De-Dollarization and Trade

Be careful what you wish for, because currencies are not abstractions we ponder, they are commodities that serve real-world functions that place demands on the currency as a mechanism of trade, trust, value and risk.

The current telling of the story of de-dollarization - the replacement of the US dollar as the global economy's primary reserve currency with a new BRIC (Brazil, Russia, India, China) funded reserve currency - depicts the loss of the reserve currency as a catastrophe that will crush America.

As delightful as this prospect may be to various audiences, once we shift from considering a reserve currency as an abstraction to a mechanism of trade and finance, then another outcome takes shape: supporting a reserve currency is a burden, and lifting that burden from the US will benefit the US and hurt mercantilist exporting nations.

As a bonus, it will also shift the burden of supporting a reserve currency to the BRIC participants, who will then have to do what the US has done for decades:

1. Export their new reserve currency in size by running vast, sustained trade deficits, for the only way a reserve currency can function is there is sufficient quantities of it floating around as a transparently traded, market-priced commodity to grease trade and finance.

2. Become the dumping ground for the world's surplus production of goods and services as the means to run the vast, sustained trade deficits that are the other side of exporting currency so others can use it in global trade.

Many commentators such as Mish Shedlock and Michael Pettis have explained these mechanisms of reserve currencies and pointed out that being relieved of the burden of supporting the primary reserve currency would be a great long-term benefit to the US. I have written about Triffin's Paradox for many years, the reality that no currency can serve both the domestic economy and the global economy (i.e. be a reserve currency) as issuing a reserve currency demands running trade deficits as a means of exporting trillions of units of the currency for use by others.

In a similar fashion, proponents of a gold-backed currency view such a currency as an abstraction without considering the actual mechanics of backing a currency with a tangible commodity. The currency isn't actually "backed" by the commodity unless it can be converted into the commodity upon demand. A currency is only "backed by gold" if there is a conversion mechanism in which the holder of the currency can trade the currency for the equivalent quantity of gold.

This is the only mechanism that counts. Waving around the phrase "backed by gold" doesn't turn a fiat currency backed by nothing tangible into a currency backed by gold unless that currency can be converted into gold upon demand.

So let's think this through a bit rather than expound on abstractions. Let's say the US loses its reserve status; nobody wants the USD any more and so nobody will trade goods and services for dollars. That means the US can only import as much as it exports, i.e. a trade balance.

According to the Bureau of Economic Analysis (BEA), the US exports about $3 trillion of goods and services and imports about $4 trillion. So once surplus imports can no longer be purchased with dollars, that surplus $1 trillion in sales to mercantilist economies like China vanishes.

Globalists love to weep and gnash their teeth over the fact that costs of goods made in the US will be higher than in sweatshops overseas. But globalists never consider quality, which has been declining since globalization took the world by the throat. Let's do the math: a poorly made imported item that only lasts a year before it must be replaced costs $25. This item costs $50 when manufactured in the US.

Oh, boo-hoo, right? Not so fast. If the domestically produced item lasts 5 years, the total cost over 5 years is $50. The total cost of the shoddy imported item is 5 X $25 or $125. The domestic product is much, much cheaper once we expand the time frame to the entire lifetime of the product.

Who's going to be crying real tears of anguish are all the mercantilist economies that have dumped their surplus production in the US for decades, as there is no alternative economy large enough to absorb the $1 trillion in (mostly shoddy) goods and services that the US will no longer buy.

The issuers of the new reserve currency will have to run massive, sustained trade deficits to export enough of their new currency to meet the demands of a reserve currency and they'll have to let the price of the new currency float freely on global markets, or it cannot be trusted to retain its value - a key attribute of a reserve currency.

If this new reserve currency is "backed by gold," then nations that pile up the new currency in trade must be able to demand gold in exchange for the currency, as France demanded (and received) gold in exchange for its surplus US dollars in 1971. If the currency can't be converted into gold, it's not a gold-backed currency. It's only backed by, well, nothing, just like all the other fiat currencies.

Actually, fiat currencies are backed by something: interest-paying bonds. The higher the interest and the lower the risk profile of the bonds, the greater demand for that currency above others with riskier profiles and lower rates of return on the bonds.

This leads to an irony: the US dollar will become much more valuable once it is no longer a reserve currency as it will no longer be exported in vast quantities. US dollars will be scarce and will thus increase in value.

Personally, I'm in favor of competition in currencies - the more the merrier. The more options available on a transparent global market where all currencies are floating freely on market supply and demand, the better for everyone.

But be careful what you wish for, because currencies are not abstractions we ponder, they are commodities that serve real-world functions that place demands on the currency as a mechanism of trade, trust, value and risk.

by Charles Hugh Smith at oftwominds.com on April 10, 2023