If you're seeing this message, it means we're having trouble loading external resources on our website.

If you're behind a web filter, please make sure that the domains *.kastatic.org and *.kasandbox.org are unblocked.

Main content

Debt loops rationale and effects

Positive and negative effects of China's devaluing of their currency. Created by Sal Khan.

Want to join the conversation?

  • blobby green style avatar for user Skatovaite.Ineta
    Where is the next video that tells where all of this might go??
    (13 votes)
    Default Khan Academy avatar avatar for user
  • blobby green style avatar for user ryan.daniel.lang
    If China continues to print money to buy US dollars, what is happening to inflation? Or what will more than likely happen to inflation in China?
    (14 votes)
    Default Khan Academy avatar avatar for user
    • leaf blue style avatar for user shiruba
      Obviously, by printing yuan, the Bank of China is causing internal inflation. Right now they prefer to allow the inflation instead of allowing the Yuan to appreciate massively. That inflation will also eventually make the exchange rate even harder to control, because over time they will have to print even more Yuan per USD they want to pay. In 2005, the exchange rate was 8:1, now in early 2012 it's 6.3:1. (Of course the US doller is affected by other events as well).
      (4 votes)
  • blobby green style avatar for user MrsM
    Very very interesting! Thank you, Sal!
    The next video is "China keeps peg but diversifies holdings", right?
    because if you watch this series from the "Core Finance" playlist it goes somewhere else.
    I'm a little confused with the order of these videos.
    Anyway, great job!
    (12 votes)
    Default Khan Academy avatar avatar for user
  • leaf green style avatar for user Banieh
    A little confused. Why does the value of China's holdings in treasuries go down once it stops buying US dollars?
    (3 votes)
    Default Khan Academy avatar avatar for user
    • leaf green style avatar for user Yogendra
      China is one of the biggest buyer of US treasuries (i.e. largest loan provider to US). So when it stops buying US treasuries (i.e. stops providing loan to US), US treasuries would find less buyers (i.e. US will find it difficult to get loan) and that will cause the interest rate on treasuries to go up (since there are less people willing to loan to US the interest that US needs to pay will go up). More interest rates means more US dollar to be printed by US. Since more US dollar are printed the value of dollar goes down. So when dollar is devalued the value of China's holdings in treasuries will go down.
      And if China starts selling treasuries on to the market, and if there was more selling pressure than willing buyers, then the price may fall as sellers reduced the amount they are willing to accept. [Thanks David.C.Quinn for the correction]
      (9 votes)
  • male robot johnny style avatar for user etrodg
    Why doesn't the United States do the same (print money and buy Chinese bonds to increase the price of Chinese Yuan). Perhaps some of the industrial base and jobs will return to the United States and it will at least prevent this trade imbalance from occurring. I understand that prices of goods would increase in the USA causing CPI, the way to measure inflaion, to increase. On the other hand, US employment numbers would all of a sudden start looking better.
    (3 votes)
    Default Khan Academy avatar avatar for user
    • mr pink red style avatar for user Salah Chafik
      The reason China must print Yuan in the first place is to service the reality of a trade imbalance - they sell more to the US in terms of value and volume of goods than the other way around. This move of printing Yuan satisfies the actual demand for Yuan without making the price go up (the Yuan to appreciate). Therefore, they can continue to sell their goods at a cheap price at the same volume. Since the US is already lacking behind in the selling of their goods, printing dollars will cause the supply to go up and the eventual depreciation of the dollar- but to what advantage? More importantly, at what cost?
      I think the process is called "currency wars" and just like any war, they aren't pretty. If the US prints money, the dollar depreciates, effectively making the Yuan appreciate... US goods become cheaper and their Chinese counterparts more expensive. However, the US dollar is depreciating against ALL currencies and suddenly things that we purchase from abroad (most notably oil) will become even more expensive. Worst of all, we will have to deal with inflation in an already struggling to recover domestic economy! These are some of the reasons I think going into an all out currency war is just not feasible....
      (8 votes)
  • mr pants teal style avatar for user jyd.chang
    So this situation is like a bubble?
    (4 votes)
    Default Khan Academy avatar avatar for user
  • female robot amelia style avatar for user nicknomo
    If China accumulates most of our currency, wouldn't that artificially keep the value of the dollar high?

    If I'm correct, when this winds down, China will have a large portion of the actual money supply (M0). There should be a large deflationary aspect due to this. They will then start buying up large portions of American real estate + businesses. As this happens, yes then American dollars will become worthless... but they'll own half of America buy now, and we'll make them cheap goods.
    (4 votes)
    Default Khan Academy avatar avatar for user
    • blobby green style avatar for user Elizabeth Shaw
      I believe your right. The chinese already own Banks, realestate etc. It's just not published in the front pages of the papers. Why hasn't the American people done more to correct the problem? It appears to me time is running out. I don't completely agree with Sal on this one. Not an expert, it's just plain common sense as I see it.
      (0 votes)
  • leaf blue style avatar for user Hapi
    Tell me if my analysis is wrong : China stockpiling the dollars and using them to fund infrastructures, universities,R&D, etc and send many chinese students abroad to US to obtain higher degree. So Chinese government will not stop printing Yuan until China becomes developed country and China will have a knowledge base economy like U.S?
    (2 votes)
    Default Khan Academy avatar avatar for user
    • blobby green style avatar for user lmandrieu
      An interesting question. My guess (I am not an expert, far from it) is that the Chinese government economic policy is politically motivated. What they are trying to do is to stay in power as long as possible, exactly as their communist comerades tried to do in Eastern Europe and Russia. To do so they try to expand the economy as fast as possible, hoping that rises in standard of living will somehow reduce discontent in the country and allow them to keep control. However, the stockpiling of US treasuries be the Chinese Central Bank cannot go on for ever. At one stage, the Chinese authorities will have to allow the Yuan to rise, causing perhaps a slowdown in the rate of job creation in China. This is doable given that the Chinese population is aging fast and the rate of new entrants on the labor market is likely to decline drastically in the not too distant future. If this currency adjustment is done gradually over a fairly long period of time, this may not be too bad. Indeed interest rate will rise in the US contributing to chocking growth, but this may be offset by a rise in US exports and a re-industrialization of the US perhaps, creating new jobs in the US. This is the rosy scenario of course....
      (2 votes)
  • blobby green style avatar for user romitmitra
    Super. A real eye opener. Thank you, Sal.

    - Clearly this isn't sustainable from both sides and the winding down needs to be done very carefully
    - On a structural reform, Is a plausible solution therefore that the US treasury puts less bonds into the free market so that it can regulate who they sell to?
    (3 votes)
    Default Khan Academy avatar avatar for user
  • piceratops sapling style avatar for user jksohara
    Is China hedging Dollar risk / inflation risk by aggressively purchasing sources of essential raw materials in Mid East, South America, United States... Worldwide? Can this be done efficiently enough to make unbundling effectively risk free? Goods from China would no longer have to be cheap because having control of raw material resources insures they are the only source of many goods and they become a monopoly or is it super hegemony.
    (2 votes)
    Default Khan Academy avatar avatar for user

Video transcript

Now that we have a general layout in our minds of how all of the mechanics are fitting together, what I want to do in this video is discuss a little bit about why the different actors would do what they are. How they could benefit or get hurt from this cycle. And really, why it's so hard to unwind each of the actors, why it's so hard for them to unwind themselves from the scenario. Where I finished off this last video, I talked about more cash being in American pockets because of essentially, debt being cheaper, government can spend more money, lower taxes. And I said that's more money to buy Chinese products, but it's in general more money just for Americans to spend on each other. They might buy each other's houses or buy each other's services. So in a lot of ways, it does stimulate the economy. For any Keynesians out there, the more you spend, that will stimulate the economy, lower taxes. For more conservatives, that also can stimulate the economy. And in general, debt being cheaper, lowers interest rates, all of these things stimulate the economy. Now, normally when you're stimulating the economy like this, and you have all of these factors, you have the risk of higher inflation. But remember, inflation, or at least price inflation, is just the price of all of your goods. But notice, we're buying more and more cheaper goods, and interest rates are low. So to some degree this whole cycle also keeps-- I guess you could say, the surface growth that the average American consumer experiences looks very positive and inflation stays slow, so we can also say money to buy each other's services. Now with that said, let's think about why the different actors want to do this. So let's think about it from the Chinese perspective. So if you are China and you're starting off, you are a real Communist country maybe 30 years ago. And then you start to have market-based reforms and you really want to enter the developing world. But you don't have the industrial base in the late '70s or early '80s to to really compete with the Germanys, and the Americas, and the Japans-- and when I say Americas, I mean United States-- on their terms. So one advantage of export-led growth is when you're just beginning to develop, you have a less-developed society, you have less of an industrial base. So when you have export-led led growth, you can actually build, you actually will encourage investment in factories that can go and produce things for the developed world. And by keeping your currency low-- by artificially keeping your currency low-- and let me be clear. With just standard free trade, labor costs are going to be cheaper in a place like China or India that has a lower standard of living. So there would be just straight-up free trade with no manipulation of currency. You would have things that would move offshore, manufacturing and services that move offshore. But if you super charge it, if you make it even cheaper to manufacture, to do business in China, it'll just accelerate the investment in production in China. So this export-led growth-- let me put it this way. Artificially suppressed currency-- and this also happened with Japan after World War II-- artificial suppressed currency, and to some degree we wanted that, because we want to Japan to become intertwined with the United States. We wanted it to be successful. We saw what happened to Germany after World War I, where it was so economically unsuccessful that it was very easy for a character like Hitler to come to power. So we learned our lesson. We said, you know, it's never good for another country to not have an economic recovery. So we actually, to some degree, many people think, encouraged it in Japan. But anyway, you artificially suppress a currency, it makes your exports cheaper, and which then encourages more investment in production at home. And in this case, when I'm talking about home, I'm talking about China or Japan. And more production at home means more investment at home. More investment. If you're producing more in China, you're going to have to build more factories. And this means literally more jobs and, to a large degree, capital for the Chinese people. More jobs and capital. And as you become more efficient and as you go down that development curve, you'll become more and more competitive over a whole series of industries. And the idea is, once your people get developed enough, you will have enough capital at home. You will have enough of a consumer base at home that some of this extra capacity can then be turned back to your own people. That you can then use these goods to sell to your own people to increase their standard of living. So at first, you are building washing machines and refrigerators for the United States and Europe. And because you're building those washing machines, those are jobs for Chinese and eventually, once they have enough money, once there's a critical mass of a middle-class Chinese, that same capacity could be used to sell washing machines and refrigerators to the Chinese, and it would raise their standard of living. So it builds a manufacturing base and a home market. Let me put it that way. So from China's point of view, it looks unambiguously good. It builds manufacturing base, and a domestic consumer market-- which just means people in China, once they have jobs and they have capital, will be able to buy the goods themselves-- and domestic consumer market. Now where is the negative here? You could imagine, if you are the developed country that is buying these goods, they would be cheap to begin with, but now they're even more artificially cheap. Well you lose your manufacturing base. So if you look at it from the U.S. point of view, you lose the manufacturing base. And it's very clear that this has been happening, whether you want to point to Japan or in general, we've been losing our manufacturing base to other countries. And some people view this as a good thing. Some people say, hey, we are further down the development curve. We shouldn't focus on manufacturing, since manufacturing always tends to go to whoever can do it for the cheapest price. We should focus on knowledge things, whether it's pharmaceutical industry or the IT industry. So there's maybe an argument there. But the other reason why this is maybe compelling to the United States is its lower costs. So this looks like a negative, and it is really a negative on some level, but the one I guess you could call it a superficial positive is lower cost for American consumers. So if you're not one of the people who lost their jobs at the manufacturing plant, and your the great majority of the rest of Americans, it seems like a good thing. Things are cheaper for you, it's cheaper to buy clothes for your kids. It's cheaper to buy a car. It's cheaper to buy a refrigerator. It's cheaper to buy an air conditioner. Now the problem is, when and how does this end? Because this whole cycle that we create, it might sound good for China. In theory it sounds good. You suppress you currency, your goods are cheap, more production at home, more investment at home, more capital and jobs eventually, point that capital, point that investment back at your own home market and now you are a developed country. Seems to make a lot of sense, but it's easier said than done. In particular, it's not a trivial thing to make that whole market be as consumptive or as consumer-driven as maybe some of these developed markets abroad. The other problem is this whole time, remember what's happening. You're just accumulating this mass of, in this case, U.S. dollars and you're using it to go essentially lend to Americans, to lend to the government, and it essentially gets lent to the American people. And the minute that you stop doing it, think about what happens. The minute that you stop, let's not even talk about unwinding this, let's say the minute that you stop buying dollars, your currency will inflate and the holdings-- these trillions of dollars of assets-- will drop in value, because the minute you stop buying dollars, the currency markets will allow the yuan to appreciate, the dollar to drop and so stopping buying leads to drop in value. And that's just if they stop buying. If they actually ever tried to unwind this situation, as they start selling these, that would drop the value of whether you want to call it the dollar or the U.S. Treasuries even more, and so everything else they're holding would drop in even more value. So the whole time, in order to keep their currency propped up, they've been buying these assets, they've been buying these dollars. But the very act of unwinding it will-- I won't say make it worthless-- but it will make the value of their holdings go down dramatically. So you have a very hard situation for the Chinesese. It's a hard situation to even get out of. And it's just as hard for the U.S. because if you think about it, a lot of people in the U.S. would look at this and they'd say, hey, this is horrible. This is why our manufacturing base has gone away and it is partially true. And so they'd say hey, let the currencies just do what they will. No more artificial distortions, no more manipulation by government. Let the currencies be freely trading. But what would happen then to the United States? The minute that China stops doing this, stops artificially supporting their currency, or even worse, the minute they start unwinding all of these dollars that they've accumulated, what's going to happen? They're going to start selling U.S. Treasuries, there's going to be lower demand for U.S. Treasuries because they're not even buying it, they might be selling it. Interest rates are going to go up, long-term interest would go up in the United States. Now when long-term interest rates go up, that means that borrowing is harder, that people will want more interest to lend you money, that credit card rates will go up and in general, the entire United States economy will go down. Why are we in this recession right now? Because it is harder to borrow. We were so dependent on cheap debt, and when that debt got a little less cheap, everything kind of ground to a halt. That would be even worse if the Chinese stopped buying our debt and allowed interest rates to go up. So we are kind of locked in this very perverse cycle, where although it looks like the Chinese are unambiguously I guess, benefiting from this, they are accumulating these assets and the minute that they try to stop accumulating those assets, the value of those assets are going to go down. And even though the United States looks like it's getting their manufacturing base depleted-- and that is true, it is getting its manufacturing base depleted because of this-- it is keeping interest rates low. And if you're a politician, you like that. It makes the overall environment look superficially positive. I'll leave you there and let you think about this whole situation for a little bit. In the next video, I'll try to do a little bit of analogy to think about where all of this might go.