Trade Deficits, Tariffs and Reserve Currencies, Oh My!

Time for a deeper dive into these three related topics.

Let’s start with the relationships established in my prior blog:

1.      If a country devalues its currency, this market distortion will increase the trade deficit between that country and its trading partners.

2.      If a country increases tariffs on imports, this market distortion will also increase the trade deficit between that country and its trading partners.

As these actions are very related, it is not surprising that they have similar outcomes.

Now let’s consider the impact of the U.S. Dollar being a reserve currency.

This graph displays the percentage of the global reserve currencies that are dollars (the blue line), and the amount of dollars that are held in foreign reserves, corrected for inflation to be in “2024 dollars” (the orange line).  The thick yellow line highlights the three “stages” to be discussed later.

Note: While I use the term “dollar”, one should assume that most of these “dollars” are in the form of U.S. Treasuries, which are very liquid dollar denominated debt, so I will just refer to the whole mix of treasuries and dollars as “dollars”.

Second note: Converting this graph to real 2024 dollars gives us a more realistic picture of the wealth flow involved.  When I refer to dollars in reference to this graph, I am really talking about the 2024-dollar equivalent.

Recall that when the U.S. government spends more than it should, it either simply creates more dollars (which devalues the dollar), or the Treasury borrows dollars by issuing treasury debt, that often is indirectly purchased by the Federal Reserve (which also devalues the dollar). The bottom line is that excessive deficit spending tends to overly increase the money supply, causing inflation.  Which the Federal Reserve then addresses by raising interest rates…

But let’s see what happened in the case of dollars being created for use as reserve currency over time.

First Stage: 1945 - 1990

A gradual increase in wealth represented by reserve dollars of about $300 billion.   But as our GDP was quite smaller than it is today, it had a significant economic impact.

An increase over time of the orange line indicates that the amount of wealth represented by the reserve dollar is increasing, which also indicates that the U.S. received a bonus of $300 billion of wealth (goods imported).

In addition, it is safe to assume that most of these dollars were converted to U.S. treasury debt, which allowed the U.S. government to borrow an additional $300 billion over that period.  Normally such an increase in borrowing would increase interest rates, but with this extra demand for treasury debt, interest rates remained artificially low.

So as the orange line increases over time, the U.S. government enjoyed an excessive budget deficit without penalty, without the danger of higher inflation or the associated higher interest rates.

Second Stage: 1990 – 2010

A dramatic increase in the wealth represented by reserve dollars, by about $5 trillion dollars, which no doubt contributed to the era of “easy money”.  Note the corresponding gradual decline in interest rates starting in the mid 1980’s, thus confirming the relationship between reserve dollars issued and lower interest rates.

Why the dramatic increase in reserve dollars from 1990 to 2010?

1.      The global economy grew, increasing the demand for reserve currencies as a whole.  A result of the end the Cold War, the implementation of NAFTA, the establishment of the WTO and a wave of financial deregulation.

2.      The U.S. economy, as the world’s largest, was at the center of this expansion, averaging 4% GDP annual growth.  Meaning that dollar, backed by deep and liquid U.S. financial markets, made it attractive for reserve accumulation.

3.      Lack of competition until the Euro launched in 1999.

 Third Stage: 2010 – Present

Essentially flat line, meaning that the amount of wealth represented by reserve dollars has not changed.

Unfortunately, our government continued to excessively borrow as if nothing had changed, no doubt contributing to our present predicament of excessive debt combined with higher inflation and interest rates.

Which leads to the obvious question, what happens if the orange line decreases?

The quick answer is that this would stress the U.S. economy in several ways.

1.      Wealth would leave our economy as the five trillion worth of dollars begin to return home. This will be an actual outflow of wealth, countering the decades of inflow.

2.      This inflow of dollars will increase the domestic supply of dollars, significant inflationary pressure, pushing up interest rates.

3.      There will be less demand for U.S. Treasury debt, also pushing up interest rates.

Pretty much an opposite reaction to the benefits we enjoyed over the prior decades.

This is the percentage breakdown of the global reserve currencies today.  Note that from a percentage point of view the dollar is already losing ground.  But for now, this decrease in percentage has been countered by an increase in the total amount of reserve currencies.

However, it would be irresponsible to assume that this slide will not continue, for reasons to be perhaps covered in a later blog.

What can be done to be prepared for this possible “unwinding”?

1.      Our domestic economy must be as strong as possible. Get inflation and interest rates under control.

2.      The global economy must be as strong as possible.  Less wars and balanced, minimal tariffs.

3.      Our government will have to finally figure out how to balance its budget or risk excessive inflation.

The first and third points are correlated, in that a smaller, leaner government will be required for a more productive domestic economy.

Finally, consider the detrimental side effects of this decades long condition of “easy money”:

-          By creating this artificial demand for the dollar, the dollar was strengthened relative to other currencies, making U.S. imports cheap and exports expensive.  This transformed the US economy such that we lost our manufacturing base and became overly dependent on imports.  Well beyond what a more balanced global free market economy would have settled on.

-          Allowed our government to borrow more at low rates, encouraging deficit spending, and wasteful spending.

We lost our independence and amassed debt.  And we are very unprepared for the very possible unwinding.  This is quite the hole that we need to dig ourselves out of. 

The sooner, the better.