I was watching Dateline tonight, and saw what has to be the most absurd fear ever. Of course, the topic of Chinese investment in the US economy has generated a lot of stupid worries, from the usual protectionist worries to fears over the Chinese somehow infiltrating defense contractors*. But this one has to be the most idiotic yet. This fear is the so-called "financial nuclear option."

The worry, as I heard it, is this: China will buy up a massive number of securities. At some point, upset over US policy, China will "dump" these securities and destroy the US financial markets.

Well, except they won't.

OK. The basics are there. Yes, the fears are real, if we take a myopic view and think a one day drop in the market is a "crisis" and imagine a massive subsidy of investors at the expense of China is an act of aggression. On the other hand, if we look at this "threat" realistically, it will be immediately obvious that this is foolishness of the highest caliber.

Let us take anti-Chinese paranoia out of this and imagine we are talking about a very rich man, Bill Gates or George Soros. Whether an action is taken by a nation or individual, the results are the same. So let us imagine a single man, Mr.X wants to cause market panic.

Mr. X buys up $100 Billion of securities, let us say 5 billion shares at an average price of $20/share, over a number of years. Then, the day arrives and Mr. X offers all of those shares for sale at $0.10/share. (Changing the scale here does not really change the argument. I used $100 billion only because it was clearly large enough to move the entire market and the round numbers made the math easier.)

Obviously, investors leap at this offer, snatching up every share. On paper, the market has suddenly lost $99.5 billion in value. For a brief time, maybe a day, maybe even two, the indices may drop. People may be reluctant to buy those stocks at the old asking price, as they may be offered at fire sale prices again, so trading will be low for a short time. But those who want or need shares to cover short sales or as part of an index investing strategy will find that they still have to make trades, so the reluctance to buy will be very short lived, and the market will very rapidly return to normal.

And that's it**.

By selling those stocks cheaply, Mr. X changed nothing. The fundamentals of those stocks have not changed, the reasons that investors priced them as they did has not been altered by Mr. X's actions. All that has happened is that Mr. X tranferred $99.5 billion dollars from himself to a few lucky investors. He may have shut down the market for a day or two, more likely he caused a day or less of slightly depressed prices and sluggish trading, but in either case it would have cost him a fortune to do so. And, if we figure in the money he made for those who picked up his steeply discounted stocks, he probably benefited the market as a whole more than he harmed it. Yes, there would be some short term market distortions immediately after his sale, but they would correct themselves soon enough, and their impact would be negligible compared to the costs.

And that does not change if we substitute China for Mr. X.

Of course I think the Chinese realize this too. I really doubt they would spend untold billions to have a result equal to a bad Microsoft earnings report.  It certainly sells advertising time to broadcast reports about the Chinese having the ability to destroy the US financial markets, but I cannot see the proposed scheme working as advertised, nor do I think the Chinese are foolish enough to attempt it. Only a journalist could imagine it even makes sense***.

I may be naive, but I think they may be investing in the securities market to earn money. But that is just a guess.

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* I have always wondered how people think this will work. If China buys up Westinghouse, does that suddenly turn their American employees into sympathizers with the People's Republic of China? It seems that those who push this theory think defense contractors are staffed by obedient robots who will follow the whim of the majority shareholder.

** Should the indices drop, there may be some unexpected complications such as margin calls on overextended trading accounts, but that is all. The impact on the market as a whole will be no worse than an unforeseen drop in the prime rate or a bad earning report.

*** One thing this story did reveal to me is that economics must still be optional for those studying journalism, and an option very rarely exercised.

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UPDATED 04/06/2008

I just thought of another likely reason for large scale Chinese investment in US stocks.

As the US has a trade deficit with China, China receives mroe dollars than they use to buy US goods. Their choices of how to spend these dollars are three:

1. They can just sit on them, earning no interest.
2. They can trade them to other nations which wish to buy US goods
3. They can invest them in the US

Since option #1 is absurd, we are left with only #'s 2 and 3. If there is no nation which wants to exchange goods China wants for US dollars, then China is left with only option #3, investing in the US.

Considering the rather massive amount of trade we have recently conducted with China, is it surprising they are investing heavily in the US? It is almost exactly parallel to the situation between the US and Japan in the 1980's. (And recall all the fears of the Japanese destroying the US economy or else buying the entire country. See how they turned out? Perhaps that should serve to make us a little less worried about similar fears regarding China.)