Can China afford to downgrade the U.S.?

AUG 8, 2011 10:20 EDT

Reuters

By Joseph S. Nye, Jr.

The opinions expressed are his own.

After the rating agency Standard & Poor’s downgraded America’s long-term debt, China said that Washington needed to “cure its addiction to debts” and “live within its means.” It must have been a delicious moment in Beijing, accustomed over the years to lectures from Washington about its management of the yuan.

But actions speak louder than words. The real test will be whether China moves away from the dollar in any significant manner. While it makes modest adjustments to its reserve holdings, there are few good alternatives to the dollar. And while it calls for an international basket of currencies to replace the dollar, there are few takers. Of course, China might move toward opening its currency and credit markets in an effort to make the yuan a reserve currency, but the authoritarian political system is unwilling and unprepared to move to that degree of economic freedom.

Many commentators see the downgrading of American debt as a great shift in the global balance of power between the U.S. and China. Some wags have warned the American navy not to sail too close to China, because if the Chinese captured our ships, we would no longer have enough money to ransom them. But such jokes misunderstand the nature of power. Analysts point to China’s seemingly unstoppable growth and its holdings of United States dollars. But as I show in my latest book, The Future of Power, they fail to take into account the role of symmetry in interdependence in creating and limiting economic power. If I depend on you more than you depend on me, you have power. But if we both depend equally upon each other, there is little power in the relationship.

Some observers claim that China could bring the United States to its knees by threatening to sell its dollars. But in doing so, China would not only reduce the value of its reserves as the price of the dollar fell, but it would also jeopardize U.S. willingness to continue to import cheap Chinese goods, which would mean job loss and instability in China. If it dumped its dollars, China would bring the United States to its knees, but might also bring itself to its ankles. The situation, analogous to the Cold War’s balance of terror, where the price of aggression was the inevitable destruction of both sides, has both sides eager to maintain the balance of interdependence even as they continue to jockey to shape the structure and institutional framework of their market relationship. In 2010, when the United States angered China by selling arms to Taiwan, some People’s Liberation Army generals suggested that China punish the U.S. by dumping its dollars. The Chinese leadership wisely rejected their advice.

On American power relative to China, much will depend on the often underestimated uncertainties of future political change in China. China’s size and high rate of economic growth will almost certainly increase its relative strength vis-a-vis the U.S. This growth will bring it closer to the U.S. in power resources, but doesn’t necessarily mean that it will surpass the U.S. as the most powerful country. Even if China suffers no major domestic political setback, many current projections are based simply on GDP growth. They ignore U.S. military and soft-power advantages, as well as China’s geopolitical disadvantages. As Japan, India and others try to balance Chinese power, they welcome an American presence.

The United States faces serious problems regarding debt, secondary education, and political gridlock, but one should remember that they are only part of the picture. In principle, and over a longer term, there are solutions to current American problems. Given the challenges they face, both China and the United States have much to gain by working together. As the largest and second largest economies in the world, the two countries have a responsibility to provide such international public goods as financial stability and less carbon intensive growth. But hubris and nationalism among some Chinese, as well as unnecessary fear of decline among some Americans, make it difficult to assure this future. Extrapolating the wrong long-term projections from short-term cyclical events like the recent financial crisis or the S & P downgrade can lead to costly policy miscalculations.