Sunday, November 18, 2012

Understanding the "Exorbitant Privilege" of the U.S. Dollar

The dollar rises for the same reason gold and grain rise: scarcity and demand.

Which is easier to export: manufactured goods that require shipping ore and oil halfway around the world, smelting the ore into steel and turning the oil into plastics, laboriously fabricating real products and then shipping the finished manufactured goods to the U.S. where fierce pricing competition strips away much of the premium/profit?

Or electronically printing money and exchanging it for real products, steel, oil, etc.?

I think we can safely say that creating money out of thin air and "exporting" that is much easier than actually mining, extracting or manufacturing real goods. This astonishing exchange of conjured money for real goods is the heart of the "exorbitant privilege" that accrues to the issuer of the global reserve currency (U.S. dollar).

To understand the reserve currency, we must understand Triffin's Paradox, a topic I discussed in What Will Benefit from Global Recession? The U.S. Dollar (October 9, 2012) and Is There Any Correlation Between the U.S. Dollar and Gold (Or Anything Else?)
(November 14, 2012).

It seems very few grasp the implications of the Paradox, and even fewer relate it to global trade. I recently discussed Triffin's Paradox and The Rule of Law in a video program with Gordon T. Long, who noted that the U.S. Council on Foreign Relations (CFR) described the conditions in which Triffin's Paradox becomes unsustainable:
"To supply the world's risk-free asset, the center country must run a current account deficit and in doing so become ever more indebted to foreigners,until the risk-free asset that it issues ceases to be risk-free. Precisely because the world is happy to have a dependable asset to hold as a store of value, it will buy so much of that asset that its issuer will become unsustainably burdened."
In other words, if the U.S. issues too many dollars, that could destabilize the dollar. But this is only one aspect of Triffin's Paradox: the basic idea is that when one nation's fiat currency is used as the world's reserve currency, the needs of the global trading community are different from the needs of domestic policy makers.

Trading nations need dollars to lubricate trading and as foreign exchange reserves that bolster the value of their own currency and provide the asset base for the expansion of credit within their own nation.

U.S. exporters want a weak dollar to spur foreign demand for their products, while foreign holders want a strong dollar that holds its value/purchasing power.

This is one aspect of Triffin's Paradox that is intuitive. But it is misleading in several important ways.

Consider Apple's iPhone. It is a U.S. product, right? And so it is counted as a U.S. export when it is shipped and sold in Europe. How much of the iPhone is manufactured in China? How is the "value-added" part of the product accounted for? What if Apple partially owns the foreign factories that make the parts that are in its "export"?

This example shows how complex and potentially misleading it is to simplistically assume an "export" manufactured with imported parts is somehow purely a U.S. export that would be severely impacted by a strengthening dollar.

If the dollar strengthens, wouldn't Apple be able to buy imported parts for lower costs? Wouldn't a stronger dollar actually lower production costs?

This also ignores the fact that most large U.S. global corporations already earn 60+% of their revenues overseas, in other currencies. If the iPhone parts are made in Asia and the completed phone is sold overseas in exchange for other currencies, then exactly where does the strong dollar come in to destroy this trade?

The only impact the dollar has is when overseas earnings are reported in dollars. I have often commented on this "trick": as the dollar weakened, global corporate profits skyrocketed as earnings in euros, yen, etc. rose when stated in dollars.

As the dollar strengthens, overseas profits will decline when stated in dollars. But since roughly two-thirds of global Corporate America is already overseas--its factories, labor forces, back-office, etc.--and two-thirds of its revenues are earned in other currencies that are used to pay local labor and materials, then the supposedly devastating effect of a stronger dollar on corporate sales is illusory.

This supposedly horrendous impact of the U.S. dollar rising also completely overlooks the premium of necessity. If you need grain and soybeans to feed your people, and the only available surplus available is American grain and soybeans that cost 25% more when priced in dollars, you will pay the premium without hesitation.

If the U.S. starts exporting natural gas, buyers will happily pay a premium due to a strong dollar: U.S. gas could double in price and still be less than half the current price Europe is paying.

Let's not forget that exports are 14% of the U.S. economy. The truly domestic-only part of that 14% is less than meets the eye, as so many U.S. exports (such as Boeing airliners) are assembled from globally manufactured components priced in local currencies.

If the dollar strengthens, the price of all imported goods and services declines significantly. That helps 90% of the economy, for recall that imported components used in the manufacture of exports (such as oil) also decline in price as the dollar strengthens.

Does it make sense to demand a policy that helps at best 10% of the economy (and even that "help" is marginal for all the reasons outlined above) while hurting 90% of the economy? No it does not. A stronger dollar will help the U.S. and foreign holders of dollars.

Lastly, we need to understand the flow of U.S. dollars. Foreign nations don't end up with dollars by magic--they end up with dollars because they sold the U.S. more goods and services than they bought from us.

The U.S. got the goods and the exporting nation got the dollars.

The exporting nation ran a trade surplus with the U.S. and now has dollars. It can hold them as reserves, either in cash or U.S. Treasuries, or it can "recycle" the dollars back into the U.S. economy by buying real estate, investing in companies, going to Las Vegas, and so on.

What happens in global recession? Trade declines along with everything else. And what happens when trade declines? Trade deficits also decline. In the case of the U.S., which exports large quantities of what the world needs (grain, soy beans, etc.) while buying mostly stuff that is falling in price in recession (oil), the trade deficit could decline significantly. (It is currently $41.5 billion a month.)

And what does a declining trade deficit mean? It means fewer dollars are being exported. Think about this: the global economy is about $60 trillion, of which about 25% is the U.S. economy. Into this vast sea of trade, the U.S. "exports" about $500 billion in U.S. dollars via the trade deficit. Put in perspective, it isn't that big compared to the machine it is lubricating. (That is $250 billion less than was "exported" in 2006.)

It is an astounding privilege to conjure up dollars out of thin air and exchange them for real goods.

So what happens when there are fewer dollars being exported? Demand for existing dollars goes up, pushing the "price" of dollars up--basic supply and demand.

It also means that there will be fewer dollars seeking a safe haven in U.S. Treasuries, which will slowly but surely exert pressure on Treasury yields to rise.

Higher yields on Treasuries will then feed back positively into the value of the dollar, pushing it higher.

We can now understand why global recession will actually boost the value of the U.S. dollar and push interest rates higher in the U.S., even as the stronger dollar lowers the cost of imported goods. Rather than be the catastrophe many believe, a stronger dollar will greatly benefit the U.S. and anyone holding dollars.

Triffin wrote in an era of rapidly expanding trade, and so we can understand why the possibility that the interests of domestic and international holders of dollars might align, i.e. an era of declining trade where dollars will actually become scarce, was not the focus of his analysis.

If we follow the above analysis carefully, we can understand why those worrying about a surplus of dollars got it wrong: the real problem going forward for exporting nations will be the scarcity of dollars.

This explains the dynamics that will continue pushing the dollar higher for years to come. This is not an intuitively easy set of forces to grasp, and so many will reject it out of habit. That could prove to be a costly error.

The dollar rises for the same reason gold and grain rise: scarcity and demand.

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