For all the outward signs of cooperation, relations between the US and China look headed for an extremely dangerous period. This has nothing to do with Taiwan, North Korea, Iran, missile defense systems or human rights. On most of these topics, Beijing and Washington are not as far apart as in the past.
The issue is economic. How on earth does one move from a situation where China owns an increasingly huge slice of US federal debt, enjoys a trade balance five to one in its favor and is accumulating foreign exchange reserves at the rate of US$20 billion a month to an economic relationship which is sustainable?
The return of a Democrat-dominated Congress in the US mid-term elections has given this renewed focus.
Although historically US Democrats are generally not any more protectionist than Republicans, many of their election candidates spoke out in defense of American jobs against "unfair" developing world competition. This suggests they will use the trade deficit, and China trade in particular, to attack the Bush administration.
But possible new protectionism is more effect than cause when it comes to the US-China economic imbalance – and both sides must carry blame for the situation.
In exchange for short-term gains, they have chosen to ignore the fact that the longer the imbalance remains and the more unsustainable it becomes, the more the dangers of a sudden breakdown.
Recent events may suggest we are getting close to the tipping-point.
The evidence for this is not so much found in the trade numbers – the rates of increase in both China's exports and America's deficit have slowed and this is likely to continue – as in the financial markets.
Overflowing with cash
Almost all assets everywhere in the world – stocks, real estate etc – are trading at or near record highs. Costs to high risk borrowers – junk bonds and some emerging market bonds – are close to all time lows. Hedge funds, leveraged buyout funds, private equity funds are growing by the billions. The world is awash with money and it is all down to an expansion of global base money as represented by foreign exchange reserves. These are currently growing at 18% a year, some four times the rate of growth of the global economy.
Apart from the oil exporters, China's reserve growth has been the most spectacular, but other East Asian economies have also seen big increases. This is possible because the US deficit roughly equals the rest of the world's surpluses and the US is accepted as an IOU everywhere.
It suits the US that its consumers can carry on bingeing; it suits China because US consumers keep its factories working; it suits both because cheap money causes an investment boom in China and a profits boom in the US, and supports rising real estate values in both.
Such excesses inevitably lead to crisis. Quite what form it will take is hard to predict, the timing even more so. But because the financial issue is a consequence, at least in part, of the trade imbalance, a crisis in one will lead to crisis in the other.
One can only guess at whether the US trade deficit issue is resolved by a major US recession, a very sharp – at least 30% – decline in the dollar, especially against east Asian currencies, or a wave of protectionism targeted primarily at China and perhaps other Asian countries. Or a relatively benign combination of those three.
But resolved it will have to be in order to bring the annual US current account deficit back from US$850 billion to a perhaps acceptable (for now) US$300 billion.
Any of these solutions is likely to be accompanied by a fall in global liquidity, increasing real interest rates and a sharp decline in asset value – and rising inflation in countries linked to a sharply declining dollar. The value of China's dollar-heavy forex reserves will likely fall considerably, exposing the dangers of excessive reserve accumulation and devastating the central bank's balance sheet.
So what can China then do to insulate itself against the double whammy of reduced imports and increased protectionism that is America's likely response to a downturn?
First, be aware of the problem. China, like the US, has buried its head in the sand and talks are needed if a trade war is to be averted. Second, step up yuan appreciation. This won't turn around the trade surplus but it's important to the US and will also push up domestic incomes and local consumption. Third, the government should spend more on education and health care to overcome the social safety net fears that make the Chinese savers not spenders. Fourth, measures to control bank lending and thereby investment should be accompanied by further consumption-boosting measures including wage hikes and infrastructure spending in deprived areas.
Finally, strict environmental regulations should be used to make firms take action on pollution. These would not only improve the quality of life and reduce the cost of future clean-ups, they would also reduce the trade surplus as a lot of the equipment would need to be imported.
These are the serious measures needed – not the parading of free trade agreements with small economies, agreements which even if they do more good than harm will not have significant impact for many years. The US-China trade relationship is fundamental to global economic stability. And both are approaching the edge of a cliff.