My thought was that China's exports to Europe were threatened by a weak Euro, compared to the dollar, while the Euro was down around $1.25. This might have been, in part, due to the need of European debtors to pay US$ denominated debts. This could have been most effectively remedied had China used some of its US Treasuries to buy Spanish treasuries, etc. This would give China something beneficial, (protecting its European export market) to do with US$ assets that it cannot or does not want to use in the USA. Do you know if they have done anything of the sort.

As the Dutch said while fighting the Spanish: "It is not necessary to have hope in order to persevere."

I recall discussion of a "dollar squeeze" in the forex markets a month or so ago. I also recall the Fed renewing currency swaps in the same time frame. It may be that the amount of the currency swap was calibrated to prevent a currency meltdown, but not to prevent the euro from going to $1.22 or so. But if that was part of a dollar squeeze, (by US banks?), the Chinese might have just administered a lesson. You cannot run a dollar squeeze if the world's largest holder of US$ reserves doesn't allow you.

As the Dutch said while fighting the Spanish: "It is not necessary to have hope in order to persevere."

But that assumes there's something happening to invest in, and that the debt payments are converted into credit and/or disposable income.

Suppose all debt that EU countries would otherwise buy from each other is instead bought by China. This frees up a substantial fraction of GDP to invest within the EU (or to spend buying iPods).

I'm not so sure. Let's go over the mechanics.

First, the Chinese central bank converts European legal tender into Chinese legal tender through open market operations. Then, having obtained credit for an amount of European legal tender, it can convert some European sovereign bonds into European legal tender. The net effect of this process is to convert European sovereign bonds into Chinese legal tender.

This process makes the cost of liquidity - that is, the risk-free interest rate - go down in both Europe (because the price of bonds goes up, which decreases the effective compensation paid to providers of liquidity for their service) and China (because there is more liquidity available). But on the other hand, it creates a fiscal contraction in Europe, by lowering the overall monetary mass (since the Chinese legal tender will swiftly find its way back to China).

The main consequence of decreasing the price of liquidity is that it allows a going concern to convert its highly illiquid equity into highly liquid legal tender, though the magic of fractional reserve banking. Now, if you have a business environment in which equities are great or growing, the reduction in the cost of liquidity will prompt a great conversion of illiquid equity into liquid legal tender, thus increasing the average circulation velocity of the money supply greatly. This increase in average circulation velocity can then greatly outweigh the reduction in monetary mass. If, on the other hand, you have a depressed business environment where equities are small or decreasing, very little such conversion can take place - and the reduction of total monetary mass will dominate over the increase in velocity.

So the beneficial effect for Europe is not that these Chinese debt purchases stimulate our economy. It is actually contractionary under the current business environment. The benefit is that they are importing our inflation, which gives us more room for expansionary fiscal policy. However, this underwriting of the option for expansionary fiscal policy comes at the cost of impairing our foreign trade balance. So the fiscal expansion must be of a sort that comes with a reasonable story about how it will mitigate and reverse the de-industrialisation that goes with a trade deficit.

Which means that we have three basic options:

1. Do nothing, or engage in further austerity. In that case, the contractionary and deflationary effects of the Chinese operation will further deepen our recession.

2. Engage in expansionary fiscal policy in order to underwrite consumption (this includes bailing out banksters). This will help to get us out of the recession (faster if we underwrite the consumption of the poor and the middle class than if we underwrite the bad bets of the banksters, due to the greater multiplier effect from the former than the latter). But in the medium term, it will simply substitute the harsh de-industrialisation of a serious business depression with the softer, but no less effective, de-industrialisation through structural trade deficits.

3. Engage in expansionary fiscal policy in order to underwrite investments in industrial capacity that will (preferably more than) offset the destruction of industrial capacity caused by the trade imbalance.

Only if we pick the third option will this be of any durable benefit to us.

- Jake

If you only spend 20 minutes of the rest of your life on economics, go spend them here.