The Dollar Dike Gives Way?

“China stuck in dollar trap,” says the headline on the front page of the Financial Times.

The FT says China is buying more U.S. bonds than ever. It must…according to the news report…because it has too many. Unless it supports the dollar, it risks a big collapse in the value of its foreign exchange holdings (mostly in dollars).

China has its finger in the dike. But it may need a bigger finger. This morning it is trading at $1.40 per euro – a new low for the year. Measured against gold, it now takes 958 dollars to buy a single ounce of gold.

“We have a huge amount of money in the United States,” said Wen Jiabao, premier of the People’s Republic of China, back in March. “I request the U.S. to maintain its good credit, to honor its promise and to guarantee the safety of China’s assets.”

In response to this request, U.S. Secretary of the Treasury, Timothy Geithner, answered in the positive. Whether he had his fingers crossed behind his back, or not, we do not know. But for the moment, the United States is honoring its promises in the short run…but doing so in such a way that dooms the Chinese in the long run.

Now, the Fed is buying U.S. Treasury bonds. So are the Chinese. Supporting each other, they are also supporting prices of bonds – which happen to be the largest single source of financing for the U.S. government and the largest single liquid asset of the Chinese government. Despite the support of the biggest investors in the world, the price of bonds and the price of the dollar both sank last week. Which makes us wonder: what happens when both the United States and China turn into sellers?

That may not happen soon. But it will happen.

For now, the United States has to sell trillions more in bonds to finance its imperial ambitions, bailouts and boondoggles. The Fed will have to buy them…along with the Chinese. If stocks fall – as we expect – they are likely to be joined by many other buyers too – all seeking safe haven in the world’s leading credit.

But at some point, as always, what must happen will happen. Not forever can the United States spend $2 for every dollar it receives in tax revenues. Not forever can the Chinese support the value of a bad investment, in which they are already too heavily invested, by buying more of it. Not forever can the dollar hold its value when the Fed is busy creating hundreds of billions more of them. And not forever can the Fed continue to inflate the currency when the dollar is falling.

Since the Fed inflates by buying bonds, when consumer price inflation begins to menace the bond market, it must deflate by selling them. When that moment approaches, even if it is months or years ahead, Daily Reckoning readers are warned: that will be a bad time to be visiting China…and a bad time to be holding U.S. Treasury bonds…and a bad time to be standing behind the dike.

Meanwhile, the International Herald Tribune says that Latvia is being crushed under a huge government deficit. Formerly middle-class citizens are out of food, says the paper. Further down on the socio-economic ladder are scenes of “Dickensian misery.”

What provoked this horror, according the IHT, is a current budget deficit equal to 12% of GDP.

Wait! The US budget deficit is 13% of GDP. Sooner or later, that deficit will crush Americans too…

Enjoy your Memorial Day,

Bill Bonner

The Daily Reckoning