I’ve been reading about the weak dollar for more than two years and yet we have somehow managed to avoid economic armageddon. In fact, what’s concerned me more is the weird insistence on the part of China to peg their currency to ours at a very low value. Over the short term it hurts us by making China’s imports cheap and destroying jobs. Over the long term it causes China to destabilize their banking system by trying to maintain the peg against the dollar as it drops.

As I understand it (monetary theory is not my bag, man) the process involves printing additional yuan (or renmimbi) and simultaneously issuing new debt to soak up the new currency. I’ve heard these referred to as “wash transactions” or something similar. The additional debt that China must issue becomes untenable and destabilizes their banking system. Asset prices collapse, bank failures abound (because many debts are tied to asset prices) and the country enters a deflationary spiral, not unlike Japan in the 1980s. A spiral they have yet to recover from fully.

China raised interest rates for the first time since 1995 or 1996 a few weeks ago, so I was still under the impression that we were seeing 1980s Japan play itself out, only this time with China. Now, though, Robert Samuelson (and many, many others) is harping on it and I generally trust his judgment:

First, the American economy has grown faster than other advanced economies. Since 1990 U.S. economic growth has averaged 3 percent annually, compared with 2 percent for the European Union and 1.7 percent for Japan. America’s higher growth sucks in imports; Europe’s and Japan’s slower growth hurts U.S. exports.

Second, the global demand for dollars props up its exchange rate, making U.S. exports more expensive and U.S. imports cheaper. Indeed, many countries, particularly in Asia, fix their currencies to keep their exports competitive in the U.S. market. Instead of allowing surplus dollars to be sold on foreign exchange markets—lowering the dollar’s value—government central banks in Japan, China and other Asian countries have purchased more than $1 trillion of U.S. Treasury securities. Private investors have also bought lots of U.S. stocks and bonds. All told, foreigners own about 13 percent of U.S. stocks, 24 percent of corporate bonds and 43 percent of U.S. Treasury securities.

Up to a point, this arrangement benefits everyone. The world gets needed dollars; Americans get more imports, from cars to clothes. But we may now have passed that point. Hazards may outweigh benefits. The world may be receiving more dollars than it wants. A sell-off could spill over into the stock and bond markets and cause a deep global recession. Here’s how.

Samuelson’s is only one scenario (click through to read it) and I am convinced that there are so many variables at play that no one can know for sure what will really happen. Even so, it’s worth considering. I wish China would break that damned peg in any case. They would benefit, as would we. Update: The Economist's Buttonwood column has a good explanation of why this is such a big issue. They don't address the downside for Asia, though, as I would expect. They pretty explicitly expect the dollar to lose its status as the world's reserve currency. That would be shocking, to say the least. The euro has been well managed since its inception -- very little inflation -- but it seems unlikely that the financial markets would turn to the currency of a declining power.