China's Chance to Be Our Economic Savior

Can China save the world economy? That is a question that people should be asking as the other potential candidates withdraw from the race. At the moment, the economies of the United States, Europe and Japan are all suffering from weak growth or worse. The debt crisis of eurozone countries threatens another financial crisis that could lead to another plunge in output, not just in Europe but throughout the world.

Meanwhile, the actors who could, in principle, take steps to reverse this dismal course of events are largely paralyzed. The eurozone countries are struggling with efforts to form the necessary fiscal union to support their currency. This requires creating a new legal structure, while also confronting intense political opposition in Germany and other better-off countries that will be asked support the debt of the Greece and other struggling economies.

Meanwhile, the European Central Bank (ECB) is finding it difficult to break with its cult of 2.0% inflation targeting - even after the economic disaster caused by this single-minded policy focus. It actually raised its overnight rate by 0.5 percentage points in the spring, slowing growth and increasing the cost of borrowing for debt-burdened governments.

The United States does not face the same imminent crisis, but it is likely to see slow growth and rising unemployment as both fiscal and monetary policy are largely checkmated by politics. Furthermore, a eurozone financial freeze-up will almost certainly lead to a double-dip recession in the US, as well.

And Japan has just seen another prime minister sent packing after failing to deal effectively with the aftermath of the earthquake and tsunami. The country now has its fourth prime minister in four years.

With the key actors in the wealthy countries either unwilling or unable to take the necessary steps to support the world economy, it is reasonable to ask whether China can fill the gap. Certainly, China has the ability to act as a backstop for the world economy, if it chooses to play this role.

On a purchasing power parity basis, China's economy is already more than 75% as large as the US economy. It is projected exceed the size of the US economy by 2016. China also has a vast amount of reserves, holding almost $1.2tn in US dollar assets, and has close to $2tn in total reserves.

It would need only a small fraction of this wealth to have an enormous impact on the sovereign debt crisis in Europe. In the case of Greece, it would need to set some floor on the value of Greek debt as an orderly restructuring is arranged. Greece has roughly $450bn in debt outstanding. Much of this debt has already been partially written down by its holders. Certainly, $100bn in debt purchases would be more than sufficient to arrange an orderly write-down and restructuring of Greece's debt to a sustainable level.

The other troubled countries actually suffer primarily from a crisis of confidence more than a serious debt problem. For example, Spain has a debt to GDP ratio that is just over 60%, well within anyone's conception of manageable. Italy has a more troubling debt to GDP ratio of 120%, but has a near-balanced budget. In both cases, if interest rates could be kept at reasonable levels, the debt burden could be easily met.

Interest rates on both countries' bonds have soared in recent months as the ECB has demanded harsh austerity measures at a time when the downturn has sent budget deficits soaring. The austerity measures threaten a downward spiral where weak growth leads to rising deficits, which, in turn, require further austerity measures. With the ECB determined to tell investors that sovereign debt can default, they have created a perfect recipe for a self-imposed disaster.

China can reverse this picture by providing guarantees to support the bonds of these governments. By setting a floor on the price of their bonds (or a cap on interest rates), it can ensure that they can borrow at interest rates that make their debt sustainable. In addition, by easing up on the austerity measures demanded by the ECB (actually, the IMF and European Union are also actors in this story), China's intervention can help these countries to return to normal levels of growth, reducing the burden of the debt in the future. It is likely that such guarantees would never cost China anything, since the debt-burdened European governments would have little problem meeting their debt service obligations once they return to healthy growth path.

This sort of intervention by China would not require altruism. Europe is a substantial market for China's exports, as is the United States. If the eurozone collapses, the resulting financial crisis and economic fallout will send China's exports plummeting, just as happened in the fall of 2008.

China already intervenes to support its exports - that is why it holds almost $1.1tn in US government debt - so this idea of intervening to sustain export markets is not new to the Chinese government. The only thing that would be new would be the form of the intervention.

If China were to take this path, it would provide enormous benefits to the world economy. The wealthy countries would have to acknowledge China's role as the leading economic force in the world. They would also have to acknowledge the errors of their boneheaded economic leadership that put them in a situation where they could not rescue their own economies.