Central bank reserves probably generate more confused and mistaken thinking than any other topic in economics. A case in point is the recent controversy between hedge fund manager Jim Chanos and New York Times columnist Thomas Friedman, in which Friedman proposed, yet again, a common misconception over the meaning of China's huge accumulation of foreign reserves.
Chanos, a successful hedge fund manager who has made his reputation - and fortune - by identifying and shorting seriously overvalued assets, most famously Enron, started the argument three weeks ago when he claimed that China is undergoing a speculative bubble that makes it the equivalent of 'Dubai times 1,000 - or worse'.
Freidman, the columnist best known for his writings on globalisation, responded to Chanos insisting that it would be impossible to make money by shorting China. 'First,' he warned, 'a simple rule of investing that has always served me well: Never short a country with US$2 trillion in foreign currency reserves.'
Really? Friedman proposed the rule sarcastically - as both untestable and too obvious to need testing - but it turns out that reality is not as obvious as he imagines. China's foreign reserves are certainly huge. They add up to an amount equal to about 5 per cent to 6 per cent of global gross domestic product.
But they are not unprecedented. Twice before in history a country has, under similar circumstances, run up foreign reserves of the same magnitude.
The first time occurred in the late 1920s when, after a decade of record-beating trade and capital account surpluses, the United States had accumulated what John Maynard Keynes worriedly described as 'all the bullion in the world'. At the time, total reserves accumulated by the US were more than 5 per cent to 6 per cent of global GDP.
The second time occurred in the late 1980s, when it was Japan's turn to combine huge trade surpluses, along with more moderate surpluses on the capital account, to accumulate a stockpile of foreign reserves only a little less than the equivalent of 5 per cent to 6 per cent of global GDP.
