The dawn of the dollar

The beginning of the summer brought nice weather and American protectionist tariffs to a significant part of the world this year. The US already imposed tariffs on Chinese steel and aluminum products earlier this year. By the end of the spring it has also imposed those tariffs on Europe, Japan, Mexico, and Canada. The impacted countries hastily retaliated by imposing their own tariffs on products and services coming from the States. Furthermore, Japan and the EU issued a joint declaration, condemning the American move and criticizing it for obstructing international trade and jeopardizing growth. Additionally, Canada also filed a WTO complaint against the US.

Seemingly, the United States is ready to make sacrifices in order to isolate itself from the global economy, it won’t even exclude its trade relations with its own allies. The Trump administration tries everything to declare the 5th Avenue a foreign-car-free zone. The only problem is that Trump’s Manhattan friends probably have very good personal reasons for driving a Mercedes, it is not an enforced decision. Logically you can expand this reasoning to the entire economy as well. Any good or service is preferred due to its higher perceived cost/value ratio. To break it down: something can be preferred either by getting higher value for the same price, or by getting the same value cheaper. However, we must point out that value in case of consumer products is a highly subjective term. Yet, German manufacturers face the same subjectivity as their American peers.

The isolation, or voluntary self-exclusion of the United States from the global economy carries countless political, economical, and social implications. Let us focus on a plain, yet extremely crucial aspect for now: its currency. The US Dollar undoubtedly serves as the world currency in the contemporary economic setting. It is present in case of offshore lending, and it is a crucial instrument of the intra-regional trade for several emerging economies. Most of the commodities on the world stage are denominated in dollar terms, hence making the dollar a non-excludable element of international commodity trade. The greenback is the most wide-spread reserve currency too, creating the precondition of a liquid dollar market for the stability of emerging currencies (one must buy/sell dollars to safeguard the value of its own currency).

The countless uses and the liquidity of global markets are guaranteed by the US financial system, not to mention its trade deficit with the rest of the world as well. Each year the US economy pumps billions of dollars of available liquidity onto the global economy, guaranteeing a continuous de facto monetary expansion. Notwithstanding, it would be foolish to think that this symbiosis is a lopsided phenomenon, or that the flows described above are part of a giant zero-sum game. The excess dollars in circulation are used to provide cheap credit for the US economy, and to help its lavish consumption. Moreover, it is a further advantage for the domestic users of the world currency to gain resistance against world price fluctuations (e.g. a Brazilian soybean producer must keep and eye of both soybean prices and the Brazilian real, whereas her American peer has to focus on only one).

In case the United States want to forcefully decrease its deficit – by using tariffs, quotes, or sanctions in extreme instances – the global economy can be easily left without sufficient supply of liquidity. This scenario would lead to opposing implications on the two sides of the American border.

On the one hand, within the States an isolationist policy will result in less and/or more expensively available goods, while the money in circulation would initially increase, since it cannot leave the economy through foreign trade channels. Both factors support inflationary forces and leads to the diminishing value of onshore dollars. The Fed could counterbalance this by hawkish monetary policies, however, it is questionable whether such policies would be feasible once cheap foreign credit dries up.

On the other hand, the rest of the world would experience a shortage of greenbacks and piling of unsold goods simultaneously. Within the financial sphere, the lack of available liquidity leads to increasing funding costs, aka nominal yields. The lack of money and the abundance of goods points towards deflation otherwise. The real yields of offshore USD will almost inevitably increase. The biggest winners of the divergence in the difference between onshore and offshore prices are the financial institutions who can play this arbitrage opportunity.

If we take the base scenario of an escalating trade war between the US and its partners, investing in offshore USD money markets can be an attractive trade/hedge. Nonetheless, persistent financial conditions can easily create the need for a new world currency; and it leads to the breakdown of the US dollar’s hegemony.