When will China finally realize that it cannot accumulate U.S. dollars forever? It already has more than $2-trillion. Do the Chinese really want to be sitting on $4-trillion in five to 10 years? With the U.S. government staring at the long-term costs of the financial bailout, as well as inexorably rising entitlement costs, shouldn't the Chinese worry about a repeat of Europe's experience in the 1970s?
During the 1950s and 1960s, Europeans amassed a huge stash of U.S. Treasury bills in an effort to maintain fixed exchange-rate pegs, much as China has done today. Unfortunately, the purchasing power of Europe's dollars shrivelled during the 1970s, when the cost of waging the Vietnam War and a surge in oil prices ultimately contributed to a calamitous rise in inflation.
But perhaps the Chinese should not worry. After all, the world leaders who just gathered at the G20 summit in Pittsburgh said they would take every measure to prevent such a thing from happening again. A key pillar of their prevention strategy is to scale back "global imbalances," a euphemism for the huge U.S. trade deficit and the corresponding surpluses elsewhere, not least China.
The fact that world leaders recognize that global imbalances are a huge problem is welcome news. Many economists, including myself, believe that America's thirst for foreign capital to finance its consumption binge played a critical role in the buildup of the economic crisis. Cheap money from abroad juiced an already fragile financial regulatory and supervisory structure that needed discipline more than it needed cash.
Unfortunately, we have heard leaders, especially from the United States, say before that they recognized the problem. In the run-up to the crisis, the U.S. external deficit was soaking up almost 70 per cent of the excess funds saved by China, Japan, Germany, Russia, Saudi Arabia and all the countries with current-account surpluses combined. But, rather than taking significant action, the United States continued to grease the wheels of its financial sector. Europeans, who were called on to improve productivity and raise domestic demand, reformed their economies at a glacial pace, while China maintained its export-led growth strategy.
It took the economic crisis to put the brakes on the U.S. borrowing train - America's current-account deficit has now shrunk to just 3 per cent of its annual income, compared with nearly 7 per cent a few years ago. But will Americans' new-found moderation last?
With the U.S. government currently tapping financial markets for a whopping 12 per cent of national income (roughly $1.5-trillion), foreign borrowing would be off the scale but for a sudden surge in U.S. consumer and corporate savings. For the time being, America's private sector is running a surplus that is sufficient to fund roughly 75 per cent of the government's voracious appetite. But how long will the private-sector thrift last?
As the economy normalizes, consumption and investment will resume. When they do - and assuming that the government does not suddenly tighten its belt (it has no credible plan to do so) - there is every likelihood that America's appetite for foreign cash will surge again.
Of course, the U.S. government claims to want to rein in borrowing. But, assuming that the economy must claw its way out of recession for at least a year or two, it is difficult to see how the government can fulfill its Pittsburgh pledge.
Yes, the Federal Reserve could tighten monetary policy. But it will not worry too much about the next financial crisis when the aftermath of the current one still lingers. In our new book, This Time is Different: Eight Centuries of Financial Folly, Carmen Reinhart and I find that if financial crises hold one lesson, it is that their after-effects have a very long tail.
Any real change in the near term must come from China, which increasingly has the most to lose from a dollar debacle. So far, it has looked to external markets so that exporters can achieve the economies of scale needed to improve quality and move up the value chain. But there is no reason in principle that Chinese planners cannot follow the same model in reorienting the economy to a more domestic-demand-led growth strategy.
Yes, China needs to strengthen its social safety net and to deepen domestic capital markets before consumption can take off. But, with consumption accounting for 35 per cent of national income - compare that with 70 per cent in the United States! - there is vast room to grow.
Chinese leaders clearly realize that their hoard of T-bills is a problem. Otherwise, they would not be calling so publicly for the International Monetary Fund to advance an alternative to the dollar as a global currency.
They are right to worry. A dollar crisis is not around the corner, but it is certainly a huge risk over the next five to 10 years. China does not want to be left holding a $4-trillion bag when it happens. It is up to China to take the lead on the post-Pittsburgh agenda.
Kenneth Rogoff is professor of economics and public policy at Harvard University and former chief economist at the International Monetary Fund.