China and the US play a mean game eating pies

American debt saturation is spoiling what has been a nice little side contest between the two nations on how to handle a barrage of cheap exports and an inflation threat.

President Barack Obama and first lady Michelle Obama greet China's President Hu Jintao at the Grand Staircase as they arrive for a state dinner at the White House in Washington, Wednesday, Jan. 19, 2011. (AP Photo/Carolyn Kaster) *** Local Caption *** DCSA144_Obama_US_China.jpgShow less

In an interview with two US newspapers, the Chinese president Hu Jintao called for an end to the "zero sum mentality". Whether this is an indication that Beijing is finally taking the undervalued level of its currency seriously is anybody's call.

Zero sum is best explained with reference to blokes and pies. Let's say there are two blokes and one pie. If one bloke gets a quarter more of the pie, then the other bloke gets a quarter less: gains and losses result - sum to zero.

Now let's say that there are two pies, one belonging to Hank and one to Chang. Both these fellows would rather have two courses than just plough on through their own pie.

So they come to some kind of arrangement and swap some of their pie for some of the other guy's pie (say half for half). Hank loses the half of his pie, which Chang demolishes, but in return he gets half a blueberry pie. Having eaten half a meat pie, he much prefers to finish off with a blueberry pie than to plough on with his meat pie. Chang feels the same. By trading they both gain more than they lose: result - non-zero sum.

In the current context, the zero sum game is the fight over the export pie. There are various weapons in the arsenal to enhance your prospects in the pie-grabbing game. One of the most controversial is artificially depressing your currency. This zero sum game has always been there. It's just that the US and China were engaged in a sweet little game of their own.

And that bilateral game was non-zero sum. China sends its raft of exports to the US. In return America provides financial instruments in which to hold the proceeds. In other words the US holds funds as debt so that China does not need to repatriate and face inflationary pressure on its peg. This is extra sweet because undervaluing the currency means that China can churn out a mound of especially cheap exports on the top of which the US currently sits: a very neat game.

Unfortunately, the game is over. The loop has broken down with the debt saturation of the US. And this level of debt means deflation. The textbook solution is to devalue and tighten fiscal policy.

But now the zero sum game comes back out from the shadows. The very player against whom the US wants to devalue is its old buddy China. This particular exchange rate is set in Beijing. Does that mean the two giants of the international pie-eating competition are now set to fight it out head to head? So far that seems to have been the case. China has preferred to stamp on domestic demand by fiddling with reserve ratios rather than let go of the pegging weapon.

However, pegging is not a free ticket to dine. The past decade has left the US feeling exposed at the top of a pile of goods that have not been paid for. At the foot of the mound sits China. Robbed of its devaluing weapon, the US has been only too happy to resort to its remaining policy tool: spinning the quantitative taps at its central bank, the Federal Reserve, and flooding Beijing with inflationary pressure. This is the cost of pegging to a deflation-fearing superpower.

This US-China side game is of an altogether different nature to the gambit of the boom. American gains in avoiding deflation are Chinese losses in incurring inflation. And Beijing has very little with which to protect itself. Sooner or later something's got to give.

The gentlemanly, and sensible, thing to do is to support each other in stumbling home. China can carry on financing the US administration as it limits its debt addiction. At the same time China can steadily revalue and undertake the domestic adjustments needed to achieve that sought-after home-grown consumer demand. Perhaps the best clue as to US sentiment was the choice of a bright red dress by Michelle Obama, the wife of the president, at the state dinner.