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What happens if China plays the nuclear option?

Gold investors are curious. And no one delights more in wondering "what happens if" than gold investors.

It's not hard to understand why. We're a suspicious lot, uneasy with the status quo, not given to following the media-fed herd. We got into gold, in part, because-may as well face it-we don't have all the faith in the world in traditional stocks, bonds and dollars. Many of us harbor a sneaking suspicion that, one of these days, gold will return to its historically-recurring role as the currency of last resort.

The fact is, if China has any say in the matter, that day may not be as far off as some of us thought.

What Happens If China Stops Buying Treasuries?

China has $1.4 trillion in currency reserves. That number alone is staggering enough, especially if you've ever heard just how large a trillion is. One researcher thought a trillion grains of salt could easily fill up a classroom.

No matter how you look at it, it's a pretty large number. And China has over a trillion of our dollars.

No worries, though. As long as the Chinese are willing to sponge up our excesses and buy U.S. Treasuries (they already have about $400 billion) at the rate they have been, this Rube Goldberg contraption we call an economy can, I suppose, continue.

But what happens if Beijing gets other ideas?

Case in point, a Chinese official, a Mr. Cheng Siwei, vice chairman of the National People's Congress, shook the world when he declared that his nation should take advantage of the appreciation of strong currencies by diversifying out of its 1.43 trillion in weak dollars. This is the supposed nuclear option. Wall Street instantly took notice: The Dow plunged 350 points.

That was preceded by the startling bit of news from China's finance minister Renqing that China will soon create one of the world's largest investment funds, a fund that could give the U.S. fits in the way we collect that $2.1 billion "fix" we need each and every day to finance our record budget deficits.

"We can achieve more profit from other investments," Renqing told a news conference, belaboring the obvious.

Treasury securities, you see, return something shy of 3 percent on China's $1.4 trillion...even as other area governments are doing a whole lot better. Temasek Holdings, the investment arm of the Singapore government, for instance, claims it's averaging a whopping 18 percent annual return. Needless to say, boasts like that are making the Chinese mighty antsy.

But whether China succeeds in reaping higher rewards or not, its change in investment strategy could well leave the U.S. facing a monstrous deficit dilemma: If China doesn't finance our debt, then who?

Unintended Consequences

Of course, the Chinese nuclear option isn't quite as simple a matter as the media sometimes portrays it.

China obviously has to be exquisitely careful its currency remains low against the dollar to keep us buying Chinese goods. It doesn't want to end up being just another "expensive foreign import" and cut its own economic throat.

Moreover, a Chinese "firesale" of U.S. Treasuries might have the opposite effect: Dumping T-bonds would make them cheaper, the cheaper they are, the higher their effective yield...and the more attractive T-bonds could actually become.

The mere possibility that the Chinese could face serious losses by dumping its U.S. assets should make the nuclear option unlikely. What's more likely is something Benjamin Reitzes of BMO Financial Group said: "If China were to start a fire sale of its US$-assets, it would face prohibitive losses. A more likely scenario would be for China to stop accumulating US dollars, not an outright sale."

Which wouldn't exactly be good news for the U.S., either. Serious consequences could certainly result.

Would, for example, China's action hasten similar actions from other nations? As it is, several potential dollar defectors are lining up, including Saudi Arabia (the kingpin of the holders of $3.5 trillion in the Middle East), Iran, Venezuela, South Korea, Sudan and Russia.

Gold "Out of Circulation"

No less than Sir John Templeton, creator of the Templeton Fund, believes that the dollar is in serious danger.

Templeton's scenario goes something like this...

When and if China and Japan sells the dollar, the Fed will have no choice but to raise interest rates higher to attract $2.1 billion in new capital we need to fuel our monstrous deficit. Those continuing rate jumps, however, will squeeze corporate profit margins and send an ominous signal to the stock market. Rising rates will further decimate the nation's real estate industry. This will put a stranglehold on any recovery. Stagflation, a combination of economic stagnation and inflation, could then set in. American consumers, seeing their living standards backtrack, will then withhold spending and that will send another shockwave through the economy.

In a scenario like that, with both a tanking dollar and out-of-control inflation, gold could emerge as the only means of exchange worth exchanging. That's if it is even available. Analyst Nick Guarino wrote about severe conditions that could essentially take gold "out of circulation."

The good news is, at last check at least, you could get as much of the precious metal as you wanted. As Bill Bonner once aptly put it, "While the dollar could never say 'no,' gold says nothing else: No to debt. No to new spending schemes. No to improving the world. No to re-electing scoundrels. No to bubbles. No to foreign wars. No to trade deficits. No, no, no, no, no."

To that I might add one more no: Gold also says no to you suffering in case China-or anyone else-plays the nuclear option.