There is hardly an economic discussion from a Berkeley professor that does not touch on China’s holding of US bonds and the tremendous danger thereof. It is especially fashionable amongst the professors to view Chinese economic expansion as inherently bad for America and that the Chinese are purchasing our debt as part of a grand scheme to undermine our power.

But really, what would China actually do with the debt to hurt us?

In one scenario the Chinese loose faith in the government’s ability to repay its debt (probably preceded by a drop in our sovereign credit rating) and sell the bonds, driving down the value of the dollar and America’s ability to raise capital.

The problem with this scenario is that investors all over the world, in America and abroad, would be selling their bonds en mass if we were actually approaching default. This would be rational investor behavior. Everyone buys bonds for the same reason: that the profit of the interest and increasing face value will outweigh the risk of lending. This is true for investors in Topeka, Shanghai and Bombay.

The cause of this first crisis would not be pernicious China but the fiscal stupidity of Congress who would have spent America into the ground. Blaming the foreign bond holders in this scenario would be like a broke gambler blaming the bank for lending him money to waste.

The second scenario is that China, in reaction to a crisis with the United States, would sell the bonds in order to punish us. The problem is that this move would not benefit China in any way, and would cause as much harm to it as it would to us.

The moment that China makes indications to sell its gigantic holdings, the markets would immediately start shorting the dollar and selling bonds; it is a persistent phenomenon of markets that no one wants to be left holding the bag (a sale of bonds on the scale of the Chinese holdings would take some time to execute). By the time that the Chinese bond order is completed, the value of the notes would be significantly hit and China would suffer an enormous currency loss on the transaction. In addition, the plummeting value of the dollar would render their pegging of the Yuan useless and cut down on their export capacity.

In short, they would loose most of their money themselves and their currency advantage would be eliminated.

America as well would be hurt, but it would be rather odd for China to shoot at us through their own foot.

It is tempting to blame foreigners for America’s fiscal problems, but they are ultimately home grown. Foreigners want to buy bonds and invest capital in the United States because we have low taxes, regulations and a stable state. These things are contingent on our domestic leadership. It is the responsibility of our Congress to keep spending in line and maintain free trade, otherwise we may well face a Chinese sell-off, and one that is entirely our own fault.