Over the past few years China’s “currency manipulation” has been a particularly hot-button issue. Pundits claim the Chinese government, by artificially suppressing the value of its currency, unfairly subsidizes Chinese exporters while destroying American jobs. Although there is truth to this claim it overlooks the benefits to American consumers from the Chinese policy. Americans should stop fretting about the Chinese currency.

To get a sense of the accusations leveled at the Chinese, we don’t need to scour letters to the editor written by economic illiterates. We can turn to Paul Krugman, who won a Nobel Prize for his work on international trade theory. Krugman has been leading the charge for punitive action against China—including retaliatory tariffs unless its government changes its ways. In a particularly bellicose column last year, “Taking on China,” Krugman wrote:

China’s policy of keeping its currency undervalued has become a significant drag on global economic recovery. Something must be done. . . . This is the most distortionary exchange rate policy any major nation has ever followed. . . . [I]f sweet reason won’t work, what’s the alternative? In 1971 the United States dealt with a similar but much less severe problem of foreign undervaluation by imposing a temporary 10 percent surcharge on imports, which was removed a few months later after Germany, Japan and other nations raised the dollar value of their currencies. At this point, it’s hard to see China changing its policies unless faced with the threat of similar action—except that this time the surcharge would have to be much larger, say 25 percent.

Before continuing we should clarify Krugman’s charges: The Chinese government uses some of its revenues in its own currency (collected from taxation, State-owned enterprises, and so on) to augment its stockpile of foreign currency reserves. In other words, in addition to spending its (yuan-denominated) revenues on tanks, bombers, and infrastructure, the Chinese government also spends some on acquiring more dollars, euros, and other currencies.

Just as the Chinese government’s purchases of, say, gasoline for its military equipment would tend to push up the yuan-price of gasoline, its efforts to buy dollars with yuan will push up the yuan-price of a dollar. By having more yuan chase U.S. dollars in the foreign-exchange market, the Chinese government’s purchases tend to make the dollar appreciate against the yuan.

Because China’s currency is weaker than it otherwise would be, Chinese exports are cheaper: The stronger dollar allows Americans to buy more Chinese goods, and so they will favor Chinese over domestic producers. On the other hand, Chinese consumers will view American goods as more expensive because they ultimately are priced in dollars and it takes more yuan to buy one dollar at the (allegedly) distorted exchange rate.

Consequently countries with overvalued currencies (such as the United States) tend to export less and import more, while China—having the supposedly undervalued currency—tends to export more and import less. This disturbs some people because it enlarges the trade imbalance between China and the United States.

Even if we classify the Chinese government’s policies as nothing but a pure subsidy to its exporters, they benefit Americans on net. The harm imposed on U.S.  exporters is more than offset in dollar terms by the benefits to U.S. importers and consumers.

The standard arguments for free trade apply, even in cases where foreign governments give money directly to their exporters. For example, rather than using their revenues to prop up the dollar in the foreign-exchange market, suppose instead that the Chinese government told major Chinese exporters that they could cut their prices to foreign customers and it would make up the shortfall with tax-financed subsidies.

Note that this policy too would “destroy American jobs” in particular sectors—namely, the ones competing with the subsidized Chinese exporters—but it would generally make Americans richer. To see why, consider the extreme case, where the Chinese government used its tax receipts to buy TVs, cars, and computers from its own producers, then sent the goodies to the United States for free. This would be an unambiguous gift to the American people. If the policy persisted, the U.S. economy would adapt itself to the new reality. Particular producers might be worse off, but Americans would clearly be richer in general, just as surely as if brand new cars magically fell from the sky. The American workers who previously made the goods that we could now obtain for free would be available to produce other items, increasing the total amount of consumption possible from the same amount of labor and other resources.

So if we analyze Chinese currency policies as merely a hidden subsidy to exporters, the standard arguments for free trade show that the U.S. government can only hurt Americans by retaliating (by, for example, imposing tariffs on Chinese imports). This doesn’t mean the Chinese policy is efficient on a global scale. On the contrary, the Chinese are poorer because the losses imposed on them as taxpayers and consumers are higher than the gains to the Chinese exporters, as measured in terms of material output. But it is simply wrong to conclude that “China” is hurting “America.”

In fairness, Krugman has a sophisticated Keynesian twist to the accusations, whereby the “classical” analysis I’ve conducted here breaks down because the whole world is stuck in a “liquidity trap.” I’m going to ignore this subtlety of his argument, largely because most of the people complaining about the Chinese don’t rely on it.

Now that we’ve established that the “worst case” scenario is nothing to fear, we can introduce some further complications. In the first place, the Chinese haven’t made their own currency fall against the dollar, but have merely pegged the one currency to the other, so that the yuan/dollar exchange rate was constant (for long stretches).

As the graph  indicates, from 1995 through 2005 the yuan/dollar exchange rate was roughly constant, and this peg was maintained by Chinese, not U.S., officials. If the yuan started to appreciate against the dollar the Chinese would sell yuan to buy dollars. On the other hand if the yuan started falling against the dollar Chinese officials would sell dollars to buy yuan and restore the exchange rate to the desired target.

To maintain their peg the Chinese needed to have a large stockpile of dollar-denominated assets. The safest such asset has been U.S. Treasury securities. To convince international investors that it is safe to put their money in China—especially after the wild currency fluctuations during the “Asian contagion” of the late 1990s—China quite understandably needed to accumulate more and more Treasury securities.

The Dollar Standard

The situation for China was analogous to when the United States was on the gold standard. To reassure investors of the integrity of the dollar, the government for a long period pegged it to gold at a constant “exchange rate” of $20.67 an ounce. To back up the peg U.S. authorities obviously needed to accumulate large stockpiles of gold. If there had been only one country in the world that exported gold, the United States every year might have sent over tangible goods in exchange for the gold.

A similar analysis holds for China, with its “dollar standard.” To build up its reserves of foreign currencies—a perfectly sensible defensive move after the aforementioned Asian problems—the Chinese wanted to buy more foreign assets collectively than the rest of the world wanted to invest in Chinese financial assets. This is referred to as a “capital account deficit.”

As a matter of simple accounting, if a country (such as China) runs a capital account deficit, then it must simultaneously run a current account surplus (which is a broader category than the more familiar “trade surplus”). Intuitively, if the Chinese want to acquire financial assets (on net) from the rest of the world, then the Chinese must export goods (on net) to pay for them. After all, it is a valuable asset to have an IOU from the U.S. Treasury promising to send future streams of dollars, and a purchaser has to give up something valuable in exchange for it.

Referring back to the graph, it’s important to note that since 1995 the Chinese currency has either stayed the same or strengthened against the dollar. (When the line goes down it means the dollar buys fewer yuan; that is, the yuan appreciates against the dollar.)

When Krugman and others complain about the Chinese keeping their currency “artificially weak,” what they really mean is that the Federal Reserve—under both Alan Greenspan and Ben Bernanke—has been out-inflating the rest of the world. Under those circumstances the dollar ought to be sinking against other currencies. (Indeed, from February 2001 to February 2011, the dollar fell 31 percent against a trade-weighted basket of currencies.) In this context, if the Chinese stubbornly refuse to let the dollar weaken against their own currency, they are accused of “manipulation” to benefit themselves at the expense of the world.

To add yet more irony to the situation, notice that since June 2010 the Chinese have in fact been allowing their currency to steadily strengthen against the dollar. (This is the falling squiggly line at the end of the chart.) This has gone hand in hand with their slowdown in purchases of new debt issued by the U.S. Treasury. Yet rather than praising the Chinese for creating American jobs, most analysts are fretting over the fate of the dollar and U.S. interest rates if the Chinese don’t resume financing more of Uncle Sam’s deficits! If U.S. officials really want to eliminate an “overvalued dollar,” they should tell Bernanke to stop printing so many dollars.

Most macroeconomists see the boom-bust cycle as an unsolved problem.  Like physicists in search of a Grand Unified Theory, they long for a model that accounts for all the major aspects of the business cycle.  Perhaps they are hampered by looking through the wrong end of a telescope.  Mansharamani uses not just one but five “lenses” to examine the subject. In addition to micro- and macroeconomics, they include psychology, politics, and biology.  He is not the first economist to invade these fields.  Rather his accomplishment lies in assembling ideas from each of those areas, applying them to past boom-bust cycles, and putting his ideas on the line by issuing a brave prediction of a forthcoming Chinese economic train wreck.

Austrian Business Cycle Theory

The author’s macro lens includes Austrian business cycle theory. That theory says inflation of the money supply causes a drop in interest rates, which is misinterpreted as an increased aggregate preference for saving over consumption, leading to investments in more roundabout means of production.  When it becomes clear that there has been no such preference shift, these undertakings are seen to be at least partial mistakes, requiring write-offs and retrenchment – a bust.  The boom is the problem, not the bust, which is the market’s attempt to realign itself to the realities of time preference.  Austrian business cycle theory has great merit but leaves some things unexplained.

Mansharamani’s micro lens includes the concept of reflexivity.  Market participants don’t just observe prices but also influence them.  Reflexive dynamics occasionally give rise to instabilities in which rising prices lead to increased demand.  A simpler term would be a “bandwagon effect.”  I recall an office party in 1980 where one of the secretaries asked about buying gold – precisely at the peak, as it turned out. All she knew about gold was that it was way up and therefore must be going higher.  I should have realized that when you see financially unsophisticated people like her climbing on a bandwagon, you can be pretty sure there’s no one left to sell to and nowhere for prices to go but down, which is where gold and  silver prices went in 1980, and in a big hurry.

From psychology Dr. M. borrows ideas and data about cognitive biases.  For example, subjects asked to guess some bland statistic, like the number of African countries that belong to the UN, are influenced by the spin of a wheel of fortune: When the wheel lands on a high number, they guess higher.  He translates this and a dozen other cognitive biases into irrational market behavior that can foster booms and busts.

He introduces his biology lens with an analogy to the spread of an infectious disease.  When the prevalence of a disease reaches a high level, the infection rate necessarily slows and the disease begins to wane, just like the 1980 gold market.  But it is devilishly difficult to “inoculate” oneself against infectious ideas.  Individual investors who can do so have a decent chance to beat the market averages over time, I believe.  (Those who would pursue these ideas in greater depth would do well to find James Dines’s quirky and expensive but worthwhile book, Mass Psychology.)

Unintended Consequences

Turning to politics, Mansharamani illustrates unintended consequences of taxes and regulations.  The U.S. Tax Code (Title 26, Subtitle A, Chapter 1, Subchapter B, Section 179) allows businesses to expense purchases of vehicles heavier than three tons, a provision aimed at helping farmers. Guess what. The BMW X5, a luxury SUV, weighs 3.003 tons!  On a more serious note, he cites the mortgage interest deduction as a magnifying factor in the housing boom and bust.

Mansharamani examines the tulip mania, the Great Depression, the Asian financial crisis, and other past cycles. For each he cites a dozen or so aspects of the cycle and categorizes them under his five lenses.  He summarizes the housing boom, for example, with 14 observations on things including reflexive credit/collateral dynamics, anchoring on prices, perverse tax policies, and popular media.  None of these is particularly surprising, but I found it instructive to see them listed and categorized.

When I was young a book appeared called Are the Russians Ten Feet Tall? It was the post-Sputnik era when Paul Samuelson’s economics textbook pronounced Soviet socialism a workable alternative to markets and CIA “intelligence” analysts  projected that Soviet GDP would overtake ours.  We know how that worked out.  Fast forward to the 1980s when the Japanese were paying top dollar for iconic U.S. real estate.  We know how that turned out too.  Now it’s China.  I can’t help thinking: I’ve seen this movie before.

Chinese Bubble?

Mansharamani goes far beyond my gut feeling, marshaling evidence of a Chinese bubble from each of his lenses.  He gathers tidbits such as garlic fanatics bidding prices up 10- 30-fold in 18 months; the skyscraper indicator – starting with the Empire State Building, record high buildings are consistently started in a boom and finished well into the subsequent bust — and the $230,000 that a Chinese man paid for three bottles of 1869 Château Lafite. Then there’s Ordos, a massive new city meant to house one million souls but left incomplete and unoccupied.

Mansharamani looks at Chinese state-owned enterprises through his political lens, reporting that if they had to pay a market rate of interest, their reported profits would be wiped out.  Through his reflexivity lens he saw Chinese steel production exploding from 23 million tons in 1977 to 650 million through the first half of 2010 — with up to 20 percent being used to construct more steel mills!  “Truly a reflexive dynamic if ever there was one,” he gasps.

Boombustology is a worthwhile read for anyone who seeks a better understanding of booms and busts.  I especially recommend it to individual investors.

China can be proud of the rapid economic progress it has made since 1978, when it was still a centrally planned economy with little foreign trade. Today, as the world’s second-largest economy, the People’s Republic (PRC) has gained wealth but not freedom. The Chinese people have a vastly wider range of economic and social opportunities than under the dictatorship of Mao Zedong, but their basic human rights continue to be denied by a ruling party determined to maintain its monopoly on power.

As head of the Chinese Communist Party (CCP), Hu has paid lip service to “putting the people first,” but there has been little progress in liberalizing the political regime. The reality is that his idea of a “harmonious society” is one directed by the ruling elite, in which order emerges from the top down, not spontaneously under a constitution of liberty.

One of the CCP’s long-held tenets is “to seek truth from facts.” The most glaring fact is not the inequality of wealth, but the inequality of power that strips the Chinese people of their fundamental rights. Putting the people first means limiting government power and safeguarding rights to life, liberty, and property.

The great Chinese liberal Lao-Tzu understood the importance of freedom and limited government. For him and other Taoists, harmony cannot be forced; it must be natural. In the Laozi, also known as the Tao Te Ching, we read: “The more restrictions and prohibitions there are in the world, the poorer the people will be.” Denying individuals the liberty to exchange ideas, to criticize the government and party, and to associate freely without the fear of repression makes people poorer by restricting the alternatives open to them.

In 2004 the National People’s Congress (NPC), China’s rubber-stamp parliament, amended the PRC Constitution to better protect the private sector and for the first time added the words “human rights” to the document. Article 33, section 3, reads, “The state respects and protects human rights.” Such language encouraged Chinese liberals to test the waters, only to find that reality did not match the rhetoric.

The drafting of Charter 08, a manifesto for fundamental human rights, earned Liu Xiaobo the 2010 Nobel Peace Prize, the first awarded to a Chinese citizen. It also earned him 11 years in prison. The empty chair at the Nobel ceremony was yet one more iconic image of the individual versus the State. Before his sentencing in 2009 Liu stood before the court and declared, “To block freedom of speech is to trample on human rights, to strangle humanity, and to suppress the truth.”

Like others before him, Liu was accused of “incitement to subvert state power.” Yet the Chinese people have always believed that when government acts unjustly it loses the Mandate of Heaven. Charter 08 recognizes that “China has many laws but no rule of law.” The charter, initially signed by 303 liberals, now has more than 10,000 signatories—all of whom recognize that people everywhere have the rights “to freedom, to property, and to the pursuit of happiness.”

Charter 08 and Preexisting Rights

Charter 08 reveals an acute understanding of the case for limited government and the principle that the legitimate function of the State is to protect preexisting rights to life, liberty, and property, not to deny those rights. Civil society requires freedom. To achieve that freedom Charter 08 advocates a constitutional democracy with separation of powers, an independent judiciary, and a bill of rights. Freedom of expression, of religion, of association, and the protection of private property are all enshrined in the document. The hope of the Chinese framers is that Charter 08 will “bring to reality the goals and ideals that our people have incessantly been seeking for more than a hundred years, and . . . bring a brilliant new chapter to Chinese civilization.”

The official reaction to Charter 08 and to Liu’s Nobel Peace Prize was predictable: The Chinese government launched a storm of propaganda in support of the status quo. The mouthpiece of the CCP, the People’s Daily, wrote in October 2010, “By rumor-mongering and libeling, the charter denies the people’s democratic dictatorship, socialism, and the unitary state structure stipulated in the Chinese Constitution. The charter also entices people to join it, with the intent to alter the political system and overturn the government. Liu’s activities have crossed the line of freedom of speech into crime.”

Top-Down Order and Human Happiness

Yet as Premier Wen Jiabao noted last August in a speech in Shenzhen, “Without the safeguard of political reform, the fruits of economic reform would be lost and the goal of modernization would not materialize.” And in an interview with CNN in October, he recognized that “freedom of speech is indispensable for any country.”

The harmony, stability, and peaceful development that Beijing seeks will be on shaky ground until the CCP confronts the reality that top-down order is not consistent with human happiness, and that spontaneous order emerges from free markets and a genuine rule of law. Premier Wen, in his 2003 speech at Harvard, said that China has “found the right path of development” and that “the essence of this path is to . . . respect and protect the freedom of the Chinese people to pursue happiness.” In 2007, following the annual session of the NPC, he encouraged people to “oversee and criticize the government,” and said, “It is particularly important that we need to make justice the most important value of the socialist system.”

Justice, however, requires the prevention of injustice. Liu Xiaobo, Gao Zhisheng, and others entrapped by China’s jackboot justice system deserve to be heard, as do “the lost souls” of Tiananmen.

China can be proud of the rapid economic progress it has made since 1978, when it was still a centrally planned economy with little foreign trade.  Today, as the world’s second largest economy, the People’s Republic (PRC) has gained wealth but not freedom. The Chinese people have a vastly wider range of economic and social opportunities than under the dictatorship of Mao Zedong, but their basic human rights continue to be denied by a Communist Party determined to maintain its monopoly on power.

As head of the Chinese Communist Party (CCP), Hu has paid lip service to “putting the people first,” but there has been little progress in liberalizing the political regime.  The reality is that his idea of a “harmonious society” is one directed by the ruling elite, in which order emerges from the top down, not spontaneously under a constitution of liberty.

Inequality of Power

One of the CCP’s long-held tenets is “to seek truth from facts.”  The most glaring fact is not the inequality of wealth, but the inequality of power that strips the Chinese people of their fundamental rights.  Putting the people first means limiting government power and safeguarding  rights to life, liberty, and property.

The great Chinese liberal Lao-tzu understood the importance of freedom and limited government.  For him and other Taoists, harmony cannot be forced; it must be natural. In the Laozi, also known as the Tao Te Ching, we read: “The more restrictions and prohibitions there are in the world, the poorer the people will be.”  Denying individuals the liberty to exchange ideas, to criticize government and the party, and to associate freely without the fear of repression makes people poorer by restricting the alternatives open to them.

In 2004 the National People’s Congress (NPC), China’s rubber-stamp parliament, amended the PRC Constitution to better protect the private sector and for the first time added the words “human rights” to the document.  Article 33, section 3, reads, “The state respects and protects human rights.”  Such language encouraged Chinese liberals to test the waters only to find that reality did not match the rhetoric.

The drafting of Charter 08, a manifesto for fundamental human rights, earned Liu Xiaobo the 2010 Nobel Peace Prize, the first awarded to a Chinese citizen, but landed him in prison for 11 years.  The empty chair at the Nobel ceremony was yet one more iconic image of the individual versus the State.  Before his sentencing in 2009 Liu stood before the court and declared, “To block freedom of speech is to trample on human rights, to strangle humanity, and to suppress the truth.”

Like others before him, Liu was accused of “incitement to subvert state power.”  Yet the Chinese people have always believed that when government acts unjustly it loses the Mandate of Heaven.  Charter 08 recognizes that “China has many laws but no rule of law.”  The charter, initially signed by 303 liberals, now has more than 10,000 signatories — all of whom recognize that people everywhere have the rights “to freedom, to property, and to the pursuit of happiness.”

Charter 08 reveals an acute understanding of the case for limited government and the principle that the legitimate function of the State is to protect pre-existing rights to life, liberty, and property, not to deny those rights.  Civil society requires freedom.  To achieve that freedom Charter 08 advocates a constitutional democracy with separation of powers, an independent judiciary, and a bill of rights.  Freedom of expression, of religion, of association, and the protection of private property all are enshrined in the document.  The hope of the Chinese framers is that Charter 08 will “bring to reality the goals and ideals that our people have incessantly been seeking for more than a hundred years, and . . . bring a brilliant new chapter to Chinese civilization.”

Official Condemnation

The official reaction to Charter 08 and to Liu’s Nobel Peace Prize was predictable — not silence but a storm of propaganda in support of the status quo.  The mouthpiece of the CCP, the People’s Daily, wrote in October 2010, “By rumor-mongering and libeling, the charter denies the people’s democratic dictatorship, socialism, and the unitary state structure stipulated in the Chinese Constitution.  The charter also entices people to join it, with the intent to alter the political system and overturn the government.  Liu’s activities have crossed the line of freedom of speech into crime.”

Yet as Premier Wen Jiabao noted last August in a speech in Shenzhen, “Without the safeguard of political reform, the fruits of economic reform would be lost and the goal of modernization would not materialize.” And in an interview with CNN in October, he recognized that “freedom of speech is indispensable for any country.”

The harmony, stability, and peaceful development that Beijing seeks will be on shaky grounds until the CCP confronts the reality that top-down order is not consistent with human happiness, and that spontaneous order emerges from free markets and a genuine rule of law.  Premier Wen, in his 2003 speech at Harvard, said that China has “found the right path of development” and that “the essence of this path is to . . . respect and protect the freedom of the Chinese people to pursue happiness.”  In 2007, following the annual session of the NPC, he encouraged people to “oversee and criticize the government,” and said, “It is particularly important that we need to make justice the most important value of the socialist system.”

Justice, however, requires the prevention of injustice.  Liu Xiaobo, Gao Zhisheng, and others entrapped by China’s jackboot justice system deserve to be heard, as do “the lost souls” of Tiananmen.

Anyone who has read The Private Life of Chairman Mao (1996) by Mao’s longtime personal physician, Li Zhi-Sui, would already be disgusted with the man: his failure to bathe or brush his teeth for decades; his wanton use of hundreds of innocent peasant girls (to whom he passed a variety of venereal diseases) for his seemingly insatiable sexual desires; his pleasure in humiliating and hurting even his most loyal followers and fellow communist leaders; and his total disregard for any human life other than his own.

But Jung Chang and Jon Halliday show Mao to be a man of absolute evil. Like many Marxist leaders, Mao was not born into a working-class family. At the time of his birth in 1893, Mao’s father was a relatively successful middle-class farmer in the province of Hunan in south-central China. From an early age Mao was interested neither in physical labor nor systematic education. He preferred to loaf about and read on his own. (Throughout his life he absorbed a vast amount of literature on many subjects, and had special editions of books prepared for himself that became forbidden works for the masses.)

Like Stalin in the Soviet Union, Mao seems to have had neither personal charisma nor the gift of oratory. Rather, he had the ability to manipulate people and situations to his own advantage, slowly rising to the top of the Chinese Communist Party in the 1920s and 1930s. He was ruthless with both friend and foe, viewing everyone he encountered as mere tools to use and then dispose of in pursuit of absolute power.

Mao was married four times. He treated each wife miserably, as he did most of his children, whom he often abandoned to their fate and sometimes to their deaths. During the famous Long March in 1934–1935, when Mao lead the Chinese communist forces from south-central China to a new Red-controlled territory in the northwest region of the country, he made his third wife abandon their baby son as Chiang Kai-shek’s Nationalist armies were trying to surround them. Years later, she unsuccessfully hunted the countryside to find her lost child. Her only clue was the assumption that the son might have two of Mao’s distinguishing characteristics: oily ears and an especially pungent underarm odor.

Both before and especially after the Long March, Mao instigated reigns of terror and tyranny on the Chinese peasants who fell under the sway of his forces. Slave labor, starvation rations, and merciless propaganda and indoctrination sessions late into the night became the hallmarks of Chinese communist rule.Cruel and excruciating tortures and methods of execution were devised to assure destruction of all opposition and disobedience to Mao’s power. (The authors describe many of them in indelicate detail.)

Contrary to the left-wing myths of the time, especially in the American press, that Mao’s Red Army was the main Chinese fighting force against the Japanese during World War II, Mao instructed all his commanders to avoid battles with the Japanese. Instead, he worked to conserve his forces as a prelude to the Chinese Civil War that began in 1945 and ended in the communist conquest of the Chinese mainland in 1949.

The authors detail how Mao’s victory would have been impossible without the assistance of Stalin’s Soviet army, which overran Manchuria in the last weeks of the Pacific war. Stalin allowed Mao’s forces to occupy most of Manchuria behind the Soviet shield and turned over vast stores of captured Japanese weaponry.

The authors also explain how General George C. Marshall, then secretary of state in Harry Truman’s administration, was totally manipulated and duped by Mao and his chief diplomatic negotiator, Chou En-Lai. They persuaded Marshall that they were merely “agrarian reformers” wanting justice for the Chinese people in a coalition government with the Nationalists. All the while they were strengthening and positioning the Red Army for a grand attack to seize the rest of China. They succeeded in making Chiang Kai-shek seem to be the stumbling block to a political compromise,which resulted in the U.S. government cutting off all armament sales to the Nationalist government in 1947, just as victory was possibly in the grasp of Chiang’s armies.

Using Chinese and Soviet archival materials, the authors show that Mao happily assisted, with Stalin’s help, in the North Korean invasion of South Korea in June 1950. Mao began assembling Chinese forces to enter the Korean War long before the United Nations forces pushed back the North Korean offensive and then crossed the 38th parallel to unify a free Korea. Mao was ready to continue the war indefinitely to kill tens of thousands of Americans in a conflict of attrition, even at the cost of hundreds of thousands of Chinese soldiers’ lives. Only Stalin’s death in 1953 and the desire of the new Soviet leadership to calm international tensions forced Mao to accept a ceasefire and an end to the Korean conflict.

At an international conference of communist parties in Moscow in 1957 marking the 40th anniversary of the Bolshevik Revolution, Mao delivered a speech calling for the start of a nuclear World War III against America. He declared that it did not matter if half of China’s population was killed in the cataclysm, because there would still be hundreds of millions of Chinese left to rise out of the rubble to rule a communist world. Shortly after that, Chou En-Lai told a Soviet envoy visiting Beijing that they should be planning a new capital city for such a communist-controlled world somewhere on a manmade island in the Pacific, since both Moscow and Beijing would likely be incinerated in the nuclear destruction that was to come.That didn’t seem to bother Mao at all.

In the 1950s and 1960s Mao pushed China into a crash program to make his country an industrial and nuclear superpower. Ignorant of all economic concepts, including the ideas of scarcity and tradeoffs, Mao crushed the Chinese population into abject poverty in an attempt to make himself ruler of the world.

While tens of millions of Chinese starved and died, he lived a life of luxury with dozens of atomic bombproof mansions built for his pleasure around the country, all with large swimming pools constantly heated in case he were to show up. But he spent most of his time in Beijing, lying in bed for days on end, eating his specially prepared foods, reading books banned for everyone else, and enjoying group sex whenever the urge came over him.

The authors explain that the Cultural Revolution of 1966–1976 was all a grand plan of Mao’s to settle scores with real and imaginary enemies in order to assure his absolute and unchallenged power over China. In the process, the country was pushed into horrific violence and terror that almost destroyed everything left of civilization in China.

Mao Zedong died in bed, an old and sick man in 1976, at the age of 82. His legacy was the murderous destruction of an entire society.

In the nineteenth and early twentieth centuries, imperial and then republican China had no central bank. The monetary system was based on a diverse network of private banks operating in the various regions of the country. While copper was widely used in coins, the primary medium of exchange was silver, and the entire Chinese economy functioned on an informal silver standard for most of this time. A year after Chiang Kaishek’s Nationalist Party came to power in Nanking in 1927, the Central Bank of China was established with its headquarters in Shanghai, and the country was formally put on a Chinese silver-dollar standard.

For the first two years of the Great Depression, beginning in 1929, China not only weathered the international financial and economic storm, but actually experienced an export boom, with many domestic prices rising while the rest of the world suffered a serious price deflation. But in September 1931 Great Britain went off the gold standard and a growing number of countries engaged in currency depreciation, which adversely affected the value of the Chinese silver dollar on the foreign exchange markets.

The fatal blow came in 1933 and 1934, when, under Franklin Roosevelt’s New Deal, silver was remonetized. The U.S. government went on a silver-buying spree at a price above the world price in an attempt to push up price in the United States. As the export price for silver rose in the financial center of Shanghai, silver flowed from the Chinese countryside to the main port cities on the coast, followed by a massive export of silver from China to the United States. A resulting catastrophic price deflation severely hit both Chinese agriculture and industry.

In October 1934 the Nationalist government imposed foreign-exchange controls on silver exports. Then in November 1935 the Central Bank of China officially took the country off the silver standard, made its bank notes legal tender, and placed the country on a fiat currency with government in full control of the quantity of money. With no restraint now on the power of the Chinese government to turn the handle of the printing press, Central Bank policy soon led to monetary disaster with the coming of China’s war with Japan.

The war between China and Japan lasted eight years, from July 1937 to September 1945. The Japanese army occupied more than one-third of China, including virtually all of the country’s leading port cities and industrial centers. Over ten million Chinese civilians lost their lives in the fighting.

The end of the conflict only reopened the longstanding civil war between Chiang Kaishek’s Nationalist government and the large communist forces led by Mao Zedong. The civil war raged across China for four years, until Mao’s communists were triumphant on the mainland and the remnants of Chiang’s Nationalist army withdrew to Taiwan in late 1949. Another five million innocent civilians lost their lives in the civil war.

In the war years Chiang’s government resorted to the printing press to finance the majority of its spending, covering 65 to 80 percent of its annual expenditures through money creation. During the civil war years of 1946 – 1949, monetary expansion covered 50 – 65 percent of the government’s spending.

When war with Japan broke out in 1937, the total quantity of money in circulation (currency and demand deposits) was 3.6 billion yuan. By December 1941, when the United States entered the war, the Chinese money supply had increased to 22.8 billion yuan. For the remainder of the war years the figures were: 1942, 50.8 billion; 1943, 100.2 billion; 1944, 275 billion; and 1945, 1,506.6 billion.

The civil war brought a worse inflation. By the end of 1946, the money supply had increased to 9,181.6 billion yuan, with a more than six-fold increase to 60,965.5 billion by December 1947. Seven months later, in July 1948, the money supply had expanded to 399,091.6 billion yuan.

A New Currency

The Chinese government then created a new yuan to replace the old depreciated yuan, at a conversion rate of three million old for one new. In August 1948 the new money supply stood at 296.82 billion yuan.

But the government printing presses were set to work again, and by December 1948, the supply of this new yuan was 8,186.33 billion. Four months later, in April 1949, it had been increased to 5,161,240.0 billion yuan.

From 1937 to 1949, prices rose dramatically but to different degrees in the various regions of China, because of war-related scarcities and destruction, and the uneven impact of the monetary expansion. As one very rough indicator, we can use the wholesale price index of Shanghai during this period, with May 1937 equaling 1.

By the end of 1941 the Shanghai wholesale price index stood at 15.98. By December 1945 it had reached 177,088, and by the end of 1947 it was 16,759,000. In
December 1948 the index had risen to 36,788,000,000, and in April 1949 it was at 151,733,000,000,000.

The value of China’s paper money on the foreign-exchange market reflected this huge depreciation of the currency. In June 1937, 3.41 yuan traded for one U.S. dollar. By December 1941, on the black market 18.93 yuan exchanged for a dollar. At the end of 1945, the yuan had fallen to 1,222 to the dollar. And by May 1949, one dollar traded for 23,280,000 yuan.

It would be an exaggeration to say that China’s Great Inflation was the primary cause for the defeat of the Nationalist government and the victory of the Chinese communists. The Nationalist Party was dictatorial in its structure, notorious for its corruption and abuse of political power, and often as ruthless as the communists in its use of military force.

But it is nonetheless true that whatever basis of popular support Chiang’s government might have had against the communists was undermined by the inflation. It destroyed the wealth of the Chinese middle class and drove some segments of the rural population into severe poverty. During and after the war, the government imposed unworkable price and wage controls that only succeeded in creating even more distortions and imbalances throughout the Chinese economy.

The threat to China’s future development is not lack of resources or technology, but the absence of an institutional framework that limits government and protects property rights. It has been 15 years since the Tiananmen Square massacre in June 1989, and 25 years since Deng Xiaoping embarked on economic reform in 1979. China is now one of the most open economies in the world, with exports plus imports accounting for nearly 62 percent of GDP. Yet little progress has been made in limiting the power of the Chinese Communist Party (CCP) over fundamental human rights.

Freedom of speech and assembly are guaranteed in the Chinese Constitution, but they have no substance in the law. The CCP continues to use its monopoly position to enrich insiders at the expense of the public. Small fish may be caught, but it is rare for high party officials to be ousted or penalized for corrupt behavior. Local leaders impose arbitrary taxes on farmers and confiscate land without just compensation. And developers in urban areas use party connections to fleece long-time property owners who have little recourse for legal action.

While China has normalized its trade relations, its progress in normalizing personal liberties is dismal. That failure will prevent China from realizing its full potential — for unless people are free to pursue their dreams and exercise their natural rights to liberty and property, they cannot fully develop.

The recent amendments to the Constitution, which were approved by the NationalPeople’s Congress (NPC) last March, look good on paper, but lack any credibleenforcement mechanism. There is no independent judiciary or constitutional commission to safeguard either persons or property.1 “Judicial review” is solely up to party leaders. Even if a constitutional commission or court were instituted, it would be meaningless so long as the CCP has a monopoly on power.

Article 13 of the Constitution, as amended, states, “The lawful private property of citizens is not to be violated,” and Article 33 now reads, “The state respects and safeguards human rights.”2 Those two amendments signal the growing importance of the private sector to China’s future development. As Wang Zhaoguo, vice chairman of the NPC standing committee said, “With economic development and the rise in living standards, many people have varying levels of private property or factors of production. So they see a strong and urgent need for their properties to be protected.”3

Unfortunately, the CCP is unlikely to undermine its power by respecting property rights broadly construed. The very essence of the Communist Party is to deny others the rights it claims for itself, and only state property is deemed “sacred.” The reality is that inequality of power, not equality of rights, is the brand name for the CCP. In the “People’s Republic,” some are more equal than others. Those who sit on the Politburo Standing Committee are more equal than local officials, and CCP members more equal than ordinary citizens.

The relation between the individual and the state is upside down. As constitutional reformer Cao Siyuan notes, the citizen should be the master and the state the servant, but it is just the opposite.4 Those who try to turn China’s political system right side up will be dealt with harshly, as were the brave leaders of the democracy movement and former Communist Party General Secretary Zhao Ziyang, who is still under house arrest for merely suggesting dialogue rather than force to resolve the standoff in Tiananmen Square.

The Legacy of Central Planning

Prior to 1989, China was beginning to liberalize both its economic and political system. Today, there can be no return to central planning, but the legacy of that era is a political apparatus that is inconsistent with private property rights and individual freedom. According to Li Shuguang, a professor at the China University of Politics and Law, China’s civil code reflects the loss of freedom that resulted from the planned economy.5

Economic liberalization has no doubt put some cracks into the edifice of the state. Individuals have more personal space than they did before the growth of the nonstate sector, and a nascent civil society is developing outside of political society. Politics does not dominate everyday life as it did during the Cultural Revolution. As Wang Dan, one of the leaders of the 1989 democracy movement, notes, “Since the early 1990s, shoots of civil society have begun to sprout within China. As more Chinese enter the private sector, the state is no longer able to control every aspect of daily life in the way it used to.”6

State-owned enterprises now account forless than one-third of industrial output-value and employ far fewer workers than even a decade ago. Individuals can own their own homes, travel abroad, use the Internet, work in the private sector, and speak more freely. But all those freedoms are restricted: the state continues to control the media, narrowly limit investment options, and prohibit widespread privatization of state assets.

Beijing’s adherence to market socialism is understandable, given the income party officials are able to plunder by continuing to control investment spending and ration funds through politics rather than market interest rates. Allowing capital freedom and widespread privatization would depoliticize economic life and end the party’s monopoly on power.

It may be that China has no choice but to open its capital markets and allow freedom of the press if it wants to become a major player in the global financial markets. The forces of globalization and the information revolution may be China’s path to freedom. The continued shrinkage of the state sector will eventually make the CCP obsolete.

Political reform will then be from the bottom up, like economic reform.7 The state can then perform its legitimate role of protecting fundamental human rights and recognize private property as the bedrock of liberty. That is a vision Chinese liberals long for and one all the Chinese people deserve.

1. See Veron Hung, “China’s Constitutional Amendment Is Flawed,” International Herald Tribune, March 5, 2004.
2. For a useful listing of the new amendments, see “Constitutional Amendments Approved by the National People’s Congress in March 2004,” Congressional-Executive Commission on China (www.cecc.gov).
3. “China’s Landmark Constitutional Change Safeguards Private Property,” March 8, 2004, www.channelnewsasia.com/stories/eastasia/view/74416/1/.html.
4. Cao Siyuan is a prolific writer and commentator. He is director of the Beijing Siyuan Research Center for Social Sciences and has been a major advocate of privatization (see www.caosy.com).
5. Jia Hepeng, in an interview with Li Shuguang, reports that Li sees the present civil code, which offers little protection to persons or property, as “a result of the planned economy, giving people few rights.” “Constitutional Revision Requires Law Adjustment,” China Business Weekly, March 8–14, 2004, p. 23.
6. “Fifteen Years after the Massacre,” Wall Street Journal, June 2, 2004, p. A14.
7. Wang Dan has given up any hope of top-down political reform and now argues, “China’s democratization must be a bottom-up process, driven by forces outside the Communist system.” Ibid

Reliance on foreign lenders is as old as the republic. Indeed, loans from the French and the Dutch proved critical in keeping the American revolutionaries afloat while they broke from the British Empire and established their independence. Later, the huge foreign debt became a major reason for the new national government’s assumption of the states’ war debts and for the creation of the First Bank of the United States and other measures Alexander Hamilton devised to establish the new government’s credit.

As a rule, however, the U.S. government had little need to borrow. Except during wartime, it more or less balanced its budget, and indeed in many years of the nineteenth and early twentieth centuries, it ran a surplus, which was used to pay down the debt taken on during the preceding war. Only after 1930 did chronic deficits become a fixture of the federal government’s financial conduct. Even then, however, foreign lending did not play a large role until the latter part of the twentieth century.

As late as 1970, according to a report issued by the Federal Reserve Bank of New York, foreigners held only about $20 billion, or less than 9 percent, of all privately held U.S. securities outstanding. (A great deal of the total debt is held within the government, mainly by the Social Security Trust Fund.) During the following decades, however, foreigners acquired a growing proportion of the debt held outside the government. In the 1970s foreigners purchased $10.5 billion, or about 31 percent of the total sold to the public. In the 1980s, when large government budget deficits pumped up the debt rapidly, foreigners purchased $27.5 billion, or about 18 percent of the total sold to the public.

(Note that all such data are subject to a variety of conceptual and measurement errors. All the figures on foreign holdings of U.S. Treasury debt discussed in this article are admittedly flawed official estimates.)

During the 1990s, as the government first pared its budget deficit after 1992 and then actually ran a small budget surplus during fiscal years 1998 through 2001, the foreign share of U.S. Treasury debt held by the public increased greatly, and by the end of the decade it had reached almost 40 percent of the total, before dipping somewhat during the recession early in the following decade.

After 2002 foreign holdings rose greatly as huge government budget deficits accompanied the Bush administration’s guns-and-butter policies, and the foreigners’ acquisitions again outpaced those of Americans. By the third quarter of 2009 the foreign share of U.S. debt held by the public stood at nearly 52 percent.

According to data issued by the Treasury and the Federal Reserve Board on March 15, 2010, the largest foreign holders of U.S. Treasury securities in January 2010 were as follows: China (mainland plus Hong Kong), $1,036 billion; Japan, $765 billion; a group of 15 countries designated “oil exporters,” $218 billion; Brazil, $169 billion; a group of four island nations plus Panama, designated “Caribbean banking centers,” $144 billion; Russia, $124 billion; and Taiwan, $120 billion. These countries’ holdings altogether totaled $2,576 billion, or about 70 percent of the $3,706 billion owned by all foreign holders at that time.

China’s Emergence

China’s emergence as the leading foreign holder of U.S. Treasury debt has occasioned a great deal of commentary, including many expressions of apprehension. Many writers still view the Chinese as enemies of the United States, notwithstanding the two countries’ close financial and trade ties, among other important links. Xenophobes worry that should the Chinese “dump” their holdings of U.S. government debt, they would create financial havoc and jeopardize U.S. national security.

To be sure, Chinese government leaders and other Chinese spokesmen have recently expressed serious concern about the U.S. Treasury’s ability to service its rapidly growing debt. They worry that the U.S. government is getting itself into deeper and deeper financial difficulty by running budget deficits well in excess of $1 trillion per year in fiscal years 2009 and 2010 and, according to projections, only slightly smaller deficits for many years to come. The persistent recession that began early in 2008, from which little recovery was evident even in the first quarter of 2010, has done nothing to allay Chinese fears about the U.S. Treasury’s precarious condition. Other foreign holders of U.S. government debt have expressed similar worries.

Late in 2009 mainland China reduced its holdings of Treasury securities somewhat, from a high of $940 billion in July 2009 to $889 billion in January 2010, a reduction of $51 billion, or 5.4 percent. Meanwhile, however, Hong Kong’s holdings rose by $36 billion during these months, offsetting most of the reduction by mainland China. The overall Chinese holdings declined, then, by only $15 billion, which is scarcely enough to justify anyone’s nightmares.

Likely and Unlikely Scenarios

In any event, fear that the Chinese (or other large holders) might suddenly dump large quantities of Treasury debt is difficult to take seriously because, owing to the great amount of such debt they now hold, any such sell-off would cause a tremendous fall in the price of the securities and cause huge capital losses for the Chinese holders. Not being fools, the Chinese are unlikely to resort to such dumping. Instead, they have begun to warn the U.S. government that unless it gets its financial house in better order, it might provoke them to sell off more of their holdings—and certainly to refrain from adding to them, notwithstanding the enormous amount of such securities the Treasury will have to sell in order to finance the U.S. budget deficits projected for many years to come.

The most likely scenario, then, is for the Chinese to monitor the Treasury and Congress carefully and to use diplomatic pressure to try to discipline the wayward Americans as much as possible without angering them excessively and thereby tempting them to act rashly in a fit of nationalistic pique. Other large holders of U.S. government securities no doubt will also exert pressures to rein in the fiscally irresponsible U.S. government and the Fed, lest the latter resort to monetization of the government’s huge deficits, thereby creating price inflation that reduces the real value of the nominal interest and principal payments the Treasury has committed itself to make on its outstanding debt.

She loved traditional Chinese culture, but her world was shattered on August 30, 1966, when the Red Guards ransacked her home and, on September 27, arrested her. She spent the next six and a half years in Shanghai’s No. 1 Detention House, in solitary confinement.

Communist Party interrogators accused Cheng of being a spy, but her real “crime” was that she was viewed as a “capitalist roader.” She had attended the London School of Economics (LSE) in the 1930s, where she met her husband, Kang-chi Cheng, who later became general manager for Shell Oil in Shanghai.

When he died in 1957, Nien Cheng became a special adviser to the new general manager. She was the highest-ranked businesswoman in China at the time. Her skills in dealing with party officials were invaluable and helped Shell stay in China until the start of the Cultural Revolution in 1966.

During her imprisonment Cheng refused to admit  any wrongdoing. She was tortured and nearly died, but her determination to survive and her deep faith gave her the strength to persevere. She was released from prison on March 27, 1973, only to find that the Red Guards had murdered her only child, Meiping, for failing to “confess” and denounce her mother as a “class enemy.” Cheng’s one hope in life was gone; she left China forever in 1980 and settled in Washington, D.C., in 1983.

Anyone who knew Nien Cheng could immediately see that she was special—even the doctor at the No. 1 Detention House said he never met a more “truculent and argumentative” prisoner. When she learned of her imminent release, she refused to leave the prison unless the authorities declared, in writing, that she was “innocent of any crime or political mistake.” She insisted that they offer “an apology for wrongful arrest” and called the official statement “a sham and a fraud.”

In that statement she was accused of conspiring with the British government because in a letter she signed in 1957, shortly after she joined Shell, “she divulged the grain supply situation in Shanghai.” That accusation was ludicrous. Her secretary was merely conveying common knowledge to the incoming general manager, who was still in London—namely, that “the Shanghai government allows everyone twenty catties of grain per month.”

After nearly seven years in prison she declared, “I shall remain here until a proper conclusion is reached about my case.” The authorities refused, and two female guards had to drag her out of prison. It was not until later that Cheng learned that her interrogators were trying to get her to confess to being a spy so that Jiang Qing (Mao Zedong’s wife) and other radicals could oust Premier Zhou Enlai, a moderate who favored allowing foreign firms like Shell to operate in China.

It was only after Mao’s death in 1976 and Deng Xiaoping’s decision to open China to the outside world that Cheng was officially declared innocent of any crimes against the State and “rehabilitated” in November 1978.

The Realities of Communist Rule

It is ironic that Cheng became enticed by socialism during her studies at LSE. In her essay “The Roots of China’s Crisis” (in Economic Reform in China, which I edited along with Wang Xi), she wrote, “When I read a book on the Soviet Union by Sidney and Beatrice Webb, I thought, ‘How wonderful and idealistic socialism sounds.’”

Later, after her husband had served in Australia as a diplomat for the Nationalist government, the Chengs made the fateful decision to return to China in late 1948. They and many of their Western-educated friends were seduced by Mao’s call for democracy and wanted to help build a new China.

In her essay Cheng notes that while she had learned about socialist ideals at LSE—including the apparent success of Soviet egalitarianism, central planning, and state ownership—her professors never mentioned “class struggle” or “the realities of communist rule.” What she painfully discovered was that in a society where individuals have no economic freedom and no genuine rule of law, no one is safe from the power of the State. Economic life is politicized, corruption is endemic, and inequality of power reigns, in stark contrast to promises of egalitarianism.

As Cheng wrote in her book, “The fact is that the Communist government controls goods, services, and opportunities and dispenses them to the people in unequal proportions.” During the Maoist regime one’s rank in the party determined one’s economic status. “Though the salary of a member of the Politburo was no more than eight or ten times that of an industrial worker, the perks available to him without charge were comparable to those enjoyed by kings.”

The Chinese Communist Party under Mao’s iron fist destroyed civil society and traditional culture. A new China was created after the Communist victory in 1949, but it was not the socialist ideal Cheng had envisioned. Rather, the party created “mindless robots, unburdened by the capacity for independent thinking or a human conscience.”

Success depended on power, and justice vanished. “The result was a fundamental change in the basic values of Chinese society,” she wrote.

Mao’s mantra was, “Strike hard against the slightest sign of private property.” Nien Cheng’s property, including her priceless porcelain collection, was confiscated. Her daughter was murdered and her freedom destroyed by the State.

Crony Capitalism

While in jail, in 1971, the inmates were assembled and an official announced, “Many of you are here precisely because you worshiped the capitalist world of the imperialists and belittled socialist China. You placed your hope in the capitalist world and believed that one day capitalism would again prevail in China.”

Today, mainland China is perhaps more capitalist than any other country, but it is “crony capitalism.”  The nation lacks full-fledged private property rights, especially in land; there is no independent judiciary to protect persons and property against the party’s monopoly on power; and freedom of religion and expression are sharply curtailed. The battle for justice that Cheng fought has not yet been won.

In her book Cheng recognized the significance of President Nixon’s visit to China in 1972 and the importance of engaging China. She witnessed the progress the mainland has made since Deng Xiaoping began to liberalize markets in 1978. She understood the critical role of trade and investment in linking China to the West. But she also understood that “Unless and until a political system rooted in law, rather than personal power, is firmly established in China, the road to the future will always be full of twists and turns.”

Seeking Truth and Justice

Nien Cheng’s journey from an idealistic Marxist liberal at LSE in the 1930s to a realistic market liberal—after living through Mao’s upheavals and seeing the end of private property and the uncertainty and injustice caused by arbitrary and unlimited State power—gave her a great appreciation of America.

Near the end of her life, in a personal letter, she wrote,

I can hardly believe I have lived so long. I think it is mainly because I am never angry nor am I ever worried. I believe in “constant change,” so I always think a bad situation will change into a good situation or not so bad after all. In any case, there is always a solution. As for being angry, after what had happened to me in China, I think I have used up all the anger inside me. There is simply nothing to be angry about in America.

All Americans should be proud Nien Cheng chose to make America her home. She believed that here she would be free to choose and that her person and property would be protected by the law of the land.

Today, as the U.S. government grows in size and power, it would be well to remember the wisdom of Nien Cheng—and the danger to personal freedom when the State erodes economic freedom.

A shorter version of this article first appeared in the South China Morning Post, November 15, 2009.

Yet governments do that computation for countries. Do trade deficits between countries matter? They do, but a lot less than most people think. A high trade deficit is not a definite sign of an economy’s weakness, and a low trade deficit or high trade surplus is not a definite sign of an economy’s strength.

First, let’s define our terms. By the most comprehensive measure, there can never be a balance-of-payments deficit. If we import a higher dollar value of goods and services than we export, then the extra dollars we spend on imports balance that difference, and the net balance is zero.

Of course, when people refer to a balance-of-payments deficit they are not thinking about this comprehensive measure; they’re thinking about a narrower measure—the merchandise trade deficit. This is the difference between the dollar value of what we spend on imports and what we are paid for exports. In 2008, the latest year for which these data are available, Americans spent $840 billion more on imports than foreigners spent on U.S. exports. Offsetting this was a U.S. surplus on services of $144 billion. The net balance of trade on goods and services, therefore, was $696 billion. To put this into perspective, this was about 4.8 percent of the total U.S. gross domestic product.

Where did this $696 billion go? It went to other countries, of course, but most of it came back in one of three forms: 1) foreign purchases of American bonds, mainly government bonds; 2) foreign purchases of other assets such as stocks, land, and property; and (3) so-called direct investment whereby foreigners build plants and equipment in the United States.

Is this bad? Consider each in turn.

1) If foreigners refused to buy government bonds, the U.S. government would need to offer higher interest rates to make holding the bonds attractive to Americans. That would drive up the cost of financing the U.S. budget deficit. We can decry this deficit—and I do—but given that it exists, which is better: having the irresponsible federal government paying a higher or lower interest rate? I vote for the latter.

2) One reason foreigners invest in U.S. stocks, land, and property is that the United States is still a relatively safe haven for investment. Granted, it’s probably less safe than it was before the U.S. government changed the rules with its bailout, the so-called Troubled Asset Relief Program (TARP), and with the so-called stimulus package. But it’s still safer than investing in much of the rest of the world. So rather than being bad, the size of this investment is actually good.

3) The same reasoning applies here. It’s good, not bad, that foreigners find it attractive to invest directly in the United States. It’s especially good for U.S. workers. The more capital there is per worker, the higher worker productivity is and, therefore, the higher are real wages.

Dollars on the Penny

What if the money doesn’t come back in any of the above three forms of investment but, instead, is held in U.S. dollars? That’s even better for Americans. Instead of giving up capital in return for merchandise, we are giving up paper money. According to the Bureau of Engraving and Printing, the average cost of a unit of paper money is 6.4 cents. Because of the production process, the cost is probably higher for a one-hundred-dollar bill, and presumably a disproportionately high number of such bills is held abroad. But it’s still likely to cost under 25 cents to print a one-hundred-dollar bill, and the bills take an average of 89 months to wear out. Getting valuable goods in return for paper money that sells for dollars on the penny is a good deal for Americans. Jay Leno, in a 1980s ad for Doritos, said “Crunch all you want. We’ll make more.” Similarly, if people in other countries hold on to their paper U.S. bills, the Federal Reserve can make more.

But aren’t we as a nation, by spending more on imports than our exporters earn, actually saving less and implicitly giving up capital for consumption goods? Yes, we are. But that’s the result of decisions that millions of us make individually. And it really doesn’t matter, at an individual level, whether we save less to buy imports or to buy domestically produced consumption goods. Either way, we’re giving up capital for consumption. Is this a bad idea? We’re showing by our actions that we think it’s not. We’re showing that many of us value those high-quality Toyotas more than we value the shares of General Motors stock or U.S. government bonds that we could have bought instead. Do you think you’re giving up too much capital for consumer goods? Then spend less and save more.

I mentioned earlier that a small balance-of-payments deficit is not necessarily a sign of economic strength. Between 1980 and 2008, there have been only three years in which the United States has had a merchandise trade surplus: 1980, 1981, and 1991. Those were all years in which the U.S. economy was in recession. That is no coincidence. When economic growth is high, we tend to spend a higher share of our income on imports. The years with the highest merchandise trade deficits also tended to be the years with the highest economic growth.

What about the danger that foreigners will own a large share of the U.S. capital stock? First, it’s not a danger. Even if it happened, it would simply mean that U.S. workers would work for foreign employers. While some of these foreign owners would be worse than U.S. employers, some would be better. Incidentally, during the 1988 U.S. presidential campaign, Democratic candidate Michael Dukakis told workers at a St. Louis automotive parts plant: “Maybe the Republican ticket wants our children to work for foreign owners . . . but that’s not the kind of a future Lloyd Bentsen and I and Dick Gephardt and you want for America.” The problem? The workers he was speaking to were employed by an Italian corporation.

Second, the amount of U.S. capital owned by foreigners at the end of 2008 was $23.4 trillion. But the amount of foreign capital owned by Americans was $19.9 trillion. This difference of $3.5 trillion is only about 7 percent of the $48 trillion total value of physical assets.

To look at the $3.5 trillion another way, it is less than $70 trillion. Why is that relevant? Boston University economist Laurence Kotlikoff says that’s the amount by which the present value of the U.S. government’s future promises to spend exceeds the present value of the government’s future projected tax revenues.

Now that’s something to worry about.