Brad DeLong has another useful post on whether we should be optimists or pessimists about the U.S. dollar. Much hinges on whether we expect the Chinese central bank to continue buying U.S. Treasury securities. As many MR readers will know, I am a cautious optimist. I have never been to the Chinese central bank, or spoken with a Chinese central banker, but here is my implicit mental model of how they operate:
1. Intelligence and financial prowess aside, they grew up in an age of Communist terror, or if they are young they heard narrations of such from their parents.
2. They are deathly afraid of making mistakes and causing China to lose face on the global scene.
3. They know full well that the Chinese economy — especially the financial system — is a rickety house of cards. If capital flows out of China were unrestricted, and the yuan allowed to float freely, a financial collapse would come within five years. They see us as propping up their currency, rather than vice versa. Most of all, they want to be holding safe assets, in case the worst should happen. They are risk-averse bureaucrats.
4. They behave like many other non-profit institutions (e.g., Harvard) in accumulating an endowment of high-prestige, high-quality assets. U.S. government securities are tops on this list. Yes, it is a puzzle why Harvard accumulates such a considerable endowment, but no one expects them to stop anytime soon.
5. They don’t much care if they suffer capital losses on their dollar-based endowment, evaluated in terms of the relative exchange rate with the yuan.
6. Many Chinese have a highly conspiratorial view of the world. They would expect — indeed "overexpect" U.S. "retaliation" if they suddenly stopped buying Treasury securities.
7. They are familiar with the old chess saying: "The threat is stronger than the execution."
The bottom line: We require a better theory of endowments to predict the future behavior of the Chinese central bank. But what I do know — or at least imagine I know — does not give me cause to believe the U.S. dollar will soon plunge in value.