In a trap of their own making...

I have to honestly say that I watched the whole debt debate with a mix of both horror and sadness.

However, I can't think we can honestly talk about our debt crisis without talking about the country that's one the largest holders of our debt.  This country is of course, China.

Lots of people have argued that this puts China in a strong position, however, I think it's quite the opposite.

Here's why...

China has for years now, devalued their currency while simultaneously buying our debt.  Their market competitiveness is based entirely on being the cheapest.  It also means that they've consistently had to deal with internal inflation because of this devaluation.

I'm not sure if you noticed, but during most of our debt debate, China was quiet and then got quite vocal about how we need to get our financial house in order without raising the interest rate...

Raising the interest rate in this country would cause every dollar to be worth a bit less.  This causes two things happen in China.  Firstly, their pile of US dollars is worth less, and secondly the distance between their currently and the US dollar shrinks.  As China, what do you do?  Do you continue to devalue your currency causing additional inflation?  China's citizens are already rather pissed about that...  Since China's economy relies on exports, letting their currency catch up means they're less competitive.  China's talked about developing their domestic market, but with inflation so high and wages staying low, unless you're ultra rich, you may work in a factory making big screen tv's but you'll never be able to afford one.

China could threaten to sell some portion of their T notes.  What would that get them?  Suddenly flooding the market with say 500 billion worth of US currency would do nobody any good.  It would have the same effect as increasing the interest rate.  Plus it would hurt the other large holders of U.S. debt and could quite likely cause an inflationary death spiral where more countries would try to offload their t-notes before they become worthless, driving the price down, etc.

What are the solutions to this problem?

One thing is that China could allow their currency to slowly appreciate in a controlled way thus slowing their inflation.  This however would make them less competitive globally, but it would prevent explosive inflation.

Another thing we could to is slowly increase the interest rate, while working with the Chinese to revalue their currency.  They come up, we come down and we meet in the middle.

However, this being America, we're not big on protectiveness.  We'll wait until we can't hold out any more and then we'll flood the market with cash and/or raise the interest rates and screw everybody.