Joined at the Hip

By THOMAS L. FRIEDMAN

New York Times

July 21, 2005

On the question of whether China's Cnooc oil company should be permitted by the U.S. government to purchase the U.S. oil and gas company Unocal, my view is very simple: let the market rule. Oil is fungible. It is all one global market. And if China wants to overpay for a second-tier U.S. energy company, that's China's business. Anyway, the more starved Americans are for oil, the sooner we will adopt alternatives and get off this drug once and for all.

If I seem uninterested in this matter, I am. Because I do not think the important issue is who owns Unocal. The important issue is whether America and China are drifting into a dangerous confrontation over geoeconomics. How so? Well, in brief, the Chinese and U.S. economies have become totally intertwined. While we have been focused on 9/11 and Iraq, China and America have become, in economic terms, Siamese twins.

You know that cheap mortgage you just got? Well, who do you think subsidized it? In many ways it was China. Americans don't save anymore, and import more than they export. Normally, a nation that did that as long and lavishly as the U.S. has would have to raise interest rates to get other countries to hold its currency. But America has not had to do that, in part because China has been willing to hold most of the dollars it has been accumulating - gained from all the goods it is selling America - despite the low interest paid on those dollars and the fact that they have been depreciating against other major currencies.

How come? Call it the Tiananmen-Texas Bargain. After Tiananmen, China's leaders struck an implicit bargain with their people, argued Steven Weber, director of Berkeley's Institute of International Studies. "The bargain is that China's voters give up the right to vote, and the Chinese government guarantees China's middle class 9 percent annual economic growth. China's political stability today depends on that bargain."

The Texas side of that bargain came from the Bush team. For a long time, it ignored China's undervalued currency so China could sell us lots of cheap stuff and would continue holding our devaluing dollars and helping to keep U.S. interest rates low. Our buying binge helped keep China's workers employed and its leaders in power. Their holding our depreciating dollars helped you buy a house with no money down. We've been in symbiotic relationships like this before with Western Europe and Japan during the cold war, but they were allies and democracies, so we could adjust imbalances more easily. Not so with China.

We are Siamese twins, but most unlikely ones - joined at the hip, but not identical. That's a problem. Because we now need to adjust the Tiananmen-Texas bargain. So many U.S. dollars and jobs are flowing to China, it is becoming politically and economically unsustainable for the Bush team. Hedge funds have made huge speculative bets around the T-T bargain. We need China to revalue its currency upward against the dollar, so China buys more stuff from us and we buy less stuff from China.

But China's foreign exchange reserves today are nearly $750 billion and heading for $1 trillion - most in U.S. Treasury notes. If China is compelled by the U.S. to revalue its currency, and effectively devalue the dollar further, Beijing will take a big hit on all of its dollar reserves - especially since most experts say the dollar has to be devalued by 30 to 40 percent against the Chinese currency to have any impact on the trade balance. That would also be likely to affect the dollar's value against other currencies and create pressure for inflation and higher interest rates in the U.S.

"If the dollar falls and U.S. interest rates rise, it could cause a recession or stagflation in America," Professor Weber said. "But if the Chinese currency rises too far too fast and triggers unemployment, it could cause a revolution against the Communist Party. ... We might see our dollar policy as a market adjustment, but they could see it as an attempt at regime change."

As I said, the issue is not Unocal. The real issue is that we have slipped into a symbiotic relationship with another major power that is neither a free market nor a democracy. We have both grown dependent on that relationship - the U.S. for cheap goods and cheap mortgages, and China for high employment and regime stability. We now have to adjust the bargain at the heart of that relationship. Whether we can do that delicately, without destabilizing Beijing or the global economy, could be the big geopolitical story of 2005.