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China Does NOT Fund US Government Spending. Period.
It's Everywhere, So It Must Be True, Right?
All too often, I've read headlines that are factually inaccurate, and it makes me cringe. Just yesterday I saw a Presidential campaign ad on TV for Mitt Romney where he said "My test for the federal government is this: Is this program so critical, so important, that it's worth borrowing money from China to pay for it?" These headlines grab attention, but are nothing more than fear-mongering. Below is a very simple explanation of what is ACTUALLY happening when China buys Treasury securities.
How Does China Get Its US Dollars In The First Place?
China acquires US dollars by selling merchandise and services in the United States. In exchange for these goods, China is credited with pieces of paper with pictures of former Presidents on them (US dollars). These dollars are deposited into China’s checking account at the Federal Reserve Bank.
They Then Purchase US Government Debt (Treasury Securities).
China is fairly limited to what they can do with these pieces of paper. They can leave them sitting in their checking account, or they can buy Treasury Securities (US Government Debt). They could also try and buy US companies and/or US real estate (like Japan did in the 80’s), but those are high risk ventures. Assuming China chooses to buy US debt, the Federal Reserve simply transfers the funds from China’s "checking account" at the Federal Reserve (where they initially store the dollars that they earned) into China’s “securities” account at the Federal Reserve. US Treasury Securities are accounted a lot like savings accounts at a normal commercial bank. This is a VERY important operational action to understand. Once the funds are moved from China’s checking account to their securities account, this EXACT action is commonly referred to as “increasing the national debt”. The important take-away is that the spending of dollars by the US Government is nothing more than the Federal Reserve Bank changing numbers in someone’s reserve account. Effectively, China has opened a savings account at the Fed when they buy Treasury Securities. This doesn’t “fund” anything. Period. Did the US need China to buy those Treasury Securities before the government can spend? Absolutely not.
But What If China Sells Their US Debt??
Let’s assume China wants to sell their US Treasury Debt holdings. And for ease of argument, let’s assume they want to buy Euros from the Deutsche Bank. The Federal Reserve would simply move China's US dollars from their account at the Fed to the Deutsche Bank account at the Fed. That's it. It's almost literally as simple as changing numbers on a master spreadsheet.
What Would China Selling Their US Debt Do To The US Dollar?
It’s self-defeating for China to create too much downside pressure on the US dollar. This is two fold: 1) since China holds such a large amount of Treasury Securities, selling their holdings to someone else would potentially adversely affect the bulk of their own holdings and 2) we are China’s biggest customer, whether they like it or not. “Dumping” their US dollars is the equivalent of economic suicide.
The operational reality of China (or any foreigner) buying Treasuries is different than what we read and see in a lot of mainstream media. Ever since the US abandoned the gold standard in 1971, some of what we learned in traditional economics classics became obsolete. Government spending not being “funded” by foreigners is a perfect example. It's also important to realize that while, operationally speaking, foreigners do not fund our spending, this is not a "free pass" for inefficient or reckless government spending.
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