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:
- Jake If you only spend 20 minutes of the rest of your life on economics, go spend them here.
If the people who sold those bonds would otherwise have liquidated them and bought stuff for them, then it reduces domestic demand, by taking the liquid cash out of the economy (because the cash in question is Chinese and can therefore only be spent in China).
But the alternative to recycling those euros is not to keep them in mattresses in China - it is to allow the people who earned them to buy European stuff with them (or, which comes to the same thing, to sell them for Chinese currency that some European merchant got from selling stuff to China).
Being against the zero lower bound on interest rates means it makes no difference whether Chinal holds Euros or bonds. However, the widening spreads among Eurozone bond issuers mean that it now makes sense for China to hold (say) Spanish bonds rather than Euro cash. This partly offsets the liquidity drain from any EU trade deficit with China, as China releases Euro cash into circulation and holds illiquid bonds.
But if the fiscal policy is tight and you have a trade deficit the overall effect is still one of monetary drain.
However, China's trade balance with the US dwarfs the trade balance with the EU, so most of the action should be there, By laying out pros and cons we risk inducing people to join the debate, and losing control of a process that only we fully understand. - Alan Greenspan
