Although the risk is very small, the potential for a crisis in the dollar has to be accounted for given the fragile state of the global economy. Lying at the heart of the question is the curious inter-dependency of the U.S. and China.
The biggest foreign holder of U.S. debt, and second only to the U.S. government itself in overall holdings, is China, with $727.4 billion as of December 2008 (latest data). For the year, as the global financial crisis deepened, China increased its holdings by 52.30%. Second is Japan with $626.0 billion, up 7.94% for the year.
With exports accounting for 40% of economic output, China remains heavily dependent on U.S. consumers to continue spending in order to fuel their economy. Part of their ability to consume is tied to the cost of credit, which China helped to keep low this decade as they dramatically increased their holdings of U.S. Treasuries.
China also needs a safe stable place to invest its world's-biggest surplus, estimated to be around $2 trillion.
At his annual press conference on Friday, Chinese premier Wen Jiabao expressed concern about the safety of China’s investment in the U.S., and urged the Obama administration to provide assurances that its investment would keep its value in the face of a global financial crisis.
“President Obama and his new government have adopted a series of measures to deal with the financial crisis. We have expectations as to the effects of these measures,” Mr. Wen said. “We have lent a huge amount of money to the U.S. Of course we are concerned about the safety of our assets. To be honest, I am definitely a little worried.”
He called on the United States to “maintain its good credit, to honor its promises and to guarantee the safety of China’s assets.”
Now that the U.S. has implemented a stimulus plan which will increase the budget deficit to $1.2 trillion in fiscal 2009, the need to borrow has become even more critical. So far, there's been no shortage of buyers seen for recent debt offerings; the government's auction of $11 billion of the securities on Thursday drew stronger demand than forecast and the most bids in three years from an investor group that includes foreign central banks.
But what would happen if demand for Treasuries waned, which could happen if the market believes the government will not eventually implement measures to reign in the debt.
Borrowing costs would rise as prices for Treasuries rose. If bids fell below the amount offered for an extended time the Federal Reserve would come under pressure to purchase bonds issued by the government, which would necessitate the printing of additional reserves in order to monetize the debt. Rising interest rates in the middle of the worst financial crisis since the Great Depression would make the situation far worse than it already is.
The dollar would fall in this scenario, and a full blown dollar crisis would ensue if it became apparent that the U.S. was becoming unable to fund itself in the open market. The effect on financial markets and the global economy would be devastating; the Lehman bankruptcy look like a walk in the park in comparison. For one thing, there might not be a medium of exchange in global markets, as sellers of goods became reluctant to accept any paper money at all. Oil would be the first thing cut off.
Here's where the symbiosis of the U.S.-China relationship comes into play.
Because of the fact that China (as well as the rest of the world) is so dependent on U.S. consumers, it behooves them to keep funding U.S. debt as a way to support the U.S. economy. Chinese leaders are already concerned about unrest among their people as unemployment surges. Protests have recently been seen in many provinces’ where export industries provide the bulk of employment.
So, the risk of a full-blown dollar crisis is small because of the inter-dependency of U.S. consumers and global markets. Salim Taleb would likely classify it as a black swan event, unlikely to happen but one for which the possibility of seeing surely exists.