December 04, 2024
Last week Donald Trump made a bizarre threat on his Truth Social site that he would impose 100 percent taxes on the imports (tariffs) from any country that doesn’t take a pledge to not move away from the dollar as its reserve currency.
Donald Trump’s Big Fear Exists Only in His Imagination
The threat was bizarre for several reasons. First, he seemed to imagine that the BRICS countries (Brazil, Russia, India, China, and South Africa) and their allies are in the process of setting up an alternative currency to the dollar.
This would be very hard to imagine since this group of countries has little in common other than feeling marginalized by the United States, West Europe, and the international institutions they have established. Agreeing on rules for a common currency involves considerable haggling and is difficult even among countries that are similar in their economies, history, and culture. Ask the countries in the euro zone. Bringing this group together in a common currency seems a long shot even one or two decades out.
So, Trump was making some grand threat against a development that will almost certainly not happen. Oh well, always good to be cautious.
Who Cares If They Establish Their Own Currency?
Trump’s ignorance of trade and finance issues really shines through on this one. Paul Krugman has been working hard trying to educate the public on the meaning of a reserve currency.
First of all, there is not a single reserve currency. There is no law that requires all international payments be made in dollars, and many in fact are not. If businesses find it more convenient to sell in euros or yen, there is nothing that prevents them from doing so. It’s not clear if Donald Trump is unaware of this fact or thinks that he somehow will police all the transactions in the world and require them to be done in dollars.
Central banks also hold currencies in reserve to cover international payments and to support their own currency in the event of a crisis. The dollar is the predominant reserve currency, but not the only one. Central banks also hold euros, British pounds, Japanese yen, and even Swiss francs. Perhaps Trump wants to monitor the currency holdings of central banks and start raising the tax on imports from any country where dollar holdings fall below a certain level. That seems a pretty whacky way to set trade policy (it would violate most of our trade agreements), but about par for Donald Trump economic policy.
The Dollar as a Reserve Currency Undermines Donald Trump’s Dream of Balanced Trade
Insofar as having the dollar as the world’s leading reserve currency matters, its main benefit would be increasing demand for the currency and thereby driving up its value relative to other currencies. This would be good in the sense that it makes it cheaper for people in the United States to buy items imported from other countries.
The effect is not likely to be very large. The overwhelming reason for wanting to hold dollars is to invest in US financial assets, like stock and bonds, both public and private. As long as investors think the United States has a strong and stable economy, they will want to have dollars to be able to invest here.
If the United States were just another reserve currency, like the euro, then fewer dollars would be held as reserves and for carrying through transactions. This would likely mean the dollar was valued somewhat less against other currencies, but it is unlikely that the drop would be more than 5-10 percent. This is the sort of movement in the dollar we see all the time over the course of a year or two. It usually does not get much attention. For example, the dollar rose by more than 5.0 percent against the euro between May of 2021 and the end of the year, and it seems no one noticed.
More importantly for this issue, insofar as being the leading reserve currency raises the value of the dollar, it goes the wrong way in terms of Donald Trump’s goals on trade policy. Donald Trump seems to want the United States to have balanced trade or even a trade surplus.
A higher valued dollar directly undermines the effort to achieve this goal. If the dollar is higher valued against other currencies, it makes imports cheaper for people in the United States. That means we will buy more imports.
If the dollar is higher valued against other currencies it means that foreigners will have to use more of their own currency to buy a dollar. That makes our exports more expensive for them. If our exports are more expensive, people living in foreign countries will buy less of exports.
If we buy more imports, and sell fewer exports, then our trade deficit will be larger. This means that Donald Trump’s quest to preserve the dollar’s status as the premier reserve currency goes completely against his goal of reducing the trade deficit.
Donald Trump’s 100 Percent Tariff Will Hurt Us Much More Than It Will Hurt China
The United States provides a valuable export market for China, but it would require some very strange arithmetic to imagine that China somehow needs the US market for its prosperity. First, it is worth getting an idea of the volume of exports at stake.
The US had imported $322 billion in goods from China through September of this year, which puts it on a course to import roughly $430 billion for the year. By comparison, China’s GDP on a purchasing power parity basis is projected to be $37.1 trillion this year using a purchasing power parity (PPP) measure of GDP, while it would be $18.3 trillion using an exchange rate measure. This means that its exports to the US would be equal to 1.2 percent of its GDP using the PPP measure, and 2.3 percent using the exchange rate measure.
The difference between these two measures is that the PPP measure uses a common set of prices across countries for all goods and services. It means that it prices a haircut and a heart operation at the same price in the United State and China, as well as every other country. By contrast, the exchange rate measure takes the country’s GDP calculated in its own currency and then converts it to dollars at the current exchange rate.
The large difference between the two measures is explained by the fact that many services cost much less in China than in the United States and other wealthy countries. For example, renting a comparable apartment or getting a doctor’s exam would cost far less in China than it would in the United States.
While for many purposes, such as comparing living standards, the PPP measure is appropriate, in this case the exchange rate measure is probably the right one. We are asking how much demand China would lose in its economy if it is cut off from the US market. Since the goods sold internationally are likely priced in China close to their prices internationally, the demand loss would be larger than would be indicated by their share of its GDP measured in PPP terms.
This means that in the extreme case where China loses its entire US export market, demand in its economy would fall by 2.3 percent, before taking account of any multiplier effects. This is far from trivial, but it is not likely to lead China’s economy to collapse. By comparison, when the housing bubble collapsed in the United States in 2006-2008, the share of residential construction in GDP dropped by 4.0 percentage points.
That drop gave the US a severe recession, but it is important to keep in mind the economic problem we are describing. This would be a story of inadequate demand in the economy. This can be counteracted by the government spending more money, which we did to some extent with the stimulus package enacted under President Obama in 2008-09 and with an even larger package under President Biden in 2021-22.
There may be political considerations that act as obstacles to large-scale stimulus in China, as there are here, but there is no economic reason that China could not boost its economy in a way that replaces the demand lost from the U.S. export market. If China’s government chose, it could even borrow a trick from the US playbook and send $2,000 checks to everyone in the country and put Donald Trump’s name on the check. That would hardly be a crisis from China’s standpoint.
The picture looks much worse from the US standpoint. We will be paying substantially more for the $430 billion in goods that we had been buying from China. It would be necessary to look at possible substitutes for these imports on a sector-by-sector basis, but let’s say on average that the additional cost for the replacement its is 40 percent of the price of the goods from China. In that case, we would be paying an extra $170 billion a year, roughly $1,400 per family, to cover the additional cost.
The reason this looks worse from the US standpoint than the Chinese standpoint is that China just needs to create a new source of demand, which its government can do directly by giving people money. On the other hand, the United States is seeing the cost of a number of items rise, in effect seeing a shortage of supply comparable to what happened with the supply chain crisis during the pandemic.
Most governments would not deliberately inflict this sort of pain on its population without a good cause, but Donald Trump prides himself on being unorthodox. This threat over the dollar’s status as a reserve currency certainly is unorthodox.
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