U.S. President Barack Obama made news in China last month when he announced the need to tackle the U.S. deficit to avoid a “double-dip recession.” The statement triggered speculation that America’s chief creditor admonished the President to get his fiscal house in order.

While most analysts have spent the past year arguing China is caught in a “dollar trap,” the timing and location of Mr. Obama’s statement indicates the Chinese have learned some key lessons from the last great dollar crisis. Most importantly, they appear to understand that “dollar diplomacy” is a useful tool to make U.S. policies more favorable to protecting the value of China’s $2 trillion in reserves.

To understand this, it’s worth a brief historical review of the problem facing major U.S. creditors in the late 1970s. In 1978, concern about the dollar’s health reached the top of the international economic agenda. U.S. trading partners, such as West Germany and the Organization of the Petroleum Exporting Countries (OPEC), grew particularly worried as the dollar’s weakness eroded their competitiveness or jeopardized the value of their dollar-denominated reserves. OPEC faced an especially acute problem, because the dollar served as oil’s invoice currency, meaning the oil-exporting nations had no alternative to dollar accumulation. In June 1978, for example, one estimate put Saudi Arabia’s foreign assets and reserves at $65 billion—80% of which were said to be held in dollars.

While China’s dollar reserves are orders of magnitude larger than those held by Saudi Arabia in the late 1970s, the Saudis still faced the fundamental “dollar trap” predicament: Any major effort to shift reserves from dollars to another currency would accelerate the dollar’s decline and erode the value of the remaining reserves.

Yet rather than passively accepting a fate of accumulating increasingly devalued dollars, the OPEC countries engaged in careful diplomacy, bringing pressure to bear on the United States that ultimately contributed to a tougher inflation policy. First, OPEC countries publicly discussed pricing oil in a currency other than the dollar, such as the International Monetary Fund’s special drawing rights. The cartel requested a study on the effect of invoicing oil in an alternative currency, and an OPEC committee proposed using a basket of currencies to price the commodity. One member of the cartel—Kuwait—said it would accept sterling instead of dollars.

Second, some OPEC members raised the possibility of an oil-price hike to compensate for the erosion of the dollar’s value through unchecked inflation……

….read more HERE.