Treasury Secretary Timothy Geithner heads for China for talks with officials there early next week. In January, Geithner angered the Chinese government by accusing China of manipulating its currency and undermining free trade. China shot back, blaming the U.S. for sparking the financial crisis.
Certainly, the U.S. bears a large share of the blame for the meltdown, but many economists believe China's currency policy paved the way for the worldwide crisis.
Here's the short argument that China is partly to blame for the crisis: In its rush to industrialize, China ran up huge trade surpluses. It saved too much of the money it made selling its products. Then, it lent too much of that money to America, says Peter Morici, an economics professor at the University of Maryland.
"They accumulated dollars and they invested those dollars in the New York bond market," he says. "That made it inexpensive for banks to lend us money through our homes on mortgages and second mortgages and to loan us money on credit cards and to buy cars."
China, along with some other Asian nations and oil producers, flooded the U.S. financial markets with so much excess cash that it drove interest rates down, providing an irresistible temptation for Americans to take on more debt, Morici says.
"And it meant that the Federal Reserve couldn't pull in the mortgage frenzy when it wanted to," he says. "There was not much the Fed could do. It raised short-term rates, but long-term rates didn't go up with them. Mortgage rates didn't go up. And the terms got easier and easier and people borrowed more and more."
Economist and China expert Nicholas Lardy agrees that Chinese money provided the fuel for the financial crisis.
"The Chinese gave us the rope, but we didn't have to hang ourselves," he says. "If we had had tougher regulation, the inflow of capital from China would not have led to the crisis that emerged over the last year or so."
Lardy says the lack of regulation allowed U.S. investment firms to develop riskier financial products. And they did so with abandon as they tried to boost profits in the low interest rate environment created by the flood of cash from China.
So why did China build up such large and destabilizing surpluses? Lardy and Morici disagree on China's motives. Morici thinks China made a deliberate decision to build its economy and its global power through exports.
"Quite simply, China wants to have a very large trade surplus with the United States as a development tool to employ [people from rural China] in the cities making things to sell here," Morici says. "So what it does is, it keeps its currency cheap."
But Lardy, a fellow at the Peterson Institute for International Economics, says China sort of stumbled into the situation.
Back in the 1990s, China decided to peg its currency to the dollar, a move that was viewed as positive back then. For a while it worked fine. The dollar appreciated and so did China's currency, the yuan. That meant Chinese exports were more expensive. So, despite its increasing productivity, China's trade surplus was manageable.
But early in this decade, the dollar began to fall, and with its currency still pegged to the dollar, China's exports became cheaper. China sold mountains of goods, and its trade surplus soared, Lardy says.
"Their goods became massively more competitive on international markets and they developed large trade surpluses without any precedent in recorded history," he says.
Lardy says some Chinese leaders want a more balanced economy. But he says others, with economic interests in export production, have gotten addicted to the huge profits that exports generate. They're resisting the calls from the U.S. government and others to allow the value of the yuan to rise.
Geithner will raise the issue during his talks next week, but Lardy says that with China holding $1.5 trillion in U.S. debt, the U.S. doesn't have a lot of leverage. Just last month, the Treasury blinked when it declined to officially call out China for manipulating its currency.
"Certainly one of the reasons they probably didn't raise it to that threshold is the very commonsense idea that maybe you shouldn't pick a fight with your banker," Lardy says. "If you need to borrow a lot of money from somebody, you have to treat them, perhaps, with greater deference than you would if you didn't have that dependency."
Morici argues it's the other way around. The fact that China has lent the U.S. so much money actually gives the U.S. leverage. That's because China needs a strong U.S. economy if it wants to be paid back in full.
And, of course, China is still dependent on the U.S. consumer. A Treasury official says Geithner will urge China to seek more balanced growth by boosting domestic consumption and depending less on exports.
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