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U.S. President Barack Obama made news in China last month when he announced the need to tackle the U.S. deficit to avoid a "double-dip recession." The statement triggered speculation that America's chief creditor admonished the President to get his fiscal house in order.
While most analysts have spent the past year arguing China is caught in a "dollar trap," the timing and location of Mr. Obama's statement indicates the Chinese have learned some key lessons from the last great dollar crisis. Most importantly, they appear to understand that "dollar diplomacy" is a useful tool to make U.S. policies more favorable to protecting the value of China's $2 trillion in reserves.
To understand this, it's worth a brief historical review of the problem facing major U.S. creditors in the late 1970s. In 1978, concern about the dollar's health reached the top of the international economic agenda. U.S. trading partners, such as West Germany and the Organization of the Petroleum Exporting Countries (OPEC), grew particularly worried as the dollar's weakness eroded their competitiveness or jeopardized the value of their dollar-denominated reserves. OPEC faced an especially acute problem, because the dollar served as oil's invoice currency, meaning the oil-exporting nations had no alternative to dollar accumulation. In June 1978, for example, one estimate put Saudi Arabia's foreign assets and reserves at $65 billion—80% of which were said to be held in dollars.
While China's dollar reserves are orders of magnitude larger than those held by Saudi Arabia in the late 1970s, the Saudis still faced the fundamental "dollar trap" predicament: Any major effort to shift reserves from dollars to another currency would accelerate the dollar's decline and erode the value of the remaining reserves.
Yet rather than passively accepting a fate of accumulating increasingly devalued dollars, the OPEC countries engaged in careful diplomacy, bringing pressure to bear on the United States that ultimately contributed to a tougher inflation policy. First, OPEC countries publicly discussed pricing oil in a currency other than the dollar, such as the International Monetary Fund's special drawing rights. The cartel requested a study on the effect of invoicing oil in an alternative currency, and an OPEC committee proposed using a basket of currencies to price the commodity. One member of the cartel—Kuwait—said it would accept sterling instead of dollars.
Second, some OPEC members raised the possibility of an oil-price hike to compensate for the erosion of the dollar's value through unchecked inflation. Fresh from the experience of the oil embargo, this move raised concerns among U.S. policy makers.
Finally, at least one oil exporter decided to invest reserve funds in other currencies. In 1978 Saudi Arabia placed some surplus funds into Swiss francs and German marks, instead of holding them in dollars, and at one point actually moved money from dollars to marks. These shifts appear to have been relatively small amounts, but large enough to get the attention of officials in Washington.
These moves were combined with consistent pressure from Saudi officials behind the scenes regarding the need for the United States to curb inflation. In one memorable episode, Treasury Secretary Michael Blumenthal and his key aides were so concerned about the impact on the OPEC creditors that they interrupted the Saudi Finance Minister's Disney World vacation to outline the Administration's plans for the dollar.
While it is difficult to isolate the impact of OPEC's "dollar diplomacy," there can be little doubt it contributed to the Carter Administration's policy shift on inflation, including the defense of the dollar in August 1978 and ultimately the appointment of inflation hawk Paul Volcker as Federal Reserve chairman in 1979.
Nations caught in a "dollar trap" are not as confined as it might first appear. China appears to be using some of the OPEC playbook, calling for a new global reserve currency and discussing ways to trade with Brazil and Russia without using the dollar.
While its position as the largest U.S. creditor gives China important influence over U.S. economic policy, it also makes China vulnerable to the moves of other U.S. creditors. Nine countries (or groups of countries, such as the oil-exporting nations) hold $100 billion or more in U.S. Treasuries. It is possible to imagine a scenario in which one or two of these creditors lose faith in the dollar and sell a significant portion of their dollar assets. Such a move could spark a credit run, as panicked creditors attempt to sell Treasury bonds before a dollar collapse.
The circumstances that could give rise to such a scenario would not necessarily need to reflect the underlying fundamentals of the U.S. economy. A few undersubscribed Treasury auctions, a higher-than-expected consumer price index report or a mid-session budget review indicating a larger deficit than forecast could shape creditor expectations regarding the prospects for inflation.
Proponents of the "dollar trap" view argue no reasonable creditor would undermine its asset values by a starting a dollar sell-off. However, if a creditor believes the United States is not serious about containing inflation and expects the dollar's decline to persist, it is perfectly rational for the creditor to sell dollar assets at the best possible price.
The lesson here is that the stability of U.S.-China economic relations is highly contingent on the expectations of other major U.S. creditors: It is no longer solely the province of the two superpowers. In addition, the more the U.S. becomes financially overextended, the more it is at the mercy of seemingly insignificant financial events.
While China can use "dollar diplomacy" to find a way out of a difficult situation, the U.S. has few viable alternatives to deficit reduction and eventually tightening the money supply. If the U.S. government cannot muster the will to rein in the money supply and the national debt on its own, it faces the prospect of a rival power increasingly constraining U.S. economic policy options or a collapse in global confidence in the dollar. Neither scenario bodes well for the United States, which is all the more reason for Congress and the Administration to get serious about the dollar.
Mr. Harris recently completed graduate studies in business at the University of Oxford. Previously, he served as policy director to the U.S. Secretary of Commerce during the administration of George W. Bush.
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