This post is
going to focus on reserve currencies and why countries run trade deficits; the
benefits that accrue to the issuer of the global reserve currency; and the
tension that can produce. But first, a bit of history.
Prior to WWI, the British pound sterling was the world’s reserve currency (meaning that most global trade was conducted in pounds), and London was the financial center of the world. Then WWI and WWII came along. Britain had spent its industrial dominance building (and depleting) its war machine, it had taken on heavy debt defending itself, and it had been bombed mercilessly by the Germans, requiring extensive rebuilding. Meanwhile, the U.S. emerged from WWII with half the world’s gold reserves, a massive industrial base, and little physical destruction at home.
Thus, in 1944, the Bretton Woods Agreement formalized the dollar’s role as the world’s reserve currency, linked to gold, and the pound was forever replaced in that role. President Nixon decoupled the dollar from gold in 1971 to stop other countries, which had rebuilt after the war and were now running trade surpluses with the U.S., from exchanging their dollars for gold and thus draining U.S. gold reserves. (This began the era of floating exchange rates and fiat currencies, but that’s another story.)
It’s in the U.S.’ best interest to maintain the dollar’s status as the global reserve currency, for several reasons. The first is cheaper borrowing costs. Global demand for dollars and Treasuries keeps U.S. interest rates lower than they would otherwise be. For that reason, the U.S. can borrow more cheaply than any other country. And when we need to conduct emergency borrowing, as we did during the 2008 financial crisis and the covid pandemic, when we issued trillions of dollars of new debt at very low interest rates, we have a competitive advantage over other countries affected by those crises.
Second, we can run persistent trade deficits without facing a crisis (up to a point). We can import more than we export and pay with our own currency without facing capital flight. (We’ll explore this more later.)
Third, we wield considerable geopolitical power. We can impose financial sanctions on countries like Russia and Iran, enforce those sanctions through control of dollar clearing systems, and influence global finance through institutions like the IMF and the World Bank. As the largest shareholder in those institutions, we can maintain the dollar’s dominance and promote economic policies that align with our interests.
And finally, we enjoy global seignorage, which in effect allows us to obtain zero-interest loans from other countries that trade in dollars. Here’s an example: the Fed creates $100 billion, at minimal cost. Those dollars flow abroad in one of several ways: a foreign government buys U.S. Treasuries, or a company in Europe keeps dollars to pay for oil, or tourists use U.S. cash abroad and it never comes back into the U.S.
In return, the U.S. gets real goods, services or financial assets in return.
For example, Americans buy cars from Europe or oil from the Middle East. The
other countries accept dollars and hold them rather than converting them back
into their own currency or demanding U.S. exports. The dollars may sit in foreign
central bank reserves or be used as trade currency elsewhere. Globally, about
$7-8 trillion in physical and digital U.S. dollars is held outside the U.S.,
much of that amount never returning home.
Because the U.S. issued those dollars at little to no cost and received real value in return, we’re effectively importing goods and services from the rest of the world, in exchange for paper or digital currency that the rest of the world is content to hold and not redeem. It’s like writing IOUs that are never cashed in, and that we don’t pay interest on. That interest-free loan is estimated to be worth as much as tens of billions of dollars a year, plus demand for Treasuries – especially during times of crisis – keeps U.S. borrowing costs lower than they would be otherwise.
That global seignorage is what former French President Charles de Gaulle grumpily called the U.S.’ “exorbitant privilege.” But that privilege comes with a cost. It contributes to persistent U.S. trade deficits, as other countries are more than happy to sell us goods and services in exchange for the dollars they hoard. This can eventually lead to overvalued currency and, ultimately, erode confidence in “King Dollar.”
Now we’re getting to the crux of the matter of why we run persistent trade deficits: it’s in our best interest to maintain the dollar’s primacy as the global reserve currency; we don’t ever want to lose that. To do so would be to lose our pre-eminent role in the global economy, as Britain did in 1944. But before we explore that, let’s look at a micro-level example of the “exorbitant privilege,” which may help better grasp how this plays out.
Recall the examples of the persistent “trade deficits” that I run: I pay
someone to mow my lawn, cut my hair, groom my dogs. I pay restaurants to prepare meals for me. On a less persistent basis, I pay airlines and cruise
lines; these expenditures are larger, but derive a greater benefit for each
transaction. I pay for these services to enhance my quality of life – I’m
spending my own currency in ways that bring me greater value in the form of
time, enjoyment, and experiences.
In economic terms, I’m functioning like a micro “global reserve currency” because I’m able to make these transactions and reap the benefits, similar to the way the U.S. dollar is used globally as a reserve currency: other countries trade with us because the dollar holds inherent value, and we enjoy the privilege of being able to run trade deficits with little consequence. Likewise, my dollars have value to the entities with which I trade, and I’m able to enjoy the goods and services they provide with little consequence (as long as I don’t overspend).
My “exorbitant privilege” comes from being able to spend my (relative) wealth in a way that enriches my life, so even if I incur a “trade deficit” in a monetary sense, the return on my investment is substantial in terms of my well-being. Make sense?
Okay, so here’s the issue with being the issuer of the world’s reserve currency – “King Dollar”: in order to supply the world with dollars, the U.S. must run trade deficits. In other words, we must import more than we export, so that more dollars flow outside the U.S. than other currencies flow in. This allows foreign central banks and institutions to acquire dollars for trade and reserves. However …
If we run persistent and excessive trade deficits, we risk undermining global confidence in the dollar, which could lead to inflation, devaluation, or a run on dollar-denominated assets.
This happened after the Bretton Woods Agreement, when the U.S. had to supply dollars to the rest of the world to support trade and investment. But as dollar reserves accumulated abroad, concerns grew that we didn’t have enough gold to back all of those dollars. That led to a crisis of confidence in the dollar, which was what led Nixon to end the convertibility of dollars to gold.
This conundrum – the fact that we have to run trade deficits to maintain “King Dollar,” but we can’t let those deficits become so large and persistent as to erode confidence in the dollar and thereby threaten its supremacy, became known as the “Triffin Dilemma,” named for economist Robert Triffin, who explained it in testimony before Congress in the 1950s while addressing the sustainability of the Bretton Woods system.
Today, the U.S. finds itself once again running very large and persistent trade deficits, and …
I believe that addressing the Triffin Dilemma is the over-arching goal of the Trump Administration’s tariff strategy.
Now, a naturally occurring consequence of being “King Dollar” is that by running trade deficits to supply the world with dollars, we undermine domestic manufacturing over time. This leads to gradual deindustrialization, a decline in blue-collar manufacturing, globalization of the supply chain, and a more service-based economy. It’s not that the U.S. has intentionally decimated the factory sector; it’s a naturally occurring consequence of being the global provider of liquidity. All this talk about “bad policy of previous administrations shipping manufacturing jobs overseas” is just a populist political talking point, one that’s used by both parties.
Economists like Triffin and even former Fed Chair Paul Volcker, who rescued the U.S. from the stagflation of the 1970s, understood this. Volcker said, “A global reserve currency has to be available in sufficient quantities, and that availability inevitably involves running balance-of-payments deficits.” And running balance-of-payments deficits means importing more than you export, which will naturally result in deindustrialization. You can’t have both a strong, export-led, manufacturing economy and be the issuer of the global reserve currency, at least in the long run.
So should we re-industrialize entirely, and sacrifice the status of “King Dollar?” Absolutely, unequivocally not. Doing so would mean giving up all of the benefits that accrue to the U.S. due to the dollar’s supremacy: seignorage, considerable geopolitical clout, and perhaps most important of all, low borrowing costs, especially during times of crisis. Those things are of far greater value to the U.S. than manufacturing dominance – just ask Britain.
But if our deficits get out of control, couldn’t China eventually overtake us and become the issuer of the global reserve currency? Not a chance.
Even though China is the world's second-largest economy and top exporter, the yuan faces huge structural barriers to reserve currency status. First, China strictly controls capital flows into and out of the country. You can’t have a true reserve currency if other nations can’t freely move money in and out of your system. Second, the yuan isn’t backed by an independent judiciary, a transparent regulatory regime, or a stable political system. Global investors don’t trust the CCP to keep the rules consistent.
Third, the yuan is only partially convertible. It doesn’t trade freely like the dollar, euro, pound, or yen. This makes it unreliable for reserves or large-scale trade settlement. Fourth, global reserves are parked in liquid, safe assets, with U.S. Treasuries being the gold standard. China’s bond markets aren’t nearly as liquid, or accessible. And finally, other countries simply don’t want to be dependent on China, given its track record on things like debt diplomacy, technology control, market access, censorship, spying, and IP theft.
As for any other country’s currency replacing the dollar, no other country is even close in terms of the size of its economy. U.S. nominal GDP is more than $30 trillion, nearly doubling China’s at less than $20 trillion. The third-largest economy in the world is Germany, with nominal GDP of less than $5 trillion. India is fourth, but if California were a country, it would hold that position.
That’s enough for this post. The next post will address some issues with tariffs in general and the administration’s tariff policy. If space allows, I’ll get into the possible end games, and the most likely one; if not, I’ll save that for a final post.
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