We’ve don’t have a problem with China. China has a problem with us.

They hold $801.5 billion of US Treasuries and another $720 billion of US agency debt. That’s $1.521 trillion, which is substantial to say the least. When you think about it, it is very nice of them to finance our government deficits. Right now they hold $2.132 trillion in foreign currency reserves. They have all that money because we and the rest of the world buy more of their goods than we sell to them.

The Obama Administration has been holding an economic summit with China for a week. They sent over a very high level group of officials because they are worried about their investment in America. This report came out Wednesday as the talks wrapped up:

July 28, 2009 (Bloomberg) — U.S. and Chinese economic leaders pledged to keep up stimulus efforts and to rein in trade and investment imbalances that contributed to the global crisis.

“It is vitally important for China and the United States to see through their commitments to repair the financial system and lay the foundation for recovery,” Treasury Secretary Timothy Geithner said at the end of the first Strategic and Economic Dialogue talks under the Obama administration in Washington. China’s Vice Premier Wang Qishan said the two will press for an “expansion” of the recovery.

The U.S. pledged to curb the budget deficit and boost household savings, and China committed to rely less on overseas demand for its goods. There were few signs of the disputes over the yuan and market access that characterized talks in the Bush administration. Analysts expressed skepticism whether the two governments can secure “balanced” growth. …

Zhou Xiaochuan, the Chinese central bank governor, said China will wait for the U.S. to begin to pull back on its stimulus measures before deciding whether it will do the same.

“If we see that the U.S. starts to exit its expansionary fiscal and monetary policies, then China will see what it will do at that time,” Zhou said at a press briefing today.

The People’s Bank of China governor also said that “"I believe that the Federal Reserve of the U.S. will make appropriate arrangements to prevent high inflation.” …

China’s officials reiterated their concern at the record American budget deficit, and were told by Obama’s aides that there’s a plan to achieve a “sustainable” deficit by 2013. Their comments today indicated they accepted the U.S. presentation.

“Credible steps will be taken by the U.S. to control the deficit,” China’s Finance Minister Xie Xuren said at a press briefing today. “The Treasury secretary stated clearly that they are placing a lot of importance on this issue.” …

There are a lot of interesting aspects to all of these comments.

Let’s get right to the most important thing the Chinese are concerned about: inflation. If you held $1.521 trillion in US denominated assets you would worry about US inflation too. Note that there were very specific statements in the above article about the US fiscal stimulus and the huge-by-any-standards US budget deficit of an estimated $1.8 trillion. As anyone with any gray matter can foresee, we will experience inflation and their dollar denominated assets will lose value. It’s as if we get a purchase discount on Chinese goods.

The problem for the Chinese is that there isn’t a lot they can do about it without causing a massive devaluation of the dollar. If they decide to stop buying US debt then it will have a huge impact on the cost of financing the deficit. The dollar would go into the tank, and the Chinese would be holding devalued assets. So it’s the old damned-if-you-do-damned-if-you-don’t scenario. If they continue to finance the deficit, inflation will eat away the value of their holdings. If they don’t finance the debt, they will cause the dollar into a serious devaluation and that will diminish the value of their holdings. The cost of our debt would go up as buyers would demand higher rates of return on US Treasuries. A devil’s bargain you might say.

Plus, China has their own problems. The apparent rapid “recovery” of their economy is fragile and dangerous:

July 28, 2009 (Bloomberg) -- China’s rate of inflation may rebound in the second half of this year, the People’s Bank of China said today, adding that it plans to keep policies stable to ensure an economic recovery.

China’s economy is at a “critical” stage, the central bank said in a report on its Web site today. It said the acceleration in growth in the second quarter from the first had exceeded expectations….

New lending tripled to more than $1 trillion in the first half of 2009 from a year earlier, fueling concern that banks are taking on too much risk and bubbles are inflating in stocks and property. The Shanghai Composite Index has climbed almost 90 percent this year. …

“The rapid decline in capital adequacy ratios and strengthened risk management may constrain the banking industry’s ability to sustain rapid growth in credit,” the bank said.

Ouch. This isn’t good. They are probably going to curtail bank lending to prevent a disaster and another collapse. I get the feeling they don’t know what they’re doing. But I have the same feeling about Messrs. Geithner, Summers, and Bernanke. The comments in the above article about the economic summit noted that the Chinese were tag-teaming our fiscal stimulus moves. When we stop, they’ll stop. How will that play with their attempts to control a re-ignition of their bubble?

The most naive comment to come from the Chinese was their belief that the Fed will be able to control an outbreak of “high inflation.” This has been all over the news for the last month as Bernanke has been talking about the Fed’s “exit strategy,” i.e., their ability to sop up all of the money the have pumped into the system at the time they think the economy is back on track. I am sure much of Bernanke's efforts were really made for the benefit of the Chinese. I don’t think he can do it without causing another collapse because of the effect that high interest rates will have on any recovery.

The Chinese have the same problem of course, since they are mimicking our Keynesian policies:

The jump in China's reserves adds to the already extraordinary amount of liquidity being pumped through China's economy. The People's Bank of China also said Wednesday that loan growth accelerated to 34.4% in June from 30.6% in May, while the increase in the broad M2 measure of money supply rose to 28.5% in June from 25.7% in May.

What a mess. Here’s the best part of the economic summit:

The U.S. savings rate reached 6.9 percent in May, the highest level since 1993, as Americans consumers curtailed spending. Geithner said he expects those gains to be part of a more permanent shift.

“We’re more likely to decide that these changes we’ve seen in private savings already are durable,” Geithner said. “We’ve learned some tough lessons as a country. I think the basic lesson, the importance of living within our means, is best for the country, and at the household level, is an important, necessary lesson.”

Wow, Tim. How can you say that with a straight face. You’re spending $1.8 trillion more than you have. You’re creating more and more programs. Your president is trying to push through a national health program that by any estimate will run up the deficit to even greater heights. At least the American people are wise enough to raise their savings levels to record levels because they know that you can’t borrow your way into prosperity. That can’t be very encouraging to our Chinese friends.

The Chinese need us to buy their goods but US consumption is headed down and will remain down for the foreseeable future.They don’t have much of choice about what they must do with their reserves: continue to finance our deficit. Yet they imitate failed Keynesian policies that will only result in inflation and more debt. Their loose monetary policy will result in a inflationary bubble and a bust.

They are screwed and they know it.

Jeff Harding maintains The Daily Capitalist, from which this article has been permissibly reproduced.