Reflections on Trade: Part III

This week, we continue our discussion on trade by examining the reserve currency issue.

What is the reserve currency?
When a country runs a trade surplus, it creates excess saving that must be either invested overseas or held as foreign reserves. If a gold standard is being used, the excess saving/foreign reserves can be held as gold (or other precious metals). In theory, reserve managers can hold just about any asset as foreign reserves. However, if the ultimate goal of generating saving is to build the productive capacity of the economy, then the best foreign reserve assets should be safe and easily convertible, with broad acceptability in markets.

Here is an example we often use to describe why the reserve currency is important. Imagine that a chocolatier in Paraguay wants to purchase a ton of cocoa beans. He calls a dealer in Côte d’Ivoire for a price; the seller offers $1,800 per ton. The buyer in Paraguay notes he does not have U.S. dollars but does have Paraguayan guaraní. The seller does not want the Paraguayan currency because it would limit his purchases to Paraguay because the guaraní isn’t widely accepted. The seller in Côte d’Ivoire would be able to buy a wider variety of goods (or have wider avenues for investment) from selling cocoa if he receives U.S. dollars instead.

So, how does the chocolatier in Paraguay get dollars? The most efficient way would be to export chocolate to a U.S. buyer, then use the dollars he receives to buy cocoa beans from Côte d’Ivoire. Because the reserve currency has widespread acceptance, non-reserve currency nations have an incentive to run trade surpluses with the reserve currency nation to accumulate the reserve currency, which allows them to pay for imports from around the world.

Is the reserve currency a global public good?
Economists define a public good as a product or service that must be provided by governments because the private market won’t provide the good, or will provide the good in less than optimal amounts. There are seven public goods a reserve currency nation should provide:

1. Act as a consumer (importer) of last resort;

2. Coordinate global macroeconomic policies;

3. Support a stable system of exchange rates;

4. Act as lender of last resort;

5. Provide counter-cyclical long-term lending;

6. Provide a truly riskless AAA asset for benchmarking purposes; and

7. Supply deep and predictable financial markets.

Charles Kindleberger, the famous economist who studied asset bubbles, identified the first five, and Mohamad El-Erian, the chief economic adviser at Allianz, added the last two.

The Bank for International Settlements (BIS) reports that more than 80% of trade-related letters of credit are denominated in U.S. dollars, significantly more than the second most used reserve currency, the euro, at 10%.1 That means most global trade is conducted in dollars between nations other than the U.S. Essentially, the reserve currency nation must run constant trade and current account deficits in order to provide liquidity for global trade. Thus, the U.S. doesn’t run trade deficits because we purposely “under-save” as noted earlier. Strictly speaking, as the saving identity shows, we do undersave but the reason for this activity is really the issue. It may be due to domestic policy but it can also be forced upon the U.S. by the actions of foreign trade policy.

Because of the reserve currency role, we believe the undersaving (in other words, the trade deficit) is mostly in response to foreign nations oversaving and moving that saving to the U.S. in the form of exports. If the U.S. were to run persistent trade surpluses, it would act as a form of global monetary tightening. In other words, by pulling dollars from world markets, the global trading system would face a contraction of available liquidity. If the reserve currency nation refuses to provide enough of its home currency to global markets, world trade is effectively reduced to barter, or counter-trade, meaning that nations can only engage in bilateral trade relations. Using the above example, the Paraguayan chocolatier can only acquire cocoa beans from Côte d’Ivoire if the seller there has something specific he would like to “swap” from Paraguay. Simply put, global trade would fall sharply if a reserve currency is unavailable.

How does the reserve currency factor into trade?
When a nation runs a trade surplus it accumulates foreign currency. In the era of the gold standard, the exporter could be paid in gold. As we noted in Part I, David Hume generally proved that accumulating gold eventually would lead to higher inflation and lead to a reversal in the trade imbalance.

A serious drawback with the gold standard was that the global money supply depended upon the mining industry. If the global aggregate supply curve expands due to industrialization but the gold supply remains fixed, deflation is unavoidable. At the same time, however, it also acted as an automatic stabilizer for foreign trade flows. In other words, gold generally prevented a nation from running persistent trade deficits or surpluses as shown by Hume.