James Fallows, in a brilliant article for the magazine Atlantic Monthly (online access for subscribers only, which is why I'm going to post a lengthy quote below), discusses the manufacturing monster that China has become. As a part of the piece, he also mentions the dollar quandry:
Everyone understands that that in the short run China's handling of its [dollar] reserves has been a convenience to the United States. By placing more than $1 trillion in U.S. stock and bond markets, it has propped up the U.S. economy. Asset prices are higher than they would be otherwise be; interest rates are lower ...Everyone also understands that in the long run China must change this policy. Its own people need too many things -- schools, hospitals, railroads -- for it to keep sending its profits to America. It won't forever sink its savings into a currency, the dollar, virtually guaranteed to keep falling against the RMB. This year the central government created a commission to consider the right long-term use for China's reserves. No one expects the recommendation to be: Keep buying dollars.
What's amazing to me is that there is so much talk about this one issue -- China's reserves and its eventual diversification of those reserves -- without any real understanding (ability to predict) of what the heck is going to happen if and when this diversification occurs. Here are just a few scenarios:
1. The Dollar Vomits: In this scenario, the US dollar gets whacked big time because the Chinese call up Goldman, Bear, Morgan, and everyone else, and they start selling off their dollar-denominated assets. The classic law of supply and demand says that if someone wants to sell $1 trillion of anything on the world financial markets, that "anything" is going to dive in value. It's not just the fact that there will be a glut of dollars (thus they'll be valued lower), but it's also the fact that this massive sell-off triggers a wave of buying from other people who don't want to be the last sucker at the poker table.
2. The US Fed Raises Interest Rates: China starts selling, and in order to bolster demand for US debt, Bernanke & Co. raise interest rates to attract buyers. This increased interest rate means that US debt will pay attractive returns, and thus the US can still finance it's wild descent into debtors hell (so that the US government can do important things like study the effect of a vegetarian diet on hogs, study why criminals want to escape from jail, and send man back to the moon even though it's already been done).
These aren't the only two scenarios. But this post is already long and I'll continue it later.
I do want to mention that in either scenario, either #1 or #2, the US economy still goes into the toilet. Under #1, the dollar becomes worth less, and inflation skyrockets and families can't afford such luxuries as food and shelter; additionally, that family's retirement portfolio (US stocks) blows up. Under #2, increased interest rates halt the lending that spurs the economic development that we've seen so much of over the last few years.
