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The DDD (Detrimental Dollar Dominance) Syndrome

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This post originally appeared on ZeMing M. Gao’s website, and we republished with permission from the author. Read the full piece here.

Contrary to what most people think, the dollar dominance in the long-term is not good for the United States as a nation and American people as a whole.

First of all, the dollar dominance does not benefit the U.S. evenly. It mostly benefits the financial sector, at the expense of industries especially the manufacturing.

Secondly, the dollar dominance relies on the U.S. ‘consuming‘ (i.e. depleting) its national strength without sufficient reproduction.

On top of that, the dollar dominance creates an economically undisciplined ‘fat’ nation, including its economy, government and people.

Overall, this is a different kind of manifestation of the phenomenon known as ‘the curse of resources’, or ‘the paradox of plenty.’

A stable world reserve currency does benefit the world overall because global commerce depends on it. As the host country of the world reserve currency, the U.S. enjoys an immediate benefit but also carries a large burden in long term.

While the immediate benefit is obvious and well-known, the long-term burden is not.

The dollar strength

The truth is, it is the dollar dominance that gives the U.S. the superior purchase power and the ability to tolerate persistent trade deficits, which in turn enable other nations such as China to maintain a trade surplus against the U.S.

In an ideal world of global commerce with equal trading partners, such imbalance simply cannot last very long, likely just a few years, certainly within a decade. But in the real world in which we live, the unbalance has been sustained for over three decades, and is likely to continue indefinitely.

Why? Because the Dollar bears a disproportionally high burden of the globalization, something that the U.S. took upon itself after the World War II by opening its markets.

There are two different kinds of markets involved. The first is the market of consumption which involves Americans buying foreign goods and services, and the second is the financial and asset market which involves foreigners investing in the U.S. treasury bonds, American stocks and real properties.

Both markets are necessary to sustain an unbalanced trading relationship. When a foreign country run surplus against the U.S., it has to park its surplus money which is in the U.S. dollar. By definition, the surplus money does not buy American goods and services, because that would balance the trade and make the surplus of the foreign country (or its counterparty American deficit) disappear. Therefore, the money has to go to dollar-denominated investments, not necessarily all in the U.S.

And the foreign countries are only willing to make such investment due to the U.S. stability, which is a product of many contributory factors including not only a stable economy, but also trustworthy legal system and government, and further its projected military power.

It all boils down to a very simple thing: reliability of parking the trade surplus in the U.S. dollars. And all this depends on the projected U.S. strength.

Consumption and depletion of the national strength

Therefore, from a broader viewpoint, the fact that the U.S. dollar is able to sustain continuous trade deficits is really because it is ‘exporting’ another product or service to other countries: its national strength, which is a product of many things including the rule of law, democracy, affluent consumers, its economy and the military etc.

But such a condition is a double-edged sword. On one hand, it comes as a plus to the U.S. because direct foreign investment (FDI) is usually a good thing that benefits the domestic economy.

On the other hand, the U.S. cannot ‘export’ its national strength forever, because all this is really ‘consuming‘ (i.e. depleting) the national strength without sufficient reproduction.

The weakening of the domestic manufacturing and industries is a big part of this exhausting consumption.

The above point is not easy to understand. In fact, most people including economists (even Nobel winning economists) misunderstand it. Their counterargument is typically like this: how can foreign capital inflows within the U.S. not be a good thing, when it is invested into the U.S. economy?

Here’s the key: the U.S. economy is in an advanced stage that the domestic productive investment is only restricted by the availability of productive investment opportunities rather than a lack of capital for such investment. Therefore, foreign capital inflows into the U.S. only marginally improve the productive investment in the U.S. The total amount of the productive investment is mostly fixed (perhaps just slightly elastic but only to a negligible degree).

Therefore, the foreign capital inflows only push up the asset price, rather than improving the productive economy of the U.S.

This however causes complex chain reactions that goes beyond a mere asset bubble. It automatically depresses the U.S. savings and raise the U.S. debt.

One may ask, exactly how foreign capital inflows into the U.S. don’t fund higher U.S. investment, but instead they lower U.S. savings and raise U.S. debt?

A rather obvious example is the asset market, including both the housing and stocks. Another example is the selling of treasury notes (which accumulate as the U.S. national debt).

The following are two parallel simple sequences of events:

  1. Foreign capital drives up the asset price > Americans feel richer > Americans then (i) buy more stuff from foreign imports, which in turn drives up the foreign capital inflows into the U.S., and (ii) Americans borrow more money to buy assets.
  2. Foreign capital makes it easy to sell treasury notes > the U.S. government finds an easy way to get money > the U.S. government then gets itself into a lot of debt.

And the above two go hand in hand to produce a procyclical effect: Because the growing consumption is not a real productive economy, the U.S. runs an unhealthy ‘fat’ economy with constant fiscal deficit. As a result, the U.S. government performs monetary and fiscal tricks to ‘stimulate’ the economy. An addictive cycle ensues and stays.

The above being an increasingly greater component in the whole economy, the procyclical nature of it guarantees a burst of the bubble. It is only a matter of time.

Who wins and who loses?

In other words, it is an inevitable trade-off (in fact, a responsibility) of the U.S. dollar dominance that U.S. must run persistent and large trade deficits. While nations like China, Japan and Germany export manufactured goods to the U.S., the U.S. exports the Dollar to the world.

The consequences of doing that is very clear: while the finance sector reaps huge benefits, the U.S. industries especially the manufacturing suffer spoilage and becomes weaker and weaker.

Most people do understand the trade-deficit problem, but many mistakenly think it is merely a consequence of some wrong trade policies of the U.S. government. It is not. The phenomenon is a requisite condition of the U.S. dollar dominance which most Americans think is a great thing.

In the most immediate cases it really is a good thing for Americans. It is a privilege owned by the American power earned and accumulated in the past. But it is also an effective device to ‘consume’ that privilege by gradually destroying the American industrial strength.

And without industrial strength, there would be no power.

The world has an interesting way to automatically balance itself to achieve equilibrium.

Weakening by indulgence

But there’s a greater harm beyond the straight economics. There is also human psychology. The dollar dominance spoils the nation and makes it weaker. It induces both the government and the people to do stupid and selfish things.

For example, it makes it easier for the U.S. government to create money out of thin air. Every sovereign nation does it, but it is particularly easier for the U.S. government to do it, thanks to the dollar dominance. For all new money that the U.S. government creates, almost three quarters of the inflationary burden is actually borne by the rest of the world not the U.S. That sounds great to the U.S. But wait until the privilege has been spent.

In addition, it gives Americans superior consumer power to enjoy cheaply made goods without producing them. It is an addiction that weakens the nation and the people. It is what addiction does. More broadly, it is also what unearned benefit often does.

Consider two nations, one produces goods, the other consumes the goods. The trade between the two nations will be inevitably unbalanced, one running a surplus while the other a deficit.

Which one enjoys a good life now? We may all agree is the second nation.

But which one is doing better as an economy? Economists will tell you it is also the second because it shows higher GDP. Right?

I tell you with certainty that’s a wrong answer. Despite the apparent GDP gains of the second nation due to consumption (which is always counted toward GDP), the above first nation is doing better than the second as an economy, because it has a more productive economy, and being productive has long-term implications.

But the further question to ask is, which nation will eventually become the master? I think it should be obvious to everyone.

These things don’t happen abruptly. There is a long transition period. The transition may take decades because the system relies on the stability of the status quo. But the slow transition only masks the problem and makes it even harder to avoid.

I wish U.S. dollar dominance a slow and nonviolent death, slow enough not to cause too much immediate hardship for Americans, yet serious and obvious enough to wake people up from the addiction that kills.

Searching for a better global reserve currency

Will another national currency rise to substitute the U.S. dollar?

It is both unlikely and also unjustifiable, because having a particular nation’s currency (money really, because there is a difference, see Money & Currency) is fundamentally detrimental.

But will a multi-nation ‘basket’ currency do that? The question really is, can these nations be so united that they can ignore or tolerate their trade imbalances? Isn’t the Euro effectively a multi-nation ‘basket’ currency, except it went further beyond a basket to be closer to, but not quite, the dollar of the United States (the federal model)?

Therefore, it begs the question: can the loosely collected BRICS block do better than European Union, let alone the United States in terms of resolving the ‘internal’ conflicts (here, ‘internal’ refers to that which is within the block, not domestic)?

I doubt it. It can do a lot in the near term because it will help a large block of the world economy to become less dependent on the U.S. dollar, but it won’t solve the fundamental trade imbalance problems. People who believe the Yuan or a BRICS basket currency will rise to replace the dollar only focus on the current and projected economic strength of BRICS as a collective, but ignore the fundamental issues arising from the cross-border trade imbalances, which play at least an equally if not more important role in the choice of a global reserve currency. The truth is that the BRICS nations are unlikely to be able to come to such unity that a common currency is recognized without causing deep conflicts of national interests. For that to happen, the unity needs to be stronger than the EU and close to that of the United States. One simple issue which is bound to rise: if every nation in the BRICS block wants its export to be competitive, i.e. to run a trade surplus against other nations, whose surplus is to give? By definition, not everyone can run an export surplus. Someone has to give. Besides, even if one or several nations are able to sustain their surplus against the others, where does the surplus go? With unbalanced trade, the surplus must find a place to park or invest.

The ultimate destination of the surplus can only be a currency that has the following qualifications at the same time: (1) it is stable; (2) the nation behind it is willing to bear sustained trade deficit (which eventually weakens that nation’s industries and economy).

Perhaps the nations, whichever that has become capable, will take turns. But one thing is quite clear: China currently is unwilling because it continues to emphasize and depend on its export competitiveness, which naturally means trade surpluses against other countries. China is probably also unable to absorb other nation’s surpluses against it even if it wants to.

In this regard, why can’t all these nations just agree on gold as the global reserve? Gold would be great, but it requires too much monetary discipline of the nations for it to work. Think about what these nations are ‘enjoying’ with the freedom of fiat money. China has learned how to take advantage of the U.S. and other developed countries through imbalanced trades, and the U.S. has enjoyed the dollar dominance, while both China and the U.S. have learned how to take advantage of the future generations, all thanks to the creative fiat-money-based economy. Going back to gold is harder than asking a 500-pound man to become a 150-pound athlete. Just imagine China demanding gold for is trade surplus from the U.S. instead of the dollars which can be created freely by the U.S. government!

Bitcoin is a remote possibility, but absolutely not in its current ponzimistic form. Bitcoin must first become an efficient technical solution as an efficient medium of exchange, i.e. a currency (rather than a store of value, i.e. money, see Money & Currency) before it earns its right to become a global money. For that to happen, it must be all-around productive on the chain of value creation, definition and transaction. It must be fair and have the proper moral sentiments in order to actually benefit the world, rather than harm it. It has a long way to go.

A much better and more realistic hope lies in a more effective and equitable form of money, namely community money or network money based on mutual credit among entities transacting with each other in a natural business ecosystem. Such a system can be based on mutual credits that are tokenized on a globally scalable public blockchain. It can create a system that is much more reliable and efficient not only in terms of raw transactions but also the entire accounting and auditing in the system. The integration of blockchain and triple entry accounting system is therefore not only a great solution for companies doing businesses, but also for nations doing cross-border trading.

But even with an ideal global reserve money, the problem of trade imbalances will not disappear automatically. Trade imbalances is fundamentally a behavioral problem. A nation cannot set its ‘export competitiveness’ as its perpetual goal while at the same time hope long term peaceful globalization. On the other side of the coin, another nation cannot hope to take perpetual advantage of ‘dollar dominance’ without fearing losing its national strength eventually.

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