It's far too early to say if he is right, but what will be really interesting to watch is China's response to this crisis. Will it assert its authority or continue as a peaceful trade partner: the balance of financial terror exchanging debt for toys?'
Pagano's piece is worth reading in full. However it makes one error. The 'balance of financial terror' is asymmetric even if real. China, with a huge and rising pool of savings, in excess of its current domestic investment, is strategically stronger in this area than the US, with savings at a record low level as a proportion of GDP and in the middle of a financial crisis, in such an eyeball to eyeball. It would be surprising if China did not ask for and receive significant concessions if it decides to help out the US economically.

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