Monetary Meltdown? [Bruce]

Years ago, there was a silly movie called "Rollover." The premise of it, as best I can recall from wasting two hours watching this absurdity once, was a conspiracy by Arab countries to wreck the U.S. economy by selling all of their dollars at once. Although fanciful even by Hollywood standards, the idea that our creditors can somehow ruin us through this sort of action lives on among the conspiracy-minded.

The latest version of the Rollover scenario comes from Ambrose Evans-Pritchard in this morning's London Daily Telegraph. Says Evans-Pritchard, whom some may remember for his lurid tales of Bill and Hillary Clinton's wrongdoing back in the 1990s, the Chinese are getting ready to dump their dollars if Congress enacts legislation restricting Chinese imports.

Of course it would be bad policy to impose tariffs on Chinese goods. But the idea that China would retaliate by causing the dollar to crash is absurd. For one thing, it is extremely difficult to target imports from only one country when they can easily be rerouted through other countries. Also, there would be an immediate backlash against those politicians who just made many popular goods more expensive with new tariffs, which are, of course, a form of taxation--one that falls most heavily on the poor.

But the most important reason why China will not retaliate the way conspiracy-mongers like Evans-Pritchard think is because the Chinese would suffer a massive capital loss if they tried to hurt us by dumping their dollars. That is because their dollars are not sitting around in wads of $100 bills, but fully invested in U.S. Treasury bonds. Bond prices go down when interest rates rise or there is a threat of inflation that would erode the value of the bond's principal.

If China started heavily selling its bonds, the added supply on the world market would cause interest rates to spike. If investors started to become concerned about our ability to finance our debts, it could cause the dollar to plummet, which would further depress bond prices. How much bond prices might fall under such a scenario cannot be estimated. But China would certainly suffer capital losses on its bond portfolio of tens of billions of dollars and possibly much more.

The fact is that the more dollar-denominated assets China holds, the less likely it will do anything stupid like Evans-Pritchard suggests. They will work around any trade restrictions we impose just as the Japanese did in the 1980s. But the Chinese will not risk destroying one of their largest economic assets: their portfolio of Treasury bonds.

As economist John Maynard Keynes once explained, "Owe your banker 1,000 pounds and you are at his mercy; owe him one million pounds and the position is reversed" (Collected Writings, vol. 24, p. 258). In short, the more money we owe the Chinese, the more power we have over them. Evans-Pritchard has the whole relationship exactly backwards.