Playing Chicken With China

http://www.foxnews.com/opinion/2010/11/26/playing-chicken-china/

Playing Chicken With China

By John Lott, FoxNews.com, November 26, 2010

The Federal Reserve has already injected hundreds of billions of new dollars into the economy since the recession started. Normally, when the government prints up more money, dollars are worth less and that is what we call inflation. But inflation has been surprisingly low.

One measure of the money supply, M1, which includes currency as well as checking accounts, soared by 26 percent between August 2008 and September this year. The amount of currency more than doubled. But prices barely changed.

As Fed Chairman Ben Bernanke goes forward with plans to print up another $880 billion, someone has to ask why the past increases didn't produce the inflation that everyone thought they would.

So where did all that new money go? Many blame businesses for hoarding cash. Obama recently said: “corporate profits are doing just fine. [But] they're holding onto a whole bunch of cash -- they're kind of sitting on it.”

But that isn’t happening. Companies don't just keep huge piles of cash lying around. Even if they aren't spending the money, they are putting it in the bank or they buy bonds. In either case the money is recirculated to others, not hoarded. Companies are indeed wary of starting projects and with all the uncertainty they face. And who can blame them? Yet, they are not the ones making the money disappear.
It turns out that the culprit is not so close to home. China is trying to keep the U.S. dollar more valuable than the Chinese currency, the Yuan. That sounds counter-intuitive, but a more valuable dollar means that it is relatively cheap for Americans to buy Chinese products – and that helps Chinese manufacturers’ sales.

The problem for the Chinese government is that when we print more dollars, the opposite happens.

So if the Chinese want to keep the dollar relatively expensive, what can they do? They buy up the newly printed dollars that are causing the dollar to depreciate.

While the M1 money supply has soared by $364 billion since August 2008 and the new currency we have printed up grew by over a trillion dollars, China alone has accumulated almost $500 billion in U.S. currency reserves, about $200 billion after netting out changes in China’s U.S. Treasury bond holdings. The exact increase in China's dollar reserves isn't precisely known by anyone outside of the Bank of China, but it is probably pretty close to the exact total. Other countries have also increased their reserve holdings of dollars.

The problem is that holding on to all this cash is really very costly for the Chinese. They can't turn around and spend the dollars, or all the additional dollars in circulation will again lower the value of the dollar -- defeating the very reason that the Chinese accumulated the dollars to begin with.

Yet, keeping a lot of cash around that doesn't even earn interest means that the Chinese are giving up a lot of money just to keep the price of their products relatively cheap. They don't even spend it on buying American goods. The more money that Federal Reserve puts into circulation, the more money that the Chinese have to buy up.

In a speech last week, Ben Bernanke, the chairman of the Federal Reserve, pointed to this huge increase in reserves by the Chinese. "Foreign exchange reserves by selected major emerging market economies . . . have risen sharply since the crisis and now surpass $5 trillion--about six times their level a decade ago," he said at a central bank conference in Frankfurt Germany.

"China holds about half of the total reserves of these selected economies, slightly more than $2.6 trillion."

It may seem like a pretty good deal for Americans. We give the Chinese pieces of paper (or their equivalent) and they give us goods. But no one, not even the Chinese, are going to be willing to do this forever. It would be great for us if they would let this go on, but at some point just piling up dollars and giving us products is going to be too costly for them. And when they dump all those dollars, the real problem starts. All that pent up inflation is going to be released.

Indeed, the process may be starting. Just this last Wednesday, the Chinese and Russians announced that they would quit using the dollar for trade between their two countries.

The U.S. is playing a high stakes game of chicken. Will the Chinese want to hoard more dollars as the U.S. government prints up nearly a trillion more dollars? Money that will just sit around and not even earn interest? The irony is that despite the Federal Reserve and the Obama administration attacking the Chinese propping up the value of the dollar, we must hope that they continue doing just that. If the Chinese start dumping dollars, not only will the $880 billion come back, but so might all the other money that the Chinese have been absorbing over the years.

John R. Lott, Jr. is a FoxNews.com contributor. He is an economist and author of "More Guns, Less Crime."(University of Chicago Press, 2010), the third edition of which was published in May.