Recent events have not enhanced the stature of the US as a supplier of high-quality assets. And China, for its part, will continue to develop its financial markets and its capacity to generate high-quality financial assets internally. But doing so will take time. Meanwhile, the US still has the most liquid financial markets in the world. This interpretation again implies the re-emergence of global imbalances once the recession ends and their very gradual unwinding thereafter.
One development that could change this forecast is if China comes to view investing in US financial assets as a money-losing proposition. US budget deficits as far as the eye can see might excite fear of losses on US Treasury bonds.
A de facto policy of inflating away the debt might stoke such fears further. At that point, China would pull the plug, the dollar would crash, and the Fed would be forced to raise interest rates, plunging the US back into recession.
There are two hopes for avoiding this disastrous outcome. One is relying on Chinese goodwill to stabilize the US and world economies.
The other is for the Obama administration and the Fed to provide details about how they will eliminate the budget deficit and avoid inflation once the recession ends.
The second option is clearly preferable. After all, it is always better to control one’s own fate.
Barry Eichengreen is professor of economics at the University of California, Berkeley.
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