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With all the talk in the media about countries shifting away from the U.S. dollar – commonly referred to as “de-dollarization” – it has stroked some fears.
Headlines talking about the chronic U.S. deficits has added fuel to this fire – with many experts noting that the dollar’s days may be numbered and that the U.S. economy has received a free lunch because of the dollar as the major reserve currency (aka the exorbitant privilege).
And while they have a potential point (who knows), there are some important aspects that the mainstream seems to ignore.
I’m talking about the paradox of when a major reserve currency country must seemingly always run deficits.
So, let’s focus on this aspect for the U.S. dollar, U.S. budgets, its impact on global markets, and why it may be an exorbitant burden instead. . .
I believe there’s a reason why China or Russia – contrary to what they say publicly - don’t want to replace the dollar – since they would be stuck in the same issue of constantly running deficits (directly impacting their export economies).
So, let’s break all this down. . .
Triffin’s Dilemma: What It Is, And Why It Matters
Now, this is a brief look back in history, but it’s very important to go over. So, bear with me.
Triffin’s Dilemma – named after economist Robert Triffin – is a term showing the paradox between having a global reserve currency and domestic deficits/surpluses.
See, Triffin’s original issue was with Bretton Woods1 (aka the post-World War Two dollar-gold monetary system) and how it exposed a fundamental flaw in the international monetary system.
In summary: Triffin testified2 to Congressin 1960 that the U.S. was stuck in a ‘Catch-22’ (aka a problem for which the solution is denied because of another problem).
Put simply – if the U.S. stopped running budget deficits – then the global economy would lose its main source of liquidity (aka U.S. dollars; the reserve currency). And this shortage of liquidity would increase global fragility and sink growth.
Remember: since the U.S. dollar was the reserve currency backed by gold, foreign nations needed first to gain dollars to build up their own reserves. Then later exchanged for gold if they wished. Thus the U.S. must constantly run deficits, buying more than it sells, to provide dollars globally and drive growth for foreign countries (since the U.S. was buying more of their goods).
It’s a relatively simple point that Triffin showed – but here’s where it gets interesting. . .
On the other hand – if the U.S. continued running deficits (buying more than it sells) to supply the world with dollars and thus economic growth, it would erode the confidence in the dollar. Which would lead to a run-on the U.S. gold supply (since ever-more dollars outstanding are claims on the ever-finite amounts of gold). Thus – the dollar’s value as a reserve currency would diminish, leading to further fragility, inflation, and disorder.
See the problem? It’s a “damned if do; damned if don’t” situation that Triffin noted.
Well, the U.S. government tried to fight this paradox for over a decade (1960-1971).
Why? Because it was enjoying the benefits of freely spending money. Thus, exporting inflation globally through huge deficits.
· For example: President Johnson’s ‘Guns and Butter’3 policy for funding both the domestic ‘war on poverty’ and Vietnam were wildly expensive.
Until eventually – it was too late. . .
Thus in 1971 – eleven years after Triffin testified – President Nixon suspended the dollar-to-gold window (effectively ending Bretton Woods) to prevent further gold outflows as inflation roared.
So, in the end – Robert Triffin’s monetary ‘dilemma’ proved accurate.
“But why does that matter today?”
Good point, since we’re not on a gold standard anymore. But Triffin’s Dilemma still holds true.
Why Does Triffin’s Dilemma Matter In A Dollar World Without Gold? A Few Reasons
Now – while Triffin’s-Dilemma was originally based on the dollar-gold fixed exchange system (Bretton Woods). I believe it still holds true today.
Why?
Because even in a fiat-based monetary system (aka money not backed with convertibility) – the U.S. dollar acts as paper ‘gold’.
Foreign nations still require dollars to build up their own reserves. And they do so in droves - whether it’s to buy goods from other nations or lend out the dollars.
· Most countries settle trade using dollars because they each can all accept and settle liabilities with it. They also can use dollars to maintain their own currency exchange rates, etc.
To put this into perspective, the U.S. dollar’s share of global currency reserves – according to the International Monetary Fund (IMF)4 is at roughly 60%.
Meanwhile, U.S. federal debt held by foreigners and international investors sits at over $7.6 trillion as of Q3-2023.
One thing to point out is after the 1997 ‘Asian-Contagion’ crisis – when financial fragility spread globally throughout emerging markets in Asia – foreign nations began buying huge amounts of dollar-assets. It’s likely because these foreign nations wanted a chest of dollar reserves to prevent another insolvency and currency crisis like 1997.
· And don’t forget that the “Clinton surpluses” – when the U.S. ran surpluses between 1998 and 2001 – preceded the Asian Contagion crisis and the 2001 recession.
Meanwhile, the dollar (the DXY) continues rising in value relative to foreign currencies - sitting around 20-year highs5 – due to continued global demand.
So – it appears that the U.S. dollar is still regarded as the safest and most liquid asset for global reserve holdings.
Just as gold was pre-1970s.
· Ever notice how every time the U.S. Federal Reserve raises interest rates, other countries also do? Or vice versa? That’s because of how important the U.S. dollar is in global markets.
And this is why Triffin’s-Dilemma is still very relevant. . .
Because even without gold, when the U.S. curbs dollar outflows through lower deficits or increasing surpluses – there’s a drain on global liquidity that also weighs down growth. (And vice-versa).
Put simply – it starves the world of the very liquidity it needed to generate growth and settle liabilities (such as dollar-denominated loans in foreign countries, how else will they get the dollars then?)
See, when the U.S. runs a deficit, it’s buying more than it sells, thus fueling growth to whoever exports it to the U.S. (such as China or Japan or etc).
And secondly, the U.S. treasury is the only entity able to create physical dollars. Thus, if foreign countries take out dollar-denominated loans, they will depend on dollar inflows (from exports) to even get the dollars to repay them.
Thus, it appears how the U.S. sets its own budget (influencing deficits or surpluses) directly impacts the world economy.
But this chronic deficit also comes with downsides – such as diminishing U.S. manufacturing base, heavy amounts of debt, and potential inflation.
For instance, while being the reserve currency has its benefits, it also had its costs on the U.S. manufacturing sector.
That’s because, amid the U.S. deficits, it’s crowded out domestic manufacturing as imports rose.
Meanwhile, other countries use our dollars to keep their currencies weak on purpose – known as a currency war – which has kept the U.S. dollar artificially stronger in order to keep their exports flowing into America.
· A strong currency implies cheaper costs to import, yet also makes exports more expensive. Thus, a strong U.S. dollar would hurt exports while aiding imports.
There’s so much more to all this, but you get the gist.
The point that the exorbitant privilege of a reserve currency is also an exorbitant burden (which many people don’t talk about). . .
So, next time you hear someone talk about the Chinese yuan replacing the U.S. dollar – explain Triffin’s Dilemma and ask them:
“So, will China want to completely change its own economy to run the necessary deficits required of a reserve currency? And will they be willing to stomach crushing their own manufacturing sector – which is the largest in the world?”
I’m curious how they’ll respond. . .
In Conclusion
As we learned from Triffin – the U.S. controls the global reserve currency (the dollar) and thus must supply liquidity to all those that demand it by running larger deficits.
But when the U.S. runs surpluses (or simply smaller deficits), it drains liquidity from the system, creating pockets of illiquidity, fragility, and anemic growth.
This is a true catch-22 in the current global monetary system:
Either the U.S. runs a balanced budget, and the world economy suffers.
Or the U.S. runs ever-greater deficits, fueling global liquidity and growth. But at the risk of the domestic economy through rising debt and eroding confidence in the dollar’s reserve status. . .
There’s of course more to it. And many variables impact the global economy.
But – for now – it’s some food for thought.
Sources:
1. https://en.wikipedia.org/wiki/Bretton_Woods_system
3. https://www.investopedia.com/ask/answers/08/guns-butter.asp
4. https://www.reuters.com/markets/currencies/us-dollar-share-global-fx-reserves
5. https://www.marketwatch.com/investing/index/dxy
Disclosure:
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