by Jurgen Brauer, May 2005
Copyright: J. Brauer. No reproduction without permission.

As everyone knows, you and I buy a lot of stuff from overseas: French cheese, South African wine, Chilean grapes, Canadian timber, German engineering, Australian beef, why we even like to take our vacation overseas. In fact, we buy more – much more – from foreigners than foreigners buy from us. Of course we need to pay for our appetite and so we put down the dollars we have earned (or borrowed) and hand them over to the foreigners.

We need to pay for our import appetite and so hand dollars to the foreigners. We thereby also just handed them a big problem.

We also just handed them a big problem. Since they cannot eat the dollars we have given them, they must somehow get rid of the dollars. There are only three ways of doing so. To illustrate how this works let's take a concrete example. Suppose you bought a nice American flag, made in China, and the Chinese flag-manufacturer got your $20 bill. The manufacturer can sell your $20 bill on the currency market for about 160 yuan, the Chinese currency, and then use the yuan to pay its suppliers, workers, and owners. So, where are the dollars? Let's say a Japanese company bought the $20 bill with yuan they earned by selling goods to China in the first place. Now the Japanese company has your $20 bill.

Since the Japanese sold the yuan and bought the dollars voluntarily, there is nothing wrong with that sort of freedom. But now the Japanese have a problem; they cannot eat the $20 bill. So they give it to Indonesia in exchange for half a barrel of oil. And now the Indonesians sit on the $20 bill. Since they exchanged the oil for the $20 bill voluntarily, there is nothing wrong here. Freedom is the hallmark of the American way, and if others emulate it – moreover, by using our dollars – that's just swell. The dollar becomes not just a national but an international currency to do business in.

A second way for the Chinese flag-manufacturer to rid itself of your $20 bill is to put it right back in the U.S. The manufacturer can buy real estate, buy a sports franchise, build a factory, or put the $20 bill in the U.S. stock or bond markets which help finance investment and jobs here. To do so, the manufacturer must be reasonably confident that the American economy is worth investing in. Looking at the numbers, it turns out that by far most of the dollars you and I ship abroad each year on account of trade indeed come back to the U.S. via the private financial markets. So, take heart: every time you buy foreign products, the dollars come back here.

Of course, dollars in China are worthless. So, the Chinese put them into the U.S. bond market, buying up Treasury debt, plugging our budget deficit and thereby directly assist us with our problems with the bad boys in Bagdad.

The third way for the Chinese flag-manufacturer to get rid of your $20 bill is by selling it to the Chinese government, more precisely to its central bank (the Chinese equivalent to the U.S.'s Federal Reserve Bank). The central bank gives the manufacturer 160 yuan to pay suppliers, workers, and owners, and now the central bank sits on your $20 bill. In fact, the Chinese central bank actually sits on about $700 billion of our dollars that it has accumulated over the years. And that's a big problem – for China, not for the U.S. Since the dollars are worthless in China itself, the Chinese government transfers the dollars back to the U.S. by buying up U.S. treasury bills. This helps plug the U.S. federal government budget deficit (and thereby the Chinese directly help us to fight the bad boys in Baghdad). This doesn't sit so well for ideological reasons, but the Chinese are too polite to mention that. Of course, in exchange for assisting us with our problem with Baghdad, and elsewhere around the world, the Chinese (and other foreigners who kindly lend us our own dollars) earn a low rate of interest.

Another, and more serious, problem for China is that for every dollar its central bank buys up it has to give our Chinese flag-manufacturers 8 yuan. Multiply that times 700 billion or so dollars, and you understand why the Chinese economy is drowning in yuan. To keep a lid on the resulting inflationary pressure, the central bank needs to soak up the very yuan it just handed out. There is only one way to soak up the yuan, and that is to issue yuan-denominated bonds. Unfortunately for China, it has to pay its own citizens a rate of interest on the yuan-bonds much higher than what it earns on the dollars stashed away in U.S. bonds. In a word, not only do we get Chinese-made goods, we also get the dollars back to finance our wars. In exchange, China gets a bunch of economic problems: not only is it struggling to keep inflation under control, it also is losing a pretty penny in the bargain. No wonder that Mr. Greenspan, the chair of the Federal Reserve Bank, recently noted that China actually isn't so very happy about its current exchange-rate which China has fixed at about 8 yuan to the dollar.

Why, then, does China do it? To see the answer, suppose it didn't do it. Suppose, China revalues and offers the Chinese flag-manufacturer 6 yuan per dollar, or only 120 yuan instead of 160 yuan for your $20 bill. The flag-manufacturer may well have to drop out of business. To much flag-waving and hat-tossing, you can hear the joyful shouts of "hurray" among U.S. manufacturers. That's what they want: getting some manufacturing business back. But for every Chinese business that closes down, its unemployment rate will go up, and at well over a billion people there are an awful lot of increasingly restive, angry Chinese with whom unemployment would not sit well at all. China's wily class of rulers understands all too well that they sit on a domestic powder key the likes of which the world has not seen before.

And why, then, does the U.S. play along with the 8 yuan per dollars fixed exchange rate to keep Chinese unemployment low? Simply put, because the U.S. does not like to see the Chinese powder keg explode either – at least not quite yet.

In sum, let's just say that the good, homely folks who clamor for yuan devaluation and tout the horn of U.S. manufacturers understand neither economics, nor international high-finance, nor power-politics. We are playing a dangerous game far beyond their pedestrian grasp that, at the moment, the U.S. is still winning.