Future Dollars and Current Fears

The Washington Post reports today that China is selling dollars. How much of our money belongs to China? About $800 billion.

Big fat hairy deal. What does that have to do with us?

In recent years, the value of the dollar has been buoyed by major purchases of U.S. Treasury bills by Japan, China and oil-exporting countries -- a flow of capital that has kept interests rates relatively low in the United States and allowed Americans to keep spending even as debts mount. Some economists have long warned that if foreigners lose their appetite for American debt, the dollar would fall, interest rates would rise and the housing boom could burst, sending real estate prices lower.

You have to understand a bit about how the value of the dollar is maintained to understand why this is mildly alarming (and potentially more than mildly so).

Think of a dollar bill as being backed by a portion of the American economy. When you hold a dollar bill, you aren't guaranteed a dollar's worth of gold, but only a dollar's worth of the economy. As long as the number of dollar bills grows at the same rate as the economy, that remains true. However, if the economy grows faster than the dollar bill; then your dollar rises in value and is worth more. If the economy grows slower than the stock of dollars; then your dollar is worth less and it declines in value.

Now, we'll jump a bit. Let's say the government passes a budget with no deficit and no surplus - they spend exactly as much as they bring in. There is no net effect from that budget upon the stock of dollars, but there is some effect on the economy (because the government spends the money it brings in). If the government spent less than it brought in (theoretically, it's never actually happened); then it would be removing money from the supply of capital - and that would make your money increase in value. When the government spends in deficit, as it has every year that George W. Bush has been in the White House, it does the reverse - it increases the total capital available, and thereby, reduces the value of your money.

This is true because the government cannot simply create money out of nothing - despite what some people say. If the government spends more than they bring in; then they must sell bonds in order to close the shortfall. Those bonds are actually claims against future dollars. In other words, we tell a buyer (in this case, China) that we will give them a certain number of dollars at some point in the future in return for a smaller value of their currency today. We then convert their currency into dollars and the government spends them. This shuffle is an attempt at keeping the value of your dollar roughly the same (because the devaluation of more money is offset by revaluation of the currency due to greater economic growth).

So, if everything goes just right - and enough foreign buyers are willing to trade today's money for tomorrow's - then the value of our money is safe.

China's decision threatens that balance. It is entirely dependent on the sellers they find to determine to what extent our currency is effected. If the bonds they sell are accepted at roughly the save value as they were bought, then it simply amounts to a shuffling of papers. However...

Remember that the dollars bought with bonds represent legitimate future dollars. If we run out of future dollars, then our bonds become worth less - and that means that we have to offer more future dollars in return for the same amount of current money. That is reflected in a higher interest rate.

If China's buyers believe we have spent too many of our future dollars, they may begin to believe that we don't have enough future money to pay all of our promises. That represents future default on our debts, which means that fewer people will want to buy our bonds. That translates into an inability to finance our deficit spending, resulting in drastic, across-the-board spending cuts.

That's in the future. What it means to us today is that these demands for future dollars could turn into demands for current dollars. That means that our market is flooded with cheap dollars. Woohoo! Money for everyone!

Except that cheap money is worthless money. It causes inflation - and the only tool we have for rising inflation is to choke off the money supply by raising interest rates. That means you're about to pay more for everything you buy as corporations rachet the effect of higher costs of business through the economy.

Except real estate. Real estate values have an oppositional relationship with interest rates. As interest rates rise, property values decline. The reason is simple: when people buy a house, they look at how much they can pay per month. If more money goes to the interest, then less can go to the value of the house. As people are unable to pay top-dollar for a house, they buy cheaper houses - and that drives property values down. See: the real estate boom in the last decade was caused almost entirely by low interest rates.

The only thing working in our favor is that China holds so many future dollars that if it sells too many too fast at too steep a discount, it will cause its own economy to crumble. If, however, it can pull off a grab for some other currency (Euros, for instance); then it might be able to shield itself from the negative effects - and that could cause a spiraling effect where selling US bonds drives their value down, which in turn makes them more attractive to sell.