A few months later, a veteran Communist Party politician named Cheng Siwei suggested essentially the same thing He Fan had. Cheng, in his mid-70s, was trained as a chemical engineer and has no official role in setting Chinese economic policy. But within hours of his speech, a flurry of trading forced the dollar to what was then its lowest level against the euro and other currencies. The headline in the South China Morning Post the next day was: “Officials’ Words Shrivel U.S. Dollar.” Expressing amazement at the markets’ response, Carl Weinberg, chief economist at the High Frequency Economics advisory group, said, “This would be kind of like Congressman Charlie Rangel giving a speech telling the Fed to hike or cut interest rates.” (Cheng, like Rangel, is known for colorful comments—but he is less powerful, since Rangel after all chairs the House Ways and Means Committee.) In the following weeks, phrases like “run on the dollar” and “collapse of confidence” showed up more and more frequently in financial newsletters. The nervousness only increased when someone who does have influence, Chinese Premier Wen Jiabao, said last November, “We are worried about how to preserve the value” of China’s dollar holdings.

When the dollar is strong, the following (good) things happen: the price of food, fuel, imports, manufactured goods, and just about everything else (vacations in Europe!) goes down. The value of the stock market, real estate, and just about all other American assets goes up. Interest rates go down—for mortgage loans, credit-card debt, and commercial borrowing. Tax rates can be lower, since foreign lenders hold down the cost of financing the national debt. The only problem is that American-made goods become more expensive for foreigners, so the country’s exports are hurt.

When the dollar is weak, the following (bad) things happen: the price of food, fuel, imports, and so on (no more vacations in Europe) goes up. The value of the stock market, real estate, and just about all other American assets goes down. Interest rates are higher. Tax rates can be higher, to cover the increased cost of financing the national debt. The only benefit is that American-made goods become cheaper for foreigners, which helps create new jobs and can raise the value of export-oriented American firms (winemakers in California, producers of medical devices in New England).

The dollar’s value has been high for many years—unnaturally high, in large part because of the implicit bargain with the Chinese. Living standards in China, while rising rapidly, have by the same logic been unnaturally low. To understand why this situation probably can’t go on, and what might replace it—via a dollar crash or some other event—let’s consider how this curious balance of power arose and how it works.

Why a poor country has so much money

By 1996, China amassed its first $100 billion in foreign assets, mainly held in U.S. dollars. (China considers these holdings a state secret, so all numbers come from analyses by outside experts.) By 2001, that sum doubled to about $200 billion, according to Edwin Truman of the Peterson Institute for International Economics in Washington. Since then, it has increased more than sixfold, by well over a trillion dollars, and China’s foreign reserves are now the largest in the world. (In second place is Japan, whose economy is, at official exchange rates, nearly twice as large as China’s but which has only two-thirds the foreign assets; the next-largest after that are the United Arab Emirates and Russia.) China’s U.S. dollar assets probably account for about 70 percent of its foreign holdings, according to the latest analyses by Brad Setser, a former Treasury Department economist now with the Council on Foreign Relations; the rest are mainly in euros, plus some yen. Most of China’s U.S. investments are in conservative, low-yield instruments like Treasury notes and federal-agency bonds, rather than showier Blackstone-style bets. Because notes and bonds backed by the U.S. government are considered the safest investments in the world, they pay lower interest than corporate bonds, and for the past two years their annual interest payments of 4 to 5 percent have barely matched the 5-to-6-percent decline in the U.S. dollar’s value versus the RMB.