Hank & Ben Go To China

December 18. 2006 – Treasury secretary Hank Paulson and Federal Reserve chairman Ben Bernanke (together with 59 underlings) trekked to China to meet with one of the federal government’s largest creditors. In the Great Hall of the People, under a painting of Chairman Mao, they were lectured by Chinese Vice Premier Wu Yi, who gave the US delegation a history lesson.

Her lengthy and impassioned speech startlingly focused on her country’s struggles with foreign interference and the present Chinese government’s efforts to overcome wide-spread poverty. She pointedly stated that Americans have “limited knowledge [and] much misunderstanding” about China and its present circumstances.

Though her comments were directed to Americans in general, Hank and Ben were no doubt squirming in their seats given the huge task facing them. While much has been said about their efforts to get the Chinese to revalue the yuan, their primary mission has largely gone unnoticed. Namely, how can they convince the Chinese to continue holding dollars and US government debt?

We don’t really know how many dollars the Chinese hold. They report the value of their reserves in dollars, but their composition is kept secret. Reportedly the Chinese for a few years have been actively diversifying the composition of their reserves, and that diversification has increased after the US government rejected the purchase of Unocal by the Chinese National Oil Company. That move had protectionism all over it, and has now backfired as China has stepped up the diversification of its reserve composition.

China holds its dollar reserves mainly in US government T-Bills and T-Notes. Its total dollar holdings are now believed to be no more than $600 billion, which is 60% of China’s total $1 trillion of reserves.

Importantly, this $600 billion dollar position is less than the peak position of $750 billion believed to have been reached less than two years ago. Chinese reserves have soared since then, so in addition to reducing its holding of dollars, newly accumulated reserves have been plowed into other currencies and tangible assets (particularly commodities, including gold).

So Hank and Ben face a real problem. How will the federal government get the dollars it needs to borrow if the Chinese don’t remain a large creditor and lend those dollars to it?

I wonder if Hank and Ben took with them the “2006 Financial Report of the United States Government” that was released this past week by the General Accounting Office. The federal government’s pretense of serious reporting makes it laughable by any measure of prudent financial analysis. ( www.gao.gov)

“For the tenth consecutive year, GAO has issued a disclaimer of opinion on the consolidated financial statements.” In other words, the GAO is saying that the information they are reporting is not reliable because of “material weaknesses in internal control and other limitations on the scope of its work.” And have been for ten years!

It is clearly not reasonable in the business world to accept any qualified audit. Given the importance of financial statements, they need to be relied upon, and therefore an unqualified opinion by an independent third-party is essential. That is the service auditors provide. But here we have the US government’s own accounts being qualified for ten years in a row! It is not only inexplicable, but also totally inexcusable that this state of affairs could go on for so long without the corrective action needed to bring the accounts up to proper and reliable standards. Further, given that the GAO reports only began ten years ago, it also means that the US government accounts have never received an unqualified audit.

Even Enron had unqualified audits, and look what happened there. One does not have to let their imagination run wild to understand the potential mismanagement and financial abuses that might be occurring, and that potential is particularly far reaching given the magnitude of the money that runs through the federal government’s accounts. Those numbers are indeed huge.

What’s worse is the dire picture the government’s accounts present. Because of the qualified opinion, the GAO really doesn’t know the true financial condition of the federal government, but if you accept their numbers at face value, the federal government’s negative net worth is $8.9 trillion before unfunded pension liabilities. Those equal $44.1 trillion, so add them in and the federal government has a negative net worth (i.e., liabilities greater than assets) of $53.0 trillion. And this financial imbalance does not include the potential debt obligations of the federal government from its commitments to a dozen quasi-government agencies like Fannie Mae, Freddie Mac, and Sallie Mae.

Is it any wonder that China is unwilling to increase the amount of US government debt it holds? Isn’t it understandable really, that people around the world are moving out of dollars into assets considered to be safer?

So consider the plight of unfortunate Hank and Ben. By any prudent measure, the US government is tapped out, and they know it (Hank wrote the introductory letter to the “2006 Financial Report“). Nevertheless, off they go to China hat in hand, looking for big bucks, but are only offered a history lesson.

In contrast to most other countries around the world, China has decided not to kowtow to US requests. China’s leaders are instead pursuing their country’s own national interests. It had to happen sooner or later, that a country would stand up for its own interests, because that is the way international politics work.

The US has attempted to change this reality by using its military and monetary system to get countries to ‘toe the line’. But China is not buying. They know the prospect of US military intervention is nil, but China is also saying that the international monetary system is broken. More to the point, China is saying that the dollar’s position as the world’s reserve currency is no longer a viable alternative.

It of course need not be this way. All a country has to do is re-establish Sir Isaac Newton’s greatest invention, what we now call the classical gold standard. In testimony before Congress Alan Greenspan often mentioned the system’s “automaticity”, which is the relevant point here. Cutting through all the nonsense central bankers use to explain it, the gold standard works like this.

A country pays for its imports in gold, and conversely, a country receives gold in payment for its exports. If you don’t have gold, then you cannot import until you start exporting in order to earn the gold you need to pay for your imports. In other words, the basic premise of the classical gold standard is the time-honored, financially sound principle of “pay as you go”.

By applying this principle to the present international monetary situation, we can immediately see that the destabilizing force is not China, but the US. It is paying for its imports with paper, and not gold. However, China must accept some of the blame. It should just start demanding gold in payment for its exports, but they have been in effect moving toward this policy.

I note above that China is reportedly not increasing the amount of dollars it is holding in its reserves. It is now building its reserve position in other currencies and tangible assets, including gold. This flow into other assets has become substantial, and explains in part the ongoing commodity bull market.

China is accumulating commodities in preference to holding dollars, and we should too. The best way to do that is to continue accumulating gold and silver.