Let’s delve deep into the future of the US dollar. That’s another way of saying we’re talking about everything at once.
Because the US dollar is the world’s reserve currency, the currency of the biggest economy, the currency of international trade and the currency of the world’s so called “risk-free asset”, when you’re discussing the dollar, you’re discussing everything else too.
All investments are effectively priced in US dollars in the end, with local currency exchange rates converting that price. All returns are measured with reference to the yield on US government debt because it is the risk-free rate.
Commodities are priced in US dollars. When China buys iron ore from Australia, it pays in US dollars.
You can think of the US dollar as the denominator of every price. The devil’s advocate of every decision. And the alternative of every comparison. As a result, the power of the currency is enormous.
This is most obvious during a market boom or bust. When markets boom, the US dollar falls in value. When markets bust, the dollar’s value surges.
It’s vaguely similar to the value of gold during the gold standard. People would rush out of everything and into gold when trust broke down in global financial markets. That’d put pressure on their national currency’s value in terms of gold.
Usually, people think of the US dollar’s value as reflecting developments around the world. But what if things turn the other way? What if the US dollar begins to drive markets? That’s what we’ll look into today.
How the US financed globalisation
For decades now, US dollars have been flooding into the global economy. The US trade deficit meant Americans were buying stuff from other countries and paying in dollars.
If any other country does this for a long period of time, the value of their currency begins to fall because it’s an increase in the supply of that currency on the global market.
But a falling currency has a rebalancing effect. Over time, imports become more expensive for locals and local exports become cheaper for foreigners. The trade deficit eventually rebalances as people respond to prices.
But the Americans can’t seem to get a rebalancing to happen. The key reason is that their currency is in such demand. As trade flows grow due to globalisation, the demand for US dollars grows with it. The US’ outflow of US dollars is absorbed by other nations looking to trade with each other. And so the value of the US dollar doesn’t fall enough to rebalance trade in the US.
People used to consider this a privilege. Americans have been living beyond their means for decades now. They consume more than they produce and just send printed US dollars into the world. But their currency never punishes them for it.
Perceptions have changed though. The Americans have had enough of trade deficits. Too many jobs have flown overseas. Enter Donald Trump with his trade policies and wacky politics.
Trump wants to reverse the trade deficit by adjusting prices in the way the currency would. The worry is that this will just reduce trade and destroy jobs in China instead of creating them in the US.
Trump’s position is also a bit bizarre given unemployment is low in the US. And trade is only one of a long list of factors which makes industries and their jobs come and go.
But when it comes to government policy, it doesn’t matter what’s true or makes sense. It’s all about creating outrage and then channelling it into votes.
Anyway, if the Americans manage to reduce their trade deficit, this also implies a reduction in the amount of US dollars flooding the system. It’s as if the central bank of trade were tightening monetary policy on the currency of trade.
With less dollars coursing through the world’s importers and exporters, they can afford to do less business.
Under this scenario, the US dollar will surge in value. And probably trigger a crisis of some sort.
For example, a rising US dollar would make it more difficult for countries to pay back debt denominated in US dollars. That’s how the Asian Financial Crisis of 1997 began. And the stockmarket took an incredible hit back then.
Ironically enough, a higher dollar would also make the US trade deficit worse…
But it’s not so clear cut that we’re in for a stronger dollar in the first place. Because American trade policy is just one moving part.
The curse of the dollar balances
The pound sterling used to be a reserve currency for a large trading area. As its position in the world declined and the US dollar took over, the British found themselves at the mercy of something the media called “the curse of the sterling balances”.
Because trade was conducted in pounds, countries around the world held vast reserves of pounds for trade. But with the pound no longer the favoured currency of trade, those reserves became far less useful.
The fear was that nations would sell their holdings of pounds, triggering a crash in the value of the pound. Just as being a reserve currency is a privilege because it supports the value of your currency, losing that privilege turns it into a curse.
In the end, a bundle of semi-official agreements were made with nations to prevent them dumping the pound. But those were friendly nations. The holders of US dollars are a lot less friendly.
In fact, they’re precisely the nations that Trump is picking a fight with. The Americans’ trade deficits obviously correspond with those nations holding huge amounts of dollars because that’s how the Americans have been paying for their deficits.
The fear is that nations could opt out of the US dollar reserve system. If they used yuan or euro to settle trade, the curse of the dollar balances would begin.
That’s why it’s incredibly important to watch developments in this space. The Chinese are increasingly doing trade deals priced directly in yuan with oil exporters. They’re increasingly creating commodity markets which price in yuan, such as the new gold exchange.
Over in Europe, the ambition of the euro is to become a major trading currency too.
If the US dollar’s dominance over trade begins to fade, its value could be about to tumble. And that could disrupt currencies, financial markets and economies horrifically.
This is happening at the same time as fiscal deficits in the US spin out of control, putting the US Treasury’s “risk free” borrowing status at risk too. If Treasuries lose their position as the foundation of financial markets, the demand for them could tumble too. The US government can’t afford higher rates.
Once again, China is on to this. It has stopped buying Treasury debt in the last few weeks.
Put all this together and you get some interesting conclusions. The bedrock of international trade, financial markets and geopolitics is the power of the US dollar, US Treasury bonds and US defence spending. All three are under threat at once.
But we don’t know whether a surging dollar or tumbling dollar is at hand. Either way, it’s bad news.
Until next time,
Capital & Conflict