From the Washington Post:
Late in 2006, Treasury Secretary Henry Paulson led a large American delegation on a widely-publicized and closely watched mission to Beijing. It had to be a serious trip, for was not Paulson bringing along with him Ben Bernanke, the Chairman of the Federal Reserve Board? Yes, Paulson, Bernanke — and what seemed like the larger part of the Bush Administration — would be participating in what is known, formally, as the United States-China Strategic Economic Dialogue, an innocuous-sounding venue. But what did it mean, really?
…The best-known weapon in China’s financial arsenal is the more than one trillion dollars of foreign exchange held by China’s central government. These reserves are the money China has earned in foreign trade. Of the trillion it has banked, it has invested about $400 billion in US treasury notes and bonds — another way of saying that it has lent $400 billion dollars to the US government. Suppose China unloaded the US government securities it now owns, and also decided not to buy any more, that is, not lend us any more money. What would happen then? Students of international finance tell us that our interest rates would soar and the value of our dollar would plummet. Moreover, as a Chinese general might observe with satisfaction, Chinese money would no longer be financing a part of the American military buildup. He might also wryly note that the US trade deficit with China, also financed by Chinese lending, is about $200 billion per year, the equivalent of one year of the Iraq war and its related costs.
Thus, it would appear, China has the capacity to initiate a financial first strike of no small consequence. But it hasn’t yet, and appears unlikely to; to borrow a word from Cold War days, it is deterred. Indeed, so far as this aspect of US-China relations is concerned, there exists what former Treasury Secretary Lawrence Summers has brilliantly termed “a balance of financial terror.” Like the “mutual assured destruction” of nuclear deterrence which it resembles conceptually, “the balance of financial terror” is mathematically elegant and, from one perspective, perfectly reasonable. But, like its Cold War ancestor, its breakdown would be catastrophic. Though no one quite planned it this way, a financial doomsday machine now exists and it would not only automatically inflict horrible retaliation on the Chinese economy — putting at risk the forty percent of China’s GDP which now derives from its international connections — but a big chunk of the world economy would be taken down with it.
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