Chinese officials have been highly critical of the U.S. debt buildup and the political wrangling in Washington that has failed to resolve the debt crisis. But China could well turn that leery eye inward to find policies that are preventing financial markets from functioning in a healthy manner—and which may yet spread the next serious malady to global financial markets.

One problem is that China is the largest holder of U.S. Treasury securities, with more than $1 trillion invested. Without China’s large appetite for U.S. debt, Congress would have been more constrained in its deficit spending, and U.S. growth would have been more robust.

China now holds more than $3 trillion in official foreign exchange reserves, the result of large trade surpluses and inward foreign investment. However, China is a net exporter of capital via the purchase of Treasuries and other government securities. The large accumulation of dollars is the result of an exchange-rate policy designed to undervalue the yuan.

Which brings us to the second major problem: if the Chinese currency were allowed to freely float, there would be no massive buildup of official reserves. Traders, not communist party members, would determine the exchange rate. Adjustment would occur spontaneously via voluntary decisions, not via central plans.

A more flexible exchange rate and a fully convertible yuan would increase the range of choices open to the Chinese people, expand the private sector, and increase popular pressure for political reform.

The legacy of central planning still haunts the banking sector. Lending, interest rates, and the major banks themselves are all controlled by the state. Even more ominous is that most of the lending is to state-owned enterprises. Investment decisions are therefore heavily politicized, and corruption is rampant.

Stimulus spending allowed China to escape the 2008-2009 global financial crisis, but the rapid expansion of bank credit, as well as off-balance sheet lending, has led to excess money growth and an inflation rate of more than 6 percent. UBS data show that China’s bank credit, including off-balance sheet loans, now stands at about 180 percent of GDP, up sharply from 2008.

If the economy slows, non-performing loans could swell. The excess credit could turn into a debt crisis. That crisis could be compounded by a bursting of the Treasury bond bubble, once the Federal Reserve begins to increase interest rates, or once markets think the Fed will inflate and reduce the real debt burden.

China needs to tame domestic inflation and further liberalize its economy. Yet, there is strong political pressure to continue to peg the yuan at an artificially low rate and “sterilize” the newly minted yuan—that is, drain off excess yuan by selling central bank bills, increasing reserve requirements, and setting tighter lending quotas.

Price controls and capital controls are also being used to suppress inflation and to limit private choices. But as long as China is trapped in its export-led development model, with financial repression, the hoard of foreign exchange reserves will grow and most of those reserves will be lent to the U.S government, not to private enterprise.

The reality is that both China and the U.S. are growing the state sector at the expense of the private sector. Crony capitalism, not market liberalism, is now the norm.

For China to become a global financial center and achieve financial harmony, there must be privatization of the banking system, capital freedom, flexible exchange rates, market-based interest rates, and a rule of law that assigns responsibility to private individuals, not the state.

The mispricing of credit/risk and monetary manipulation plague both China and the U.S. Beijing is right to criticize U.S. policymakers for creating fiscal and monetary uncertainty. But what Beijing wants is more, not less government control, while the solution to the problem of creating economic and social harmony is less government.

With a rule of law and limited government, voluntary exchanges in private free markets would increase individual sovereignty and wealth, while promoting the general welfare. That concept of spontaneous order is now foreign to most politicians. Politics and “legal plunder” have trumped what the great French liberal Frederic Bastiat called the “law of liberty.”

The challenge for both China and the U.S. is to restore the balance between the state and the market—to maximize freedom and minimize coercion. Rebalancing can then be market-directed, economic relations normalized, and politics put in its proper place.

About The Author James A. Dorn

James A. Dorn is Vice President for Monetary Studies and Senior Fellow at the Cato Institute. His articles have appeared in The Wall Street Journal, Financial Times and South China Morning Post. He has testified before the U.S.-China Security Review Commission and the Congressional-Executive Commission on China.