An important part of the answer is the very low interest rates that were available during the last 20 years. These low interest rates made borrowing and spending (beyond their means) very tempting for American consumers. People with low incomes had access to expensive homes and sub-prime mortgages, all thanks to temptingly low interest rates.Why where US interest rates so low? To answer this question, you have to understand the Chinese connection. Over the last 20 years, China has acted as an enabler of both US spending and fiscal irresponsibility. The American economy has become dependent on low-interest loans from China. Here's how the US-China economic relationship worked: China had a huge trade surplus thanks to its exports. It also received large amounts of foreign direct investment from Western and Japanese companies. Normally, this inflow of money would have pushed up the value of the yuan, China's currency, making China's exports less competitive and shrinking the trade surplus. But the last thing China wanted was to let that happen. Instead, China had an understandable desire to keep the yuan low in order to maintain its trade competitiveness. After all, without export-led growth, the Chinese economy would have been in trouble. And once the Chinese economy was in trouble, the political system would come under popular pressure. This is why keeping the yuan down became a top political and economic priority for China.
The country thus began shipping the incoming fund from its trade surplus and foreign investments right back to the United States. China did so by buying huge quantities of dollar assets and US Treasury bonds. Here is the paradox: China, a poor country where capital is still scarce by Western standards, began buying vast amounts of US Treasury bonds and assets. But this was the price to pay to keep the yuan low and the dollar strong. And the US has become dependent on this. Dollar purchases by China have temporarily insulated the US economy from the effects of huge budget deficits. This money flowing in from abroad has kept US interest rates very low despite the enormous government borrowing required to cover budget deficits. These low interest rates were also crucial to America's housing boom. Soaring real estate prices not only created construction jobs, they also supported consumer spending because many homeowners converted rising house values into cash by refinancing their mortgages.
Today China has nearly $2 trillion in reserves, the world's largest, as a result of years of accumulating US Treasury bonds and assets. This is a huge resource pool that will plunge in value if the dollar collapses. As China's economy slows sharply because of the US recession, the Chinese debate on how to manage these reserves is intensifying. Some propose spending the money at home; others want more diversification of investments. The consensus behind buying American government securities is coming under attack.
The discussion is hugely important for the Obama administration. If China decided to sell even part of its foreign reserves in dollars, the dollar would collapse. US interest rates would also need to go up. Yet, China is not likely to do so. There are still powerful reasons for Beijing to keep its US Treasury bonds and even buy more if necessary. The reason is simple. During the current liquidity crunch, Chinese authorities want to maintain most of their vast holdings in liquid assets. And there are few options that match the depth of the US government bond market. Moreover, if China did not want to accumulate such large reserves, it would have to let its currency strengthen -- exactly what the government does not want at a time when Chinese exports are crumbling.
This is probably why China's leaders have made it clear that, at least in the short term, they will keep their assets in dollars and support US markets. They simply don't want to shoot themselves in the foot. A strong signal that China is backing away from the dollar would damage the value of their enormous foreign reserves. Let's also not forget that the US is still the most important market consuming Chinese products. For all these reasons Chinese authorities will continue to think of the dollar and US Treasury bonds as a safe harbor in stormy times.
