China Redux

China will have to manage substantial risk factors if it is to sustain its unprecedented economic development and growth into a major global power. But the United States also faces its fair share of daunting problems as it seeks to retain global leadership.

America’s finances are a mounting concern. Take the bulging US national debt, which stands at over $8 trillion and is 64% the size of the gross domestic product (GDP). The recently released $2.9 trillion fiscal year 2008 Budget of the United States (more info from NPR) includes $260 billion, or nearly 10% of the budget, to cover debt service to our creditors. Much of that debt service goes into the coffers of China’s central bank, which holds billions in US bonds.

Then there’s the tremendous rise in US defense spending. The FY 2008 budget seeks over $500 billion for defense-related programs: $481 billion for the Pentagon’s base budget and at least another $50 billion to fight the wars in Iraq and Afghanistan (a very conservative estimate). The defenset total represents an increase of over 11% from the previous year. The opportunity costs of increased defense spending are high: more money for the Pentagon translates into less funding for education, health, infrastructure and other programs that are critical for strengthening America’s competitiveness in the global economy.

I’m not arguing that defense spending should be lower. But it’s worth noting what that new money is really funding; it’s not just the wars in Iraq and Afghanistan, which as we’ve seen, accounts for a relatively small part of total US defense spending. The Pentagon’s budget increase will pay for programs and new technologies that keep our military way out in front of any potential peer competitors. And while US officials are loathe to state it explicitly, this means China. In short, the Pentagon’s budget is built around a strategic plan to outclass China on any and all potential fronts.

The point is not that this is a waste of money. But there’s a deep irony here. A huge portion of the US budget goes to defense spending, which is used to fortify our position and create a strategic “hedge” against the potential threat from a peer-sized competitor — China. In part because of our huge defense spending, the US runs a federal operating deficit each year. Another substantial piece of that deficit is caused by growing interest payments on the national debt. And much of the debt service on our $8 trillion national debt is owed to China.

Either China is financing its own defeat, or the US is borrowing its way to bankruptcy.

My former Brookings colleague and international economics expert Dr. Lael Brainard framed this issue perfectly a few years back:

I recognize the administration has its hands full with “ending tyranny on Planet Earth” and “dismantling the New Deal” — as my friend at Cato describes it. Opening markets and establishing the nation’s finances on a firm footing just may not seem to have the same kind of urgency. But I cannot think of a single instance in history where the world’s largest military power was also the world’s largest debtor. And something tells me that one thing or the other is going to have to give eventually.

Indeed. But is there a third way? We haven’t found it yet, but I believe there is one that could prove beneficial both to the US and to China.

More on that in another post.