Global Trade, Currency Wars, and the Monetization of Debt
Global trade, in a nutshell, consists of various trading surpluses and deficits between countries. Surpluses occur when countries export more than they import, which leads to more money coming in than going out, and deficits occur when nations (like the US) import more than they export, meaning more money is leaving than coming in. I’ll discuss the US’s particular situation as it’s exceptionally unique, but, generally speaking, trade has to do with geographic availability of resources, a country’s domestic demand, and a country’s desire for economic growth. Many countries, because of where they are and what resources are directly available to them, must import goods for their economy to function. Examples of this are Japan’s need to import oil because of its scarcity on their island and Europe’s dependence on Russia’s natural gas to heat their homes among other things. It just happens to be the case that certain resources are not available everywhere or simply not available in the amounts needed so countries are forced to import those resources from other countries where they are more abundant.
In addition to this geographic dependence driving trade, there is purely economically driven trade through competitive pricing. If one nation can sell a good or service cheaper than your domestic economy, that creates demand for trade and more imports from those countries offering better prices. The most widely known case of this today is China selling cheap goods to the US and much of the developed world. The US and others could pay more to buy those goods domestically, but competitive prices drive everyone to buy those goods from wherever they can be made cheapest, in this case China. Normally, this is just the way of the world and part of the free market, but quite often countries find it too difficult to compete with outside nations and are forced to intervene to remain competitive. This can be done through tariffs (trade taxes) or embargoes (trade bans). When a country’s economy is struggling to say competitive in the face of cheaper foreign goods, sometimes the best way to reignite that domestic demand is just to make those foreign goods more expensive through taxation or the outright banning of certain goods through embargoes. By eliminating the pricing advantage of foreign nations, demand for domestic goods will go back up and begin to balance any trading deficits. While this is mostly done for practical reasons to bolster one’s economy, it is often done punitively through sanctions. Sanctions can manifest in a number of ways, but here I’m just focusing on those exercised as tariffs and trade embargoes. Sanctions are often political in nature and used to punish bad actors for a variety of reasons and allow countries to exercise power or penalize other countries for certain behavior without resorting to violence or hallow threats—rather, they attack a country’s economic profits. And if you are the reserve currency, like the US (which I’ll get into later), sanctions can effectively bar nations from world trade, which is often devastating to an economy.
Another way countries can compete with others in global trade is through currency wars. Countries that issue their own currency and, thus, have the power to manipulate its strength and weakness through quantitative easing and tightening can engage in strategic devaluations. If your country is generating a trading deficit from importing too much due to a stronger currency, that country can ease monetary policy to weaken their currency. In doing so, imports will become more expensive, but exports will become more desirable to foreigners as their currency would become stronger relative to the weakening currency. In other words, strategically devaluing your currency can shift the tides so you become a trade surplus nation as more countries find your goods (denominated in your weakening currency) cheaper. But after a certain amount of devaluation, inflation can begin to run hot and monetary policy will begin to tighten until that cycle starts over again.
One of the interesting things about the devaluing and strengthening of one’s currency is it can lead to the exportation of inflation or deflation. If one country weakens its currency, that will lead to other countries importing deflation from that country due to the new relative strength of their own currency. Conversely, if a nation strengthens their currency, it can lead to other countries importing inflation with their weaker currency relative to that strengthening one abroad. This adds a fascinating dynamic to currency wars as they have implications for economies around the world, not just the country engaging in the devaluing or strengthening of their own currency.
While currency wars are usually used as strategic moves on a global chessboard, there are instances of devaluation leading to the destruction of a nation. The Weimar Republic is a prime example of this happening. After WW1, Germany was charged with paying an unserviceable amount of reparations for the war and decided it would simply print its way out of those debts. Eventually the never-ending printing of the German Mark led to it being worth no more than the paper and ink used to print it. The nation devalued its currency into collapse, which was actually a significant factor leading to Germany’s role in WW2 years later.
A more successful use of devaluation occurred under FDR during the great depression. At the time, the dollar was pegged to gold at $25 per oz., but FDR needed to find a way to stimulate the economy so he confiscated all the gold and proceeded to change the exchange rate to $35 per oz. to increase exports and give him and the government considerable wiggle room for economic stimulus. And the newly devalued dollar did lead to a massive increase in exports as the price of US goods became extremely enticing to foreigners. So the strategy worked to stimulate the struggling economy, but eventually drove other counties to devalue as well to remain competitive. With the weaker dollar FDR created, countries were importing deflation and had to weaken their own currencies to avoid losing their competitive edge, substantial trading deficits, or monetary deflation that could create their own great depression-like environment. So currency wars became a race to the bottom, in some sense, with nations taking turns devaluing their currencies to stay competitive.
Another example of strategic devaluation was Nixon removing the gold peg in 1971. At the time, Nixon suggested more agreeable reasons for the shocking transition, but the devaluation was really because the United States couldn’t service its gold liabilities to other nations and, thus, had to transition their monetary policy to avoid losing more gold reserves. So switching to a system where banks could print instead allowed greater flexibility for the economy, but it eventually set the stage for a much weaker dollar and the extremely high inflation of the 70s. After a very large devaluation, Chair Volcker (the Jerome Powell of the time) raised rates through the roof in hopes of curbing that inflation. Eventually those efforts would work, but it would set the groundwork for a massive dollar bull run in the 80s, which brings us to the Plaza Accord.
The Plaza accord was an agreement in 1985 among the five biggest economic powers at the time, including the United States, to collectively devalue the USD to better facilitate global trade and economic growth. With so much of trade dependent on the United States and the petrodollar forcing so many goods to be priced in USD, the strong dollar was beginning to stifle economies abroad. Shortly after, the dollar began to weaken and other economies like Japan began to experience significant deflation, which led to their ‘lost decade’ as it is commonly referred.
So the purpose of explaining all this is just to show it’s fairly common for countries to strategically manipulate currencies for both selfish and global purposes. And given the economic interconnectedness of the world from global trade, the change of one currency’s strength can have serious implications for the rest of the world’s currencies.
Now, with the scene of currency manipulation now painted, I want to talk about the reserve currency because the uniqueness of that role is incredibly important. I’ll start by explaining what the reserve currency is. A reserve currency is a currency countries keep or hold in their reserves for trading purposes. With so many countries engaging in trade, it would be very complicated to trade in a dozen or more currencies so most countries hold a large amount of select and widely held currencies (usually those of the currency issuers that do the most trading like the United States, China, and the EU). If pretty much everyone has dollars, engaging in trade is much simpler than dealing with countless conversions or exchanges and offers a worldwide unit of account.
Today, most reserves (about 60%) are held in USD and that is primarily due to the Petrodollar, which I alluded to earlier. The petrodollar emerged post gold standard and was the Nixon administration’s clever way of creating demand for a currency not backed by a hard asset like gold, which is exactly what they were creating by eliminating the gold peg. So to create demand for this seemingly meaningless piece of paper, the United States coordinated a global pricing of oil and other commodities in dollars. If countries wanted to buy oil or what have you, they had to pay in dollars. And so this created significant demand for USD and, in turn, motivation to hold a lot of USD in one’s reserves. However, the demand for USD as the global reserve currency was actually partly why the US had to go off the gold standard in the first place. Because all these other nations wanted and needed to accumulate USD for trade, more and more money (gold) was flowing out of the US to accommodate all that foreign demand. To get those dollars, countries would generate trading surpluses with the US (meaning the US had to generate trading deficits with every other country). And this leads to what is known as the Triffin paradox.
If a single nation has the global reserve currency, they have to generate massive deficits with the rest of the world to supply enough of that currency to facilitate global trade. If they don’t generate deficits with other countries, those countries won’t have enough money to buy oil or whatever else is priced in dollars. So this is why we see the US with such aggressive trading deficits. This somewhat artificial demand for USD essentially encourages never-ending deficit spending and money printing to remain accommodative to global trade. Normally deficit spending or inflation from money printing lowers the demand for a currency because it’s being devalued, but the demand created through the petrodollar system has allowed the dollar to expand well beyond what would normally be economically tenable. Government debt can skyrocket due to all the artificial demand created through the global pricing of goods in dollars because that demand offsets some of the devaluation. So instead of a balanced system where debts and fiscal spending are financed through taxation, bond issuances, or trading surpluses, the United States is essentially forced to finance the global demand for dollars by printing and selling debt to foreigners. Foreigners need USD for trade so they’ll buy that debt to hold USD in their reserves as treasuries while also earning interest on those treasuries the US is eventually supposed to pay. But in periods of a strengthening dollar where other nations struggle to buy more US debt (treasuries), the US is forced to buy their own debt to finance spending, especially if the lack of demand for treasuries is pushing interest rates higher and forcing the US to pay considerably more interest on all that debt they’ve previously issued.
Alright, so what does all this mean? In simple terms, it means we’re fucked. A nation with the global reserve currency pretty much has to run these massive deficits to be the global reserve currency and that means outsourcing more and more of its economy to other nations through those deficits, which hallows out the economy until debts are so high that the US can’t afford to pay them and the whole petrodollar system collapses on itself. On the gold standard these problems were self correcting because you couldn’t spend more gold than you had and trading deficits would eventually lead to a nation strapped for gold, which would then lead to more exports to earn more gold, which led to surpluses and gold inflows, which corrected any crazy deficits. It is this inability of a global reserve currency belonging to a single nation to self correct that makes the United States’ situation so problematic.
Now, the IMF (International Monetary Fund) has attempted to solve this through the SDR (Special Drawing Rights), which is basically a basket of currencies that can act as a unit of account and take the place of the dollar, but it hasn’t gained much traction and doesn’t really solve the fundamental problems of fiat. It might help the US begin to fix their trading deficits by lightning the demand for dollars and could also provide the liquidity global trade demands, but it doesn’t really solve the dishonesty or manipulation associated with fiat. I don’t think we necessarily have to do away with fiat currencies altogether as the flexibility they afford can be very helpful at times to soften the business cycles or black swan events (which historically has usually been wars and a nation’s ability to finance them). But transitioning economies and the global unit of account back to a hard asset like gold or bitcoin would, one, lead to naturally balanced global trade via honest accounting out of necessity and, two, largely eliminate the ability for countries to engage in currency warfare because currency strength and weakness would be more the result of the actual economy, not manipulated interest rates and money printing. You might lose some of the flexibility of the fiat system, but the inelastic nature of hard assets is exactly what keeps the system from expanding far beyond its fundamentals.
I know that was a lot of information to digest, but let’s highlight some of the key takeaways. First, countries use policy rather than free markets to manipulate their currencies for more desirable short-term economic and trading circumstances or to avoid their financial responsibilities like debt obligations (think Nixon bailing on the gold standard and the US’s gold liabilities to other nations); second, the current reserve currency/petrodollar system incentivizes deficit spending by the US and really has no end until something breaks and those debts finally come back to bite the US in the ass; and, finally, moving back to a fixed exchange system where currency is backed by a real asset can move us back to honest accounting and solve many of these problems fiat has created.
So hopefully all that was at least somewhat digestible and helpful in explaining how the global monetary system works. It’s a crazy topic you can spend a lifetime studying so I encourage you to learn more because this was by no means exhaustive and we’re approaching a point where this system is beginning to shift in a major way. Alright, well that’s all I have for you today. As always, I appreciate you taking the time to read all this and wish you the best of luck.