Donald Trump And The Dollar: The Triffin Dilemma And America's Exorbitant Privilege

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Includes: AGG, DIA, IWM, QQQ, SPY, TVIX, UDN, UUP, VXX
by: David Deuchar

Summary

Donald Trump is right.

The dominance of the dollar and America's persistent current account deficits do harm U.S. exporters and leave many Americans who can't keep up without work.

This has been a reality for 60+ years - the so-called Triffin Dilemma, a bitter consequence of the U.S. dollar being the world's premier reserve currency.

But do we really want to give up our absolute financial hegemony over the world for a few more blue-collar jobs in Michigan?

Hint: Probably not.

Introduction

A common theme throughout the Trump campaign has been centered around America's persistent trade deficits and the plight of American exporters, particularly in the manufacturing sector, unable to compete because of currency imbalances.

Free trade is terrible. Free trade can be wonderful if you have smart people. But we have stupid people...

When was the last time anybody saw us beating, let's say, China in a trade deal? They kill us. I beat China all the time. All the time. When did we beat Japan at anything? They send their cars over here by the millions, and what do we do? When was the last time you saw a Chevrolet in Tokyo? It doesn't exist, folks.

- Donald J. Trump

Indeed, the U.S. current account deficits and trade imbalances seem severe at first glance. In the last quarter of 2015, the U.S. managed a $125 billion current account deficit, or 2.8% of GDP, which is actually quite decent compared to its lowest point in 2006 which hit $216 billion. From 1960 to 2015, the current account has averaged ~$46 billion in deficit. Immediately, one is prone to assume that this is a negative for the U.S. and, indeed, in some ways, it is. As I've said, the currency relationships and subsequent balances of trade between the U.S. and other countries, particularly emerging markets, incentivizes retailers and consumers to choose, for example, cheap Chinese products over expensive American-made goods. This is common knowledge.

However, it is not so simple an issue to reduce to an idea such as: We have been stupid for the past 60 years for letting the world "beat us" at trade. On the contrary, we have been smart to maintain our financial hegemony over the entire world.

The fact that we import more goods and services than we export is not inherently negative for the economy. It is a consequence of the U.S. dollar being the world's premier reserve currency - a privilege which allows us to export inflation, influence the global private sector, pursue extremely accommodative monetary policy, borrow indefinitely, and exert hegemonic geopolitical influence over the entire world. We owe the continuance of the unipolar geopolitical order to the dominance of the U.S. dollar; this is not something to lament.

The Dominance of the Dollar

Throughout the 20th century, various arguments and critiques of the international monetary system have grown and evolved around the dominance of the dollar and its consequences on the U.S. economy and other national economies around the world, originating from the theories of John Maynard Keynes. Trump is not the first to address this issue.

The most popular critique regarding the sustainability of a unipolar monetary system is the 'Triffin Dilemma' argument.

The Triffin Dilemma: America's Exorbitant Privilege

Holding a significant influence on monetary theory during the reconstruction of the international financial order after World War II, the Belgian-American economist Robert Triffin held various posts at the Federal Reserve, IMF, and OECD and was an outspoken critic of the Bretton Woods system. By the 1960s, the accumulation of dollar-denominated debt outside of the U.S. had grown into the so-called 'dollar glut'. Consistent current account deficits (as we maintain today) provided the world with a steady stream of liquidity to meet the demands of global trade, and central banks built up massive dollar reserves. However, this eventually threatened the dollar's convertibility to gold.

The strength of the dollar meant that U.S. exporters could not compete with their Japanese and European counterparts. As a result, U.S. share of global GDP fell relative to others, and thus caused countries to lose confidence in the dollar. The supply-demand equation had suddenly been flipped. Now, the world had too many dollars and the U.S. had not enough gold. U.S. gold reserves began to plummet as more and more countries lost confidence in the system and redeemed their dollars for gold.

Ironically, it was the finance minister, Valéry Giscard d'Estaing, of another infamous demagogue Charles de Gaulle who kickstarted this process and coined the term 'exorbitant privilege' to criticize the asymmetry of the international monetary financial system, which he claimed subsidized the lavish lifestyles of Americans. This critique eventually snowballed into a full-fledged movement in France that culminated in de Gaulle sending the French navy to New York to withdraw France's gold reserves, which subsequently pressured the U.S. to end the dollar's convertibility to gold in the 'Nixon Shock' of '71.

(Richard Nixon sits with economic policy advisors at Camp David)

After the Bretton Woods system had broken down, the Triffin Dilemma argument evolved as well, from the original gold variant to the new current account version which surmises simply that the U.S. will become fiscally insolvent. This is more in line with Trump's campaign stump.

Considerations of "fairness" aside, the United States is regarded as an unreliable anchor because the high demand for dollar-denominated debt means that it is not subject to sufficient discipline. It can run larger and more persistent fiscal deficits; it can run larger and more persistent current account deficits - the United States has more dollar-denominated liabilities than assets, so that a dollar depreciation actually makes the country richer - and it can run a looser monetary policy for longer. Ultimately, this spreads instability to the rest of the world in one form or another, such as higher inflation.

- Claudio Bario, Head of the BIS Monetary and Economic Department

The Situation Today

In spite of the end of the Bretton Woods system and continued devaluation of the dollar, the dollar would continue to remain the world's foremost means of exchange and store of value. According to the latest BIS research on foreign exchange markets, the dollar is involved in approximately 87% of overall foreign exchange trades and in over 90% of the FX swap market. More than 60% of foreign exchange reserves are still held in dollars, which is impressive considering (1) the dollar's relative depreciation against the euro and the yen since 1978; (2) the U.S. economy's relative decline in share of output/productivity; and (3) econo-political debate about the dollar's long-term stability.

(The dollar remains dominant despite numerous financial crises)

As the BIS puts it, the dollar also exerts a "gravitational force" on other currencies and on FX reserve composition. According to Robert McCauley and Tracey Chan, existing dollar zone weights and subsequent currency movements drive FX dollar composition in a self-reinforcing feedback loop. Using the euro and yen as reference currencies and GDP weights, McCauley and Chan utilized regression analysis to show that this weighted "dollar zone" was still around 60% in 2014. Not only did this dollar pull extend to the composition of a country's assets and liabilities and FX reserves but to private sector portfolios as well. This is perhaps why the dollar has persisted as the most dominant no matter what macro conditions have arisen in the past several decades...

(The dollar exerts 'gravitational influence' on international FX reserves and private sector portfolios)

...and also perhaps why dollar-denominated debt to non-banks outside of the U.S. continues to grow regardless of financial crises and macro conditions; between 2009 and 2015, this dollar-denominated credit has doubled to $9.7 trillion, of which $3.3 trillion went to emerging markets alone.

(Dollar-denominated debt continues to grow regardless of macro conditions)

It is clear the Triffin Dilemma is still alive and well today. What is not so clear is how the U.S. can escape the Triffin paradox or if we should even want to. Yes, the system has disadvantages for national exporters and can amplify financial crises; this is manifest in the highly loyal base of Trump supporters which mainly hail from the lower-to-middle-classes who have been skilled out of the opportunity for social advancement or employment altogether.

...manufacturing can no longer be a bountiful provider of entry-level jobs. Previous generations traded physical exhaustion and, occasionally, a considerable risk of injury, for a wage much higher than their education would otherwise permit; the unskilled workers of today are much more likely to go into the service sector, which pays less.

- Andrew McGill, Senior Associate Editor of The Atlantic

However, the benefits of the system, I would argue, greatly outweigh the risks. The U.S. can behave as a country as no other can; we export inflation without mercy, run fiscal deficits proportionately far higher than other countries without risk of insolvency, pursue monetary easing measures ad infinitum, and ultimately influence geopolitics on a scale greater than any civilization in the history of mankind. Is it worth giving all that up just so that we can manufacture Oreos in Chicago or steel in Pittsburgh?

Investment Thesis

In any case, for investors, what does one do in a... Donald J. Trump Presidency? Ultimately, what a President can accomplish is limited, but as we've seen from the past several administrations, the strength of the executive is steadily growing; this is an important reality to be aware of. Unfortunately, despite the image surrounding Trump's 'outsider' persona, much of what Trump espouses regarding monetary and fiscal policy is not that far off from current leaders' philosophies. For example, Trump has praised Janet Yellen and called himself a "low-interest rate person"; this is not surprising considering Trump is a real estate mogul.

As for the dollar (UUP; UDN), one would be inclined to assume there would be significant downside to the dollar in various forex markets, regardless of actual policy simply because of the uncertainty surrounding a non-politician with no policy experience being in the White House. Additionally, several of Donald Trump's statements and, of course, the main theme of his campaign suggests that he is aware of the dollar-trade relationship and would prefer policy suggestions that would weaken the dollar or, in the least, cap the dollar from rising too high.

I obviously like a strong dollar, but when you look at the havoc that a strong dollar causes… and I can tell you, I have friends in China, all they do is watch the dollar, they love to see it go up. So, actually, while there are certain benefits, it sounds better to have a strong dollar than in actuality it is.

- Donald J. Trump

Considering the uncertainty and fear that would surmount around the possibility of a weaker dollar, there would likely be higher financial volatility (VXX; TVIX) at times.

Of course, the irony of the Triffin paradox means that if a Trump president would pursue such policies, our country actually gets richer; if the dollar becomes weaker, foreign investments (interest, dividends, etc.) become more valuable. For example, in 2007, even as the dollar weakened by ~8% on the FX market, there was no impact to the value of our liabilities since our debts are priced in our own currency. Meanwhile, the U.S. balance sheet actually improved as the dollar's depreciation improved foreign investments by about $450 billion. To add insult to injury, in periods of extreme financial volatility, such as in 2008 or 2010, foreigners flocked to U.S. bonds and the dollar, pushing down yields and actually making it easier for the U.S. government and citizens to borrow; despite the huge mortgage crisis and scandal of that time, mortgage interest rates would continue to decline, for example.

It seems that no matter who is president or what happens, U.S. investors can't lose, as long as they are positioned correctly.

Conclusion

Clearly, the unipolarity of the international monetary financial system remains, and this continues to affect the manufacturing sectors and any other export-driven markets in the U.S. Unfortunately, this is the reality of the system and has been for more than 60 years. What Trump fails to mention is that the U.S. economy has appropriately evolved just as it has over its 300+ year history, from agriculture to manufacturing to services to digital technology. Donald Trump's suggestions that the U.S. should turn back the clock and renege on its free trade deals, such as NAFTA, or threaten China with punitive measures for manipulating its currency would likely cause more harm to the blue-collar workers that Trump claims to speak for as any unwinding of the dollar hegemony is sure to cause massive financial instability and only exacerbate inequality.

If anything, Trump shouldn't complain about our trade deficits, he should celebrate them, as its foreigners who foot the bill anyway. After all, in the culmination of the 2008 crisis, it was emerging markets that were ultimately obliged to pony up cheap financing to the U.S. whether they wanted to or not. This demand kept interest rates low in the U.S. and continues to do so today, allowing households to live far beyond their means in the U.S. As Barry Eichengreen, Professor of Economics and Political Science at the University of California, Berkeley, said in his book Exorbitant Privilege: The Rise and Fall of the Dollar, "...the United States lit the fire [of the financial crisis], but foreigners were forced by the perverse structure of the system to provide the fuel."

In any case, if Donald Trump wants to bring American competitiveness back to the forefront, he should leave the financial markets alone and focus on encouraging capital flows into America by ensuring not attacking the global free trade of goods and services and reducing the corporate tax rate that plagues the growth of our economy. That would truly make America great again.

Relevant Equities: iShares Core Total U.S. Bond Market ETF (AGG), SPDR Dow Jones Industrial Average ETF (DIA), iShares Russell 2000 ETF (IWM), SPDR S&P 500 ETF (NYSEARCA:SPY), PowerShares QQQ Trust ETF (QQQ)

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.