China owns the mortgage on your house

Brad Setser estimates that Chinese banks bought about $100 billion of US mortgage-backed securities from mid-2005 to mid-2006, and that they might have bought as much as $124 billion in the last year. He opines:

In some deep sense, this whole system is nuts.

China is a poor country. It is buying this debt on terms that almost guarantee enormous financial losses for Chinese taxpayers simply from the RMB's appreciation against the dollar. Plus, Chinese demand for safe assets – and the resulting low-yields on those assets – also helped to induce a lot of the excesses that are now clogging up the arteries of the US financial system.

At the same time, if China stopped buying -- especially now, when the private market is clogged up -- US financial markets would really seize up.

The US is in a position where it has no realistic alternative to ongoing financing from China -- at least in the short-run. In the long-run, though, I continue to believe that the scale of China's dependence of the US to provide financial assets that will retain their value and the United States dependence on credit from China is unhealthy for both parties.

I would call the U.S.'s dependence on credit from China the biggest wildcard in the world economy. This twin imbalance - China's excessively high savings rate and the U.S.'s excessively low savings rate - has to be resolved eventually. Ideally it would be resolved by high-level policy coordination between the U.S. and Chinese governments and structural adjustment in the U.S. and China (in our case, reducing the federal budget deficit and stimulating private savings; in China's case, spending more on health care and other human services). In practice, the adjustment is much more likely to come through a crisis of some kind. When all else fails, a sure way to get Americans to buy fewer goods from China (hence have less need to borrow from them) is to put the U.S. economy through a major recession. The fear is that nothing else will be tried, and a recession will be the way in which we resolve the imbalances.