Trade Deficits, Dollars, and the Damage Being Done
America’s trade deficit fuels the dollar as a global reserve currency. Trump’s tariffs will weaken the dollar and impoverish Americans. And they will hurt trade too.
By Harral Burris
Nations incur a trade deficit when they import more goods than they export. Occasional trade deficits are common, and even long-running deficits are acceptable if the imported goods go toward infrastructure projects, as often happens in the economies of emerging countries.
A trade deficit becomes problematic when it is persistent and primarily due to overconsumption. The United States has experienced that since the 1970s. Americans buy much more than they make. Holding the global reserve currency has given the country a long runway to print more dollars, when necessary, but the adverse effects of trade deficits are now becoming undeniable.
There are around 180 global currencies, many of them illiquid and unwanted by others, so any system other than outright barter needs a trading standard. Since the end of WWII, that standard has been the dollar, first backed by gold, but since 1971, it has been a fiat currency backed only by the full faith and credit of the United States.
The dollar is the world's currency. It's the ledger other nations use for trade, releasing them from the need to maintain active swaps in hundreds of currencies. If a company in Japan buys farm products from Brazil, the transaction will typically involve dollars. Brazil does not need yen, and Japan certainly does not want inflation-prone Brazilian reals.
The dollar is also the primary cross-border funding currency. When an emerging nation borrows money from China, the contract is usually dollar-dominated. Otherwise, the Chinese could simply manipulate their currency (as they often do) to make the contract more or less costly to the borrower. Trillions of these liabilities from outside the United States demand a steady supply of dollars.
Foreign central banks hold significant dollar assets, mostly U.S. treasury bonds, as reserves to back up their currencies. The U.S. Treasury bonds are seen as more stable than gold. Additionally, foreign pension and sovereign wealth funds hold high levels of U.S. financial assets such as stocks, bonds, real estate, and foreign direct investment, all of which call for dollars.
The dollar is involved in 90% of foreign exchange transactions around the world. If someone wants to exchange Taiwanese dollars for Egyptian pounds, they typically will not trade the currencies directly but will use a dollar intermediary. It's not practical for nations to maintain liquid markets in most other countries, but it's easy for them to have liquid markets with the dollar, and thus indirectly with each other.
All of this offshore dollar demand leads to a chronically overvalued dollar. It trades based on all the typical fundamentals of other currencies, but has a significant extra layer of inelasticity, which boosts U.S. demand for lower-priced imports and foreign travel.
If the rest of the world uses dollars for international trade, cross-border funding, and currency exchange, where do they acquire this unending supply of our currency? Primarily from running trade surpluses with the United States. We run a trade deficit of between $500 billion and $1 trillion annually, and most of those dollars sent overseas end up in U.S. treasury bonds.
Thus, the trade deficit and the dollar's status as a reserve currency are inexorably linked. It's all one big feedback loop. Reserve currency status overvalues the dollar, and overvalued dollars boost our imports and hurt our export competitiveness, resulting in a trade deficit with the rest of the world. That deficit is how the rest of the world gets its hands on enough dollars to continue using it as the global reserve currency.
Getting off this merry-go-round will take decades and will be orders of magnitude more difficult than the sycophants in Donald Trump's orbit believe. Due to that excess demand, American stocks, bonds, and commercial real estate values are likely inflated. A significant loss of that status will re-price stocks to lower levels, drive U.S. interest rates higher, and reduce American wealth as a whole.
Most Americans assume that the United States sends digital assets (including films and software) to the rest of the world, and they send us flat-screen TVs and Barbie dolls. That sounds like a sweetheart deal, but what does the rest of the world do with those digital assets? They buy dollar-denominated American assets, including stocks, bonds, and real estate. Decades of trade surpluses have allowed foreign investors to accumulate extensive U.S. holdings. Foreign entities control an estimated $13 trillion in U.S. debt, but own over $60 trillion in U.S. assets.
If foreign investors can no longer acquire dollars through trade, and dollar-denominated debts come due, their only option is to sell U.S. assets, generally stocks and bonds. When the Federal Reserve opens currency swap lines with other nations, it's not out of the goodness of its heart. It alleviates the immediate dollar shortage to protect the U.S. markets from selling pressure. In a situation like this, experienced in the worst of the COVID lockdowns, Chairman Jerome Powell is saying something like, "Please stop selling U.S. stocks and bonds and crashing our markets, and we'll lend you some dollars during the crisis, and if necessary, print more."
Donald Trump wants to end the trade deficit and dramatically weaken the dollar, but still expects it to remain the global reserve currency. Like so much of Trump's global view, this is not possible. If he continues down this road, we will all face massively higher interest rates and a level of debt we cannot fund. When foreign investors flee the United States, we will have less money, lower asset values, and we will have to consume less…a lot less!
The economists and Wall Street analysts who grasp simple economics and trade law understand that a policy to tariff the nation to a balanced budget is suicidal. After Liberation Day (when Trump announced draconian tariffs) and ensuing financial and economic turmoil, the president continues to insist on an across-the-board 10% tariff, which is an unworkable burden to the economy, and four times the average tariff rate before Trump took office. Then, there are 25% tariffs on automobiles, aluminum, and steel, as well as on Canadian and Mexican imports that don't meet the current trade treaty.
Trade deficits do not resolve in pleasant ways. Generally, import demand collapses first. In the case of the British pound, the global currency of its time, World War I dried up British purchasing power; most of the country’s wealth was expended on the war. This time, Trump seems capable of wreaking destruction without a world war. Once currency demand falls off, an economic depression follows, and currency weakness becomes uncontrollable. After the deluge, with a much-depleted currency, the country typically becomes more competitive, manufacturing picks up, and exports increase. But everyone will be poorer.
The global financial system is likely beginning a long transition with the United States surrendering its role as the global policeman and the dollar as the world's reserve currency. Without American hegemony, world trade will be more complicated and expensive. Regional trading blocs will emerge, and certain goods will be readily available in some regions and unavailable in others.
How long will it take those in Trump's orbit, and the MAGA faithful, to understand the extreme damage he has done? And if they ever do, will it be too late? We must educate the mainstream, voting American public…fast!
Hal is a retired investment professional with 40 years of experience in money management. The interface between geopolitics and global investments has always been his area of specialization. History has always been one of his interests and passions, in fact, that’s how Hal and Jeremi became friends in Madison, Wisconsin.