Between a Crutch and Walking Stick

China and Japan are supporting the euro zone by purchasing government bonds that the market shuns today. China and Japan have US$ 4 trillion in foreign exchange reserves and are capable of bridging liquidity problems that some euro zone economies are facing.

What China and Japan can do is to stop market panic from leading some otherwise viable economies down a vicious spiral of rising interest rates, rising debt burdens and bankruptcy. Economies that are not viable in the first place shouldn't be helped.

China and Japan's actions help themselves in two ways. First, the euro is the only alternative to the dollar for global trade, commodity pricing and storing foreign exchange reserves. If the euro falls apart, the U.S. Federal Reserve will be further emboldened to pursue inflation to decrease the U.S.'s leverage or indebtedness at the expense of dollar holders. China and Japan hold vast dollar assets.

Second, Europe is the largest trading partner for China and the third largest for Japan. It is in both economies' interest for Europe to avoid a vicious cycle and remain a healthy trading partner.

Self-fulfilling Cycle

The watchword for monitoring developed economies is debt and, for developing economies, inflation. The market is panicking over the sovereign debt situation in some euro zone economies and is demanding high interest rates for rolling over their debts or providing new money for financing their deficits. When the interest rates rise above some level, an otherwise healthy debtor can go bankrupt. This element of self-fulfilling prophecy is a major force in speculative attack against a company or country.

China recently pledged to support debt issuances by Spain and Portugal. Japan has committed to purchasing one fifth of the debt issuance by the European Financial Stability Facility ("EFSF"). China's actions were instrumental in the successful debt issuances by Spain and Portugal. Japan is taking risk behind the EFSF that is guaranteed by strong economies like Germany and France. This is not enough. China and Japan should work closely together in their European Project. They have common interests.

If China and Japan stick together, they can play a critical role in preventing the euro zone from suffering unnecessary economic hardship due to financial market panic and, by extension, supporting the euro as an alternative reserve currency to the dollar.