What happens when China quits the dollar habit?

Real money doesn’t cheat. You can trust gold. On the other hand, those paper dollars, euros and rupees are completely faithless. They say they’re worth a certain amount one day. The next, it’s a whole ‘nuther story.

Lately, the dollar has been doing well. The bond market has held up... despite the extraordinary demands placed on it by the world’s governments.

In February alone, the US government ran a record deficit of $221 billion. And February is a short month. Annualize that and you’ve got about $2.5 trillion in excess spending.

That money has to come from somewhere. And even if you took 100% of America’s savings... it still wouldn’t be enough.

If you’re married to the dollar... it’s time to see a divorce lawyer.

China says it is continuing to buy US bonds “every day”. It doesn’t have much choice. It earns money by selling things abroad.

In fact, exports in February were up more than 40% over February ’09. This leaves it with a lot of foreign money – most of it in dollars.

What can it do with so much money?

China has quietly bought stakes in America’s leading companies... and in various businesses all over the world. But the only way large amounts of US dollar cash can be readily and safely deployed is in US bonds.

That said, China could also cause one helluva problem for the US if it ever chose to do anything else.

No worries on that score, said the Chinese official in charge of its $2.4 trillion worth of foreign reserves.

China’s holdings of US debt are normal and that there is no intention of reducing them or playing politics with them.

China surely means it. And when the dollar goes down... and when the market turns, and China feels compelled to get rid of its US bonds, he’ll be totally sincere when he explains that to the international financial press too.

Markets make opinions, as they say on Wall Street.

The market in bonds and the dollar has been very good for a very long time – since 1983, to be exact. As a result nearly everyone – including the Chinese – are of the opinion that US bonds are a safe place to be.

When the market changes, so will opinions.

So far, no problem. But there’s no telling how long the foreigners will continue to support the dollar. Then what? Well... it leaves quantitative easing... in which the US central bank lends the money itself.

Where does it get the money? It just invents it.

Which is why you can’t trust paper money. You have a dollar. You have it. You hold it. And you expect to keep it ‘til death do you part. But then, along comes another dollar that looks just like it... fresh... young... full of vim and vigour. So why not? Everybody does it.

Pretty soon, there are a lot more dollars running around. And they change hands fast. In economists’ lingo, the velocity of money goes up... and the value of the dollar – like a faithless lover – goes down.