10/27/2010 09:50 am ET | Updated May 25, 2011

Why We Should Fear A China Crash

The stock market's been on quite a roll lately, today's decline notwithstanding.

In October alone the Dow Jones Industrial Average has gained more than 300 points, or around three percent. The other major stock market indices are up similar amounts as well.

On Wall Street, the performance has been a powerful elixir to a dolorous summer. Look at a chart of the market's performance over the past month and you'll see a fairly steady upward climb. The only real hiccup was a single significant down day, October 19, last Tuesday.

Of course, that was just one fluky trading day out of 252 in a year. But as is so often the case in the financial markets, it's the one-day anomaly that people really should be paying close attention to.

On October 19, the Dow fell 165 points, or 1.48 percent. The Nasdaq composite index and S&P 500 both lost more than 1.5 percent. The price of oil plummeted four percent and the value of numerous other commodities sank along with it. And the yield on the benchmark 10-year Treasury note tanked as well.

What happened to spook the financial markets? Simple. China's central bank said it was planning to raise interest rates. Slightly. And the mere prospect of this act triggered fears that China's government was ratcheting down its country's economic growth. So traders and investors freaked out.

Since then, the markets have resumed their rally and many Wall Streeters describe the episode as an overreaction to Beijing's statement. And in a sense they're right. The reality is the effects of any long range fiscal tightening in China wouldn't be felt over here for a while. So knee-jerk investors who automatically dumped their holdings out of fear that China' central bank was about to wreck the global financial markets might want to rethink that strategy.

However, from a long-term financial perspective it would be unwise for Americans to dismiss this episode. Instead, the U.S. should pay careful attention to what happened on that day because it spotlights a fundamental misunderstanding of America's relationship with China.

The primary metaphor used to describe the tangled web of financial and economic connections between China and the U.S. is codependency. Traditionally, Americans have viewed this codependency as a levee holding back the full weight of China's economic heft. The idea being that China owns so much U.S. debt and so many dollars that it only would be hurting itself if harmed the U.S.

However, it turns out this codependency cuts both ways. As last Tuesday showed, the U.S. economy has become so reliant on China's meteoric growth that any slowdown would have dire effects over here. Clearly America's financial markets believe that the U.S. economy needs an aggressive China with companies and consumers ready to step in and fill the gaps in demand left by the battered West. And what's more, Chinese officials know this as well.

All of which helps explain why China has become so belligerent lately on a host of economic issues that American leaders are trying to press.

For instance, U.S. officials have persistently accused China of manipulating the value of its currency, the renminbi, to keep the prices of its exports low. To head off a full-scale trade war the G20 over the weekend quickly put together a deal to avoid "competitive currency devaluations." Meanwhile, The New York Times reported that China has started secretly embargoing shipments of rare earth minerals to the U.S., Europe, and Japan.

So far Beijing's response has been to deny all allegations and allow the value of the renminbi to rise slightly. It also has turned the currency manipulation accusations back on the U.S. by accusing Washington of unfairly using monetary policy to stimulate the American economy. And when the White House accused China of illegally subsidizing its clean energy industry a senior Chinese official sternly warned the U.S. that it "cannot win this trade fight."

Clearly China's economic stances and rhetoric indicate that it's no longer prepared to just go along with what the U.S. wants.

Not surprisingly, China also is working the inside financial channels to make sure that America has a hard time putting together diplomatic coalitions to block its activities. For example, in July Chinese officials visited Greece and signed 14 business deals worth several billion dollars. And since then China also has offered to create a $5 billion fund to upgrade the Greek merchant shipping fleet. China also bought $558 million worth of bonds issued by Spain, and is in talks to make similar investments in troubled countries like Ireland and Portugal.

In the "what have you done for me lately" global economy, China's willingness to spread its cash around is creating goodwill where it never existed before. And it's undercutting the West's unity on crucial economic issues.

But perhaps most importantly, Chinese central bankers now know that they hold an economic bomb that they can detonate whenever they want. All they have to do is temporarily slam the breaks on growth and watch financial markets in the U.S. and around the world grind to a standstill. That's a very powerful position.

So if codependency is going to remain the overarching metaphor for the entangled relationship between China and the U.S., America probably should reexamine the fine print in the arrangement. Because from here it looks like one side of the partnership is far more dependent than the other.