For more than a decade, the modus operandi of United States-China relations has been pragmatic, interest based and disciplined. Both sides have focused squarely on economic win-wins, managing down their lurking geopolitical rivalries and keeping a lid on potentially incendiary political disagreements and military tensions. Presidents Hu Jintao and Barack Obama have already signalled their strong intentions to keep relations between their two countries on this path. The problem for both, and for the world, is that after the global financial crisis it will be become increasingly difficult to keep delivering the economic benefits that have proved calming emollient for the inherent strains in US China relations.

The leaders of both countries know that their “trade for T-bills” ties were a major contributing factor to the global financial crisis. China was happy to provide a bottomless pit of cheap American credit by buying up dollars and Treasury bills so long as Chinese goods continued to sail off American shelves. The United States was willing to live with a massive trade deficit with China and an apparently undervalued Chinese currency so long as the low interest rates made possible by China’s hunger for dollars kept the US economy humming. The historian Niall Ferguson calls this co-dependent arrangement “Chimerica”.

Now that the bubble has burst, Chinese and US leaders have joined the “never again” global chorus when it comes to what has become the most imbalanced bilateral economic relationship in human history. But undoing what everyone now agrees is most unhealthy co-dependence between the world’s top two economies will be hard. It will demand nothing less than a re-coding of the economic DNA of China and the US, one that will likely take decades rather than years.

Americans are born with the consumption gene, and the government has always fed their habit through enabling regulation and tax breaks—above all, allowing Americans to borrow, not earn, their way to the American dream of home and business ownership. Chinese, on the other hand, have the thrift ethos drummed into them from birth. Their government has continued to pour money into investment in infrastructure and industry for export to drive growth and raise living standards. But the Chinese government has not built the kind of social safety net and retail financial system that would lead its citizens to save less, consume more and build a vibrant and sustainable domestic market-led model of economic development.

Whether they like it or not, China and the United States will be stuck with Chimerica for a long time. But an economic relationship that has soothed tensions between the two countries for more than a decade is poised to become, after the GFC, a major source of frustration and irritation.

Amid the hoopla surrounding the crisis-induced coming together of the 20 century Western powers with the emerging powers of the 21st century at the April 2009’s G20 summit, the World Bank’s president, Robert Zoellick, and chief economist, Justin Yifu Lin, spoiled the multilateral party. “For the world’s economy to recover,” they wrote in the Washington Post, “the two economic powerhouses must co-operate and become the engine for the Group of 20… Without a strong G2, the G20 will disappoint.”

The two economic powerhouses were of course the United States and China. The idea of a G2 has been hotly debated in recent months. Zbigniew Brzezinski raised the idea in a Beijing celebration of the 30th anniversary of formal US-China diplomatic ties in January 2009. British Foreign Secretary David Miliband warned his European colleagues that they would have to work hard if they wanted to turn the nascent G2 into a G3 including them. Others say the whole idea is fanciful given the fundamental differences that divide China and the US.

No senior government official from either the United States or China is ever likely to call their relationship G2. Both countries want to continue their successful high-level bilateral diplomacy but to cloak it with a continuing commitment to multilateralism. Chinese Premier Wen Jiabao went out of his way to make this point at May 2009’s Sino-European Union summit in Prague, saying, “It is totally ungrounded and wrong to talk about the dominance of two countries in international affairs.”

But it was hard to disagree with US Treasury Secretary Timothy Geithner when the next month in a speech at Peking University he put his country and China at the epicentre of the long process of digging out from the global financial crisis:

A successful transition to a more balanced and stable global economy will require very substantial changes to economic policy and financial regulation around the world. But some of the most important of those changes will have to come in the United States and China. How successful we are in Washington and Beijing will be critically important to the economic fortunes of the rest of the world.

The GFC has hit both countries hard. The United States is mired in its worst economic slump in 60 years. Chinese growth in 2009 will likely be only half its 2007 level. But things look even worse for the world’s other major economies.

Europeans can’t feel very good about their prospects when The Economist grudgingly acknowledges its long-time dirigiste bête noir, France, as the continent’s strongest economy. Germany, because of its export dependence, and the United Kingdom by virtue of its own burst housing bubble and bank failures, are mired in deep downturns. Things look even worse in Japan, where the crisis halved its trade lifeblood over the year to early 2009. Japan and Europe will likely exit the crisis weakened, inward looking and in no position to compete with China and the US on the global stage.

Among the previously fast-growing emerging economies, Brazil and Russia are in full-blown recession because of their exposure to steep price declines and loss of trade volumes in commodities. India has been relatively less affected by the crisis than much of the emerging world because, despite the global successes of its information technology and software companies, the Indian economy is still mostly inward looking.

Moreover, most forecasters believe the United States and China will lead the global way back towards some sense of normalcy. This is in large measure because of the speed and scale of the GFC fighting measures enacted by both countries.

The US and China have enacted the largest fiscal stimulus measures in the world, even when measured relative to the size of their enormous national economies. President Obama signed into law an almost US$800 billion fiscal stimulus bill less than a month into office. The Chinese government announced its own fiscal stimulus package in late 2008, almost as big as Obama’s, at market exchange rates. Critics, including Obama before the London G20 Summit, have complained about the relatively desultory efforts of the major European countries, in comparison.

When all the future guarantees are taken into account, America’s financial bail-out bill has been estimated at a staggering three-quarters of annual US GDP by the IMF. China’s banks have been immune to fallout from the GFC. But the Chinese government has been far from silent when it comes to the banking sector. Its state-controlled banks have gone on a lending spree to their big corporate customers, with new loans in the first quarter of 2009 alone in excess of the entire government fiscal stimulus and greater than total loans for all of 2008.

Putting together all we know about the economics of the crisis, it is hard to avoid the conclusion that the world is moving towards a de facto G2, almost by default, as the other major economies are being hit even harder by the crisis and with longer-lasting effects than in the United States and China. The problem for both countries, and the world, is that China-US relations are likely going to be more difficult to manage than they were before the crisis.

The United States and China have already committed to upgrading their bilateral diplomacy through an ongoing Strategic and Economic Dialogue led by Vice-Premier Wang Qishan and State Councillor Dai Bingguo for China and Secretaries of State and Treasury Hillary Clinton and Timothy Geithner for the US. The top issues on their agenda will be economic. But they will not revolve around co-ordination of GFC fighting measures. Rather, both sides know they must tackle head-on their pre-crisis trade for T-bills co-dependence.

The statistics on growing Chinese government purchases of US Treasury bonds and American consumption of Chinese goods before the global financial crisis are staggering. Since 2000, China has increased its holding of Treasury bills more than sevenfold to almost US$700 billion. Over the same period, US imports of Chinese goods more than quadrupled to almost US$350 billion.

The conventional wisdom today is that US-China economic imbalances were at the root of the global financial crisis. Indeed, the governments of China and the US have made lofty declarations about “rebalancing” via dramatic reforms of their domestic economies. Secretary Geithner was very clear about what is in front of both countries:

Our common challenge is to recognise that a more balanced and sustainable global recovery will require changes in the composition of growth in our two economies. Because of this, our policies have to be directed at very different outcomes. In the United States, saving rates will have to increase, and the purchases of US consumers cannot be as dominant a driver of growth as they have been in the past. In China, as your leadership has recognised, growth that is sustainable growth will require a very substantial shift from external to domestic demand, from an investment and export intensive driven growth, to growth led by consumption.

Senior Chinese officials have made similar statements about the importance of balancing China’s export-led growth with stronger domestic drivers of economic development. The reality is clear to both China and the United States. China kept its currency weak against the dollar before the crisis by buying dollars and dollar-denominated paper, which kept US interest rates low and US debt-financed consumption booming. American red ink kept Chinese exports flying off the shelves and made possible year after year of extraordinary and even accelerating growth in China.

United States profligacy and Chinese dollar-asset purchases have long been at the heart of Chimerica imbalances. But rather than doing something about it, leaders from both countries have violated what had previously been the unwritten but closely followed rule of keeping major disagreements behind closed doors.

On the US side, Geithner let slip, in the heat of his confirmation hearing, the claim that China unfairly “manipulates” its currency. Official Chinese reaction to this diplomatic faux pas was pointed and swift. Wen Jiabao worried out loud that “of course we are concerned about the safety of our assets” in the US, given all the debt Obama is running up. A week later, the governor of China’s central bank, Zhou Xiaochuan, proposed the creation of a new global reserve currency to replace the dollar, “that is disconnected from individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies.”

But whatever the problems with Chimerica, firing it up again is the fastest and easiest way out of the crisis for both sides. The Obama administration is compensating for large-scale de-leveraging by consumers and firms with unprecedented government spending. The strategy is to revive domestic demand first, leaving the expansion of productive capacity to later. More US demand will mean more imports from China. The Chinese government is trying to make up for plummeting exports with massive investment in public infrastructure and dramatically ramped-up lending from state banks to big Chinese companies. But until Chinese consumers start buying what Chinese firms produce, exports, above all to the US, will be the principal way to translate investment into economic growth.

The Obama administration talks a good game about the importance of fiscal sustainability to the future prosperity of the United States. But there are only two ways to get there, spending cuts and tax increases, and Americans have shown time and again that they will punish politicians who undertake either.

Cutting costs in the Medicare and Social Security programs for retirees is the biggest domestic policy challenge the US will face in the coming decades. But Social Security has long been the third rail of US politics—touch it and risk electrocution—and the last Democrat in the White House, Bill Clinton, was cowed from bold progressive to triangulating centrist by a complete defeat on health care reform proposals that are not so different from Obama’s.

Americans are infamously allergic to taxes, as when fatal damage was done to the presidency of George H.W. Bush when he violated his “no new taxes” pledge. What about tax increases that would also hurt the American dream of debt- and tax break-enabled home ownership? The volume of home mortgages in the US is about as big as the entire economy, but every dollar spent on servicing mortgage debt is fully tax deductible. As housing prices ran up in the 2000s, Americans added the equivalent of another 10 per cent of GDP to housing debt, this time in the form of credit card equivalent home equity lines of credit secured against homes, with much lower interest rates than regular credit cards—and with all debt interest fully tax deductible.

China’s long-run economic challenges are the mirror image of those in the United States. Whereas Americans borrow because they are confident about the future, Chinese citizens save for a rainy day in fear that some day soon it will be pouring and the state won’t be handing out umbrellas. Individuals in close-knit extended families save because they know it is family rather than the state that will look after them when they get sick, old or lose their jobs. Even if Chinese wanted to spend and borrow more, their retail financial sector is at best rudimentary.

The Chinese government could use its vast financial war chest to build an effective social safety net. It could also change the regulatory environment to favour the growth of retail banks, credit cards and insurance targeted at consumers. Instead the government chooses to invest in infrastructure and large-scale economic activity, with state-owned banks as their increasingly preferred intermediary. This allows the government to keep tight control over the direction of economic development whilst striving to deliver on the implicit guarantees of full employment and higher living standards for all its citizens that help buoy up its political legitimacy as regular Chinese raise more questions about the autocratic state.

The government will think long and hard before undertaking the kind of reforms needed to liberate Chinese citizens to become more Western in their economic behaviour. To do so would entail giving up cherished control over the economy when the government is simultaneously worried that its political control is also under quiet siege. Chinese leaders learned well the lessons of Mikhail Gorbachev’s glasnost and perestroika, and they will not lightly walk down the former Soviet Union’s path for fear of suffering what they see as self-inflicted demise.

The bottom line is that while China and the United States both say they want to end their addiction to Chimerica, they know that this will be very hard to do. The changes that are needed are essentially domestic and within the control of governments in both countries. It is just that the political will required to make these changes is immense and will prove a monumental challenge for the leadership of both countries. In this environment, blaming the other side rather than taking responsibility at home is the political path of least resistance.

For close to three decades Australia has successfully pursued twin objectives at the very top of the country’s strategic agenda—building powerful economic links with China focused on the exploitation of Australia’s raw materials, while strengthening its security alliance with the United States, based on the long history of shared values and interests.

Like both his Liberal and Labor predecessors, Prime Minister Kevin Rudd wants to continue this essential US-China balancing act. The challenge for Australia is that the United States and China will be different countries and their relationship will be different following the GFC. Though economic imbalances have long been a source of tension between the two countries, their co-dependence has acted as the glue holding together potential cracks in US-China relations over the past decade.

How should Australia act in this environment? The 2009 Defence White Paper makes the case for an upgraded, modernised and expanded Australian defence capability to insure against fallout from military conflict among the major powers of the Asia Pacific—an unlikely outcome, but one defence planners have to consider with all seriousness and resolve. Though the White Paper talks also of India, Japan and Russia, it is widely viewed that the paper’s primary concern is China’s nascent rivalry with a slowing weakening but still dominant US:

As other powers rise, and the primacy of the United States is increasingly tested, power relations will inevitably change. When this happens there will be the possibility of miscalculation. There is a small but still concerning possibility of growing confrontation between some of these powers.

The focus of the White Paper is 2030, knowing that the progress of major military build-ups is measured in decades rather than years. Between now and then Australia will surely pursue a proactive diplomatic strategy designed not only to strengthen its relations with both China and the US but also, where possible, to facilitate better relations between the two giants.

With respect to China, Australia will have to come to grips with the prospect of substantial Chinese investment, the inevitable consequence of China’s insatiable appetite for raw materials, coupled with the equally inevitable long-term rise in the value of its currency. Australians are understandably concerned about large-scale Chinese acquisitions of crown jewels in the minerals sector. Above all else, this is because of the strong but often opaque links between Chinese firms and the Chinese government, and in turn because of doubts about the Chinese government’s ultimate objectives as a great power.

But the economic realities of China’s super-sized impact on Australia’s economic future means that sooner or later Australia will have to accept that large-scale trade with China will mean large-scale Chinese investment as well. Around the world, it has long been the case that trade and foreign direct investment have proved complements rather than substitutes. China is following this logic in Latin America and Africa already, and it will surely expect Australia to follow. Even though it may take China some time to lick its wounds and regroup, it would be unwise to view the failed Chinalco bid for a greater stake in Rio Tinto as a harbinger of things to come.

There is no indication that the United States under Obama will scale back its far-reaching global ambitions. Nonetheless, the country will grow ever more cash-strapped and psychologically exhausted from foreign entanglements, with its military stretched close to breaking point. The Obama mantra of “smart power” means many things, but one of its most important meanings is to further foreign policy goals at somewhat lower cost by asking more of US allies. From more troops in Afghanistan while maintaining a sizable long-term troop presence in Iraq to upping the ante with Iran and Pakistan, the US under Obama may no longer be fighting a “war on terror”. But the centrality to US foreign policy of the struggle against violent Islamic extremism will endure for years and probably decades. So too will the United States’ desire to protect its strategic interests in the western Pacific from Korea to Southeast Asia and the South Pacific.

President Obama will give US allies what they said they wanted but did not get under President Bush: more involvement in setting shared strategic objectives. But he will also demand that these allies take on more responsibility in furthering these objectives. Australian strategists often talk about policy towards the US in terms of “alliance management”—doing what it takes to stay on the America’s A-list of trusted allies. The costs of membership are likely to grow over the next decade, and Australia may well be better placed and more willing to pay them than some of the US’s other traditional alliance partners.

Managing these two bilateral relationships will be even more important to Australia’s national interests after the crisis than before it. But the post-GFC world will throw up another challenge for Australian foreign policy of growing import. Australia will want to involve itself in US-China relations in ways that help smooth the frictions between the two great powers without getting in the way of their bilateral relationship—a clear example of the creative and effective “middle-power diplomacy” Kevin Rudd has said is vital to Australia’s future.

Some suggest Australia should try to play a direct intermediary role between China and the United States, particularly with a prime minister who speaks Mandarin and whose innate political and policy views are very similar to those of President Obama. There is no doubt something to this notion, but it will inevitably be more effective the less attention anyone, above all Rudd, draws to it. China and the US can handle their own bilateral relationship, and will devote considerable resources to doing so. But both countries have signalled that they want to cloak their bilateral relationship in multilateral robes. Working with China and the US on the multilateral stage in areas of shared interest seems a better strategy for Australia than direct effects to intercede in their bilateral relations.

The best diplomatic track for Australia to work collectively with the United States and China seems to be in supporting the shooting-star ascent of the G20 from an obscure meeting of finance ministers into what might well become the most important institution of global economic governance in the coming decade. The G20 agenda will focus on issues of vital importance to Australia—financial regulation, resisting protectionism, furthering free trade, reconciling the climate change agenda with global economic integration. Australia’s positions on these issues will likely be viewed as leadership moves that will also sit well with both the US and China—advocating a sensible global architecture for financial integration that does not gratuitously beat up on or constrain the US; pushing for a completion of the Doha round in ways that require concessions from both China and the US as well as Europe, India and Japan; using its position as a big carbon emitter and big carbon exporter to confront climate change without gutting carbon-based industries.

China and the United States may not always agree with Australia’s positions on these issues, and Australia will not stand squarely on one side or the other when it comes to their biggest challenges. But Australia’s position will be respected in the G20. The US-China relationship will be even more important to Australia and the world after the global financial crisis than it was before the crisis. The challenges facing the relationship will grow increasingly complex. Australia is well positioned to help the two global giants work through their differences, and the G20 is the best forum in which to do this.