On August 1st of this year I wrote:

The problem is that America’s creditors will one day need America less than America needs them. That day may have already come. China continues to strongly criticise the Federal Reserve’s loose monetary policy, and artificially low interest rate policy. These policies debase China’s holdings, and China has every right to demand it stop. But America will keep borrowing, and the Federal Reserve will keep printing money to service the debt, right up until the creditors say no. And how will the creditors say no? As they have always done throughout history, by instigating a trade war.

That’s why the debt ceiling is a dead issue. The live issue is China’s response to America’s fiscal excess. And it doesn’t look happy.

Let’s have a look at the thoughts of former People’s Bank of China Member Yu Yongding writing in the Financial Times:

Chinese officials are understandably angry about the irresponsible brinkmanship demonstrated by their American counterparts in recent weeks. Unfortunately, anger counts for little in international finance. The danger facing the US is that after Tuesday’s debt deal any sense of urgency over a dire fiscal situation will dissipate. The danger for China is that it does not learn the right lesson – namely, that now is the time to end its dependency on the US dollar.

China is worried about the possibility of a US default for obvious reasons. As the largest foreign holder of US Treasuries, either a default or a downgrade would bring huge losses. Even after this week’s debt deal, however, the risk remains that US debt will continue to grow to the point where its government is left with no option but to inflate the burden away. While there is little China can do about its existing Treasury holdings, it can rethink past policies – and ask both how it fell into this trap, and how it might free itself.

The situation is ultimately unsustainable. The longer it continues, the more violent and destructive the final adjustment will be.

If there is any lesson China can draw from the US debt ceiling crisis, it is that it must stop policies that result in further accumulation of foreign exchange reserves. Given that many large developed countries are simply printing money (and the recent rumours are that the US might return to quantitative easing) China must realise that it can no longer invest in the paper assets of the developed world. The People’s Bank of China must stop buying US dollars and allow the renminbi exchange rate to be decided by market forces as soon as possible. China should have done so a long time ago. There should be no more hesitating and dithering. To float the renminbi is not costless. However, its benefits for the Chinese economy will vastly offset those costs, while being favourable to the global economy as well.

Recent rumours that the US might return to quantitative easing (or as Yu accurately puts it “printing money”)? Let’s see what Bernanke has to say about that possibility:

The possibility remains that the recent economic weakness may prove more persistent than expected and that deflationary risks might reemerge, implying a need for additional policy support

Or in plain English, “Yes, I am going to print”. Because weakness persists in the markets. Here’s the last month of the S&P500:

And weakness will persist until serious and challenging steps are taken to alleviate serious structural problems in the Western economic paradigm: namely, that we offloaded our productive capacity to China for the sake of cheap Chinese labour, among many other things. So QE3 is a dead issue, because it is going to happen. It is a shot-in-the-arm, an ad hoc, simplistic and superficial response to the deep and challenging issues of our day like over-financialization, moral hazard, ponzi-economics, laziness, skills deficit, over-reliance on services, over-speculation, the challenges of globalization, etc. And just like its two previous incarnations it will bump up the stock markets and house prices without ever really addressing any of the underlying issues.

It is intriguing that Yu uses such animated language. “Violent”.”Destructive.” It could be said that he is being metaphorical. But, I think he is subtly understating China’s case. Because if I were to try and put China’s thoughts into words they’d go something like this:

Fuck you America. Our economy is based on innovation, hard work, sweat and tears. Your economy is based on printing toilet paper money and Treasury Bonds, and shipping rolls and rolls over here to exchange for our hard work and effort. You export consumerism, fraudulent derivatives, threats, Hollywood trash, pornography, superficial culture, weapons and chicken feet. We export to you most of the goods on sale in your biggest stores like Target and Wal Mart. We don’t want your stupid paper anymore, because all you do is devalue it by printing more and more. We are the productive engine of the world. You want to take advantage of us forever? Fine. See how you do when we don’t co-operate.

And I think we are going to get to see…