Riding the Dragon?

Wednesday Li Daokui, an adviser to the People's Bank of China, told reporters in Beijing that he hopes Republicans in control of the US House of Representatives will "stop playing with fire. ... I really worry about the risks of a U.S. debt default, which I think may lead to a decline in the dollar's value."


USA Today article

Ya think?

Even getting to the point where holders of US debt perceive a significant risk of default, however "brief" or "technical" -- which they don't, yet, and I believe they don't only because they fail to grasp the seriousness of the situation in Washington -- could very well lead to large-scale selling of such debt.  But exchanging Treasury debt for dollars makes no sense, because dollars are merely another form of US government debt. The worried bondholders would, directly or indirectly, trade Treasury obligations for something else: Aussie dollars, cruzeros, copper futures, gold bullion, etc. The net effect is large-scale selling of US dollars. That's why Li is right to anticipate a decline in the dollar's value.

The question is, how far and how fast would the dollar fall? And the further question: at this (post-Lehman, post-TARP, post-QE1 & 2) juncture, how far and fast can the dollar fall without collapsing altogether?

The perception that the dollar's value is declining rapidly would accelerate the movement out of Treasuries and all other dollar-denominated debt. Thus the dollar's value declines even faster. At a certain point, a goodly number of people around the world begin to think it very likely that by tomorrow afternoon the number of yuan/euros/ounces of gold/barrels of oil/widgets FOB Detroit/economic good X that you can get for a dollar will be appreciably smaller than the number you can get right now. Then the dollar-dumping begins in earnest.

At this point, the fact that Emperor Dollar really is stark naked and there is nobody who can even toss a blanket or a towel around him will become inescapably clear to those who are paying attention. In light of recent history, the Fed and the Treasury probably could not even respond effectively to another Lehman Brothers. A run on the dollar sparked by anticipation of a Treasury default would be Lehman Brothers x 100 (at least). Measures that in days of yore might have shored the dollar up will only aggravate the panic. And the realization that there really is no bottom under a plunging dollar will engender generalized and absolute panic.

Those with any understanding of the situation will recognize that the world as we have known it is ending. The sudden death of the world's only reserve currency, the one universal measure and store of value and the vital medium of global commerce, would bring world (and even US domestic) trade to a screeching halt and spell financial, and therfore economic, Armaggedon.

Playing with fire, indeed. Only, one would think that the rich literary history of China might provide an even stronger, and thus more apt, metaphor.