What a Crisis Looks Like

There's been some discussion over the last few days of what is going to happen if China starts reducing its position in US Treasuries.  Seeking Alpha has a good summation of the problem:

In response, during a recent summit, the leaders of Brazil, Russia, India, China and South Africa (the BRICS) announced that they want to trade between themselves in their own currencies. This comes amid a growing chorus in China pushing for a limit of dollar reserves to $1.3 trillion. At present, China, whose economy the IMF says will outpace that of the US by 2016, has $3.04 trillion in dollar reserves. What's going to happen to the dollar when China sells off $1.74 trillion? And who, besides the Federal Reserve, is going to buy our bonds?
If anything, I think this understates the problem.  The real issue starts, not when China starts selling our bonds, but when China stops buying our bonds. As soon as that happens, we're in big trouble.

Right now, when Treasury goes to sell new bonds, it enters a fairly robust market, with not just the Fed but a bunch of fairly price-inelastic Asian central banks who are willing to take on our bonds at whatever the market offers.  If China exits the market, we will either need to borrow less, or attract new lenders by offering higher interest rates.  Even a noticeable decrease in volume would force us to pay more for our deficits.  We saw this on a personal level in 2009 when credit card companies reacted to the crisis by reducing credit limits, often to the outstanding balance.  This was a big problem for households who were faced with sudden cutbacks, or higher interest rates, or even both.

In fact I made a similar point about interest rates the other day.  A lot of people tend to assume that there will be warning signs telling us that we need to get our fiscal house in order: China will slow down its bond purchases, interest rates will gradually rise.  But in fact, the lesson of fiscal crises is that the "warning signs" we're watching for often are the crisis.  Unless interest rates increase (or debt buying decrease--which is really the same thing) in a very gradual, orderly fashion, then by the time your interest rates rise, it is already too late to do anything easy; your debt service burden forces you into dramatic fiscal measures, or default.

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According to economist Carmen Reinhart, who has made an intensive study of crises, there's no reason to expect the change to be orderly and gradual. She says the lesson of history is pretty unequivocal: interest rates are not a good predictor of who is about to tip into a crisis.  People are willing to lend at decent rates, until suddenly they're barely willing to lend at all.

When you look at how much of our debt comes due by the end of 2012, it's easy to see how fast higher interest rates could turn into a real problem for us.  To be sure, we're no Japan--but that's not necessarily a happy thought, because Japan 
finances something like 95% of its debt from its pool of thrifty (and nationalistic) savers.  Their stock of lenders probably isn't going anywhere.  Ours might.