The U.S. trade deficit has become essential in financing spending of the U.S. government and American consumers.

This critical source of funds depends upon continuity of international acceptance of the dollar as the preferred means of payment in international trade. Since 2002, the U.S. currency has fallen against the euro, causing worries that the “dollar franchise ” may be weakening.

The matter is important because if the trade deficit were to go away, dollar interest rates would rise sharply, there would be a “credit crunch”, unemployment would probably increase, and many goods on which American life styles depend would be in short supply and expensive. Therefore, the question is “How long can Americans count on the trade deficit?“

Many believe that the trade deficit cannot continue indefinitely and predict a “hard landing”. These forecasts are often based upon theories of cyclical behavior and models of foreign trade created under a gold standard that ended in the 1970s.

If we assume that nations are truly sovereign and distinct, and that citizens of each country inherently prefer their own currency over foreign tender, then a trade “deficit” may indeed be unsustainable and eventually end when citizens of countries with a trade “surplus” accumulate more foreign money than they need.

The substitution of dollars for gold as the international means of payment dates back only to the 1970s, but the role of the dollar as the dominant trading currency began a generation earlier.

It may be that the U.S. trade deficit, instead of representing a burden or ticking bomb, is simply an indication of gradual dollarization in economies that are America’s trading partners.

Just as we need not worry about the “trade deficit” between Florida and California, perhaps we need not worry about a “trade deficit” between the United States and an offshore “virtual nation” of the wealthy that control means of production of goods that Americans purchase in creating the trade deficit.

The trade deficit may even be stimulated and perpetuated by IMF policies that promote competing sovereign central banks and fiat currencies that start with a fundamental competitive disadvantages against the dollar.

Endemic dollarization

The U.S. trade deficit has persisted for a quarter of a century, growing more in some years, less in others, but with no signs of reverting to periodic trade surpluses.

(See graph).

Something must be going on that does not result in a cyclical pattern.

This “something else” may be long-term creeping dollarization in countries that are U.S. trading partners.

Dollarization is the persistent willingness of citizens of other countries to hold savings and draw contracts in U.S. dollars, rather than in their native currencies. Usually, this “dollarization” is informal and unofficial — a behavior pattern that reflects distrust of the stability of a national currency, a desire to avoid domestic taxes, and uncertainty regarding property rights in ones own country.

Political and economic turmoil, endemic corruption, civil war, inflation, social inequalities, and incompetent leaders spur dollarization.

Sometimes dollarization is official, such as in Ecuador and Panama, countries that have declared the U.S. dollar as their legal currency. Another form of official dollarization is the “currency board” — an arrangement whereby a central bank limits issuance of national currency to a certain ratio of its holdings of dollars.

Until 1998, Hong Kong was the most successful example of a currency board linked to U.S. dollars. In 2002, countries with dollar currency boards included Bermuda, Cayman Islands, and Djibouti. However, “informal dollarization” is more common.

Informal dollarization of economies that are U.S. trading partners may explain the growing trade deficit. In 2003, 60% of the American trade deficit was linked to trade with developing countries and 76% was associated with Latin America and Asia. American preference for goods from Asia and Latin America is obvious when checking labels of origin in U.S. shopping malls.

In most of Latin America and in many Asian countries we find: (1) long-term contracts being drawn in dollars; (2) banks soliciting dollar deposits and making dollar loans; (3) wealthy individuals holding dollar assets; (4) manufacturers preferring export sales in dollars; and (5) exporters and producers speaking English as a second language and sending offspring for studies abroad, often to the U.S.

These are symptoms of dollarization. London is the leading center for offshore dollar financing and countries that had ties to the British Empire now help feed and support the U.S. trade deficit and dollarization.

A “virtual nation” of the dollarized

Economists have made estimates of the percentage of unofficial dollarization in Latin America and Asia. In developing countries, these estimates often range from ten to thirty percent of the Gross Domestic Product.

However, the percentage that matters may be the dollarization of the wealthy in these countries. In the U.S., the top 1% of the population controls 38% of the nation’s wealth

(See: Rich and Poor).

In developing countries of Latin America and Asia, the top 1% possess an even greater share of national wealth and make most export decisions.

The dollarization of a “virtual nation” of wealthy families throughout Asia and Latin America provides support for the U.S. trade deficit. Here are some of the things we know about the behavior of this “upper crust”:

1. They control most of the means of production of goods that make up the trade deficit in the U.S.
2. Many are able to move between countries, seeking safety from asset confiscation and unstable political environments;
3. Many have education and historical perspective that provides an abiding mistrust of their own governments and reasons to fear for the safety of their assets; and
4. Most perceive that dollar assets held in offshore havens and their own command of English, provides international mobility that protects their families from economic and political unrest.

The globalization of the wealthy is hardly new. The Diaspora of Chinese merchants dates back a thousand years and has created a permanent network of Offshore Chinese that plays a dominant role in commerce of the Pacific rim.

Is dollarization reversible?

Trade deficits that are represented by contracts denominated in the currency of the importing country are not the type of “foreign debt” that forces a country into bankruptcy.

One way to reverse the trade deficit would be to reduce imports, but this would put people out of work in exporting countries and would reduce profits of the factories owned by the “virtual nation” of the dollarized international wealthy.

The World Trade Organization, supported by the United States, is dedicated to eliminating trade barriers and so, unless Americans decide against buying foreign goods, the impetus to reduce American imports must come from foreign suppliers.

Since the United States has deindustrialized much of its economy, Americans are now dependent upon foreign manufactures.

For fifty years, financing has flowed from U.S. capital markets to build industries in developing nations of Latin America and Asia, thereby creating a highly competitive environment among offshore manufacturers and excess capacity in countries with high unemployment and low wages.

If Americans were to eliminate the trade deficit by reducing imports, the negative effects on developing economies would be dramatic.

On the other hand, without drastically reversing the fundamental causes of deindustrialization (pampered labor unions, high minimum wages, excessive litigation, burdensome regulations, etc.), it seems unlikely that the U.S. will be able to increase exportable products in sufficient quantities and at low enough prices to compete with the offshore industrial capacity that American capital has done so much to finance in the last fifty years.

Of course, an atomic attack by terrorists on major U.S. cities that forces Americans to shut ports and resort to atomic retaliation, could be one of those “historical discontinuities” that radically upset the current balance of interests.

(See: Essay: Terrorism and Capital Flows).

How to interpret the “strong” euro?

Europe, in 2003, contributed to about 21% of the U.S. trade deficit. The relatively new European currency is often cited as a candidate to supplement and perhaps, someday, even replace the U.S. dollar. The graph shows the decline in the dollar/euro rate. However, the greenback has been supported by Asian governments and has held steady against Asian currencies, while depreciating against the euro.

The non-European world accounts for four-fifths of the U.S. trade deficit and is willing to accumulate dollars in seeking a positive balance of trade and international reserves.

One measure of the utility of the dollar as an international currency is the volume of cross-border claims of banks, broken down by the currency in which these claims are contracted. The chart, based on data from the Bank for International Settlements, shows changes in cross-border claims for 2002, 2003, and Q1 2004.

(See BIS Quarterly)

Although central banks may be pushing down the dollar against the euro as they attempt to diversify their holdings of reserve currencies, commercial banks, in general, have continued to increase their holdings of dollars faster than they have increased holdings of euros.

Of the total $17.1 trillion dollars in cross-border claims of BIS reporting banks, about 40% was denominated in dollars as compared to 37% in euros.

Furthermore, since the states of the United States are not counted as individual countries in measuring cross-border claims, while the countries of Euroland are, the apparent strength of the euro against the dollar may represent a shortage of euros rather than a disinclination to hold dollars.

Most of the cross-border claims of BIS reporting banks in euros are internal transactions within Euroland. In fact, Euroland has a trade surplus with the rest of the world, making it impossible for non-Europeans, as a group, to increase their holdings of this competitor currency to the dollar.

The expansion of cross-border dollar claims of BIS reporting banks has been going on for years. By Q2 2004, dollar financial assets of the rest of the world with respect to the United States reached $8.8 trillion, which was more than the financial assets of all U.S. commercial banks.

This means that America’s trading partners are holding vast dollar reserves to use as the means of payment for trading within this virtual “dollar nation”.

If we exclude the intra-Euroland holdings of euros, it appears that no other currency yet offers a real threat to the dollar’s position as a practical international means of payment in the post gold-standard era.

Will the euro replace the dollar?

The euro has a long way to go to replace the dollar:

1. Euroland would need to become a real country, instead of a proto-confederacy of nations, without unified political sovereignty. Currently, any country within Euroland can withdraw from the currency union and revert to its own currency. An investor in euros may wake up one day holding some new currency because the country with the investor’s deposits decided to withdraw from the currency union. Throughout Euroland, individual national central banks — vastly over-staffed bureaucracies — stand ready to resume their former duties. The bridges back to sovereign currencies have not been burnt. Efforts have been made towards legal convergence, but there is, in fact, no uniform legal system in Euroland nor is there a central capital market. The European Central Bank, the guardian of the euro, lacks transparency and accountability. The euro (like the dollar) is not backed by gold.

2. Both the dollar and the euro are fiat money. However, dollars are held by many more people outside the country of issue than there are non-Europeans holding euros. To become a practical trading currency, on a par with the dollar, Euroland would need to run a large trade deficit with the rest of the world for years, allowing non-European countries to accumulate a sufficient stock of euros so that importers have euro reserves with which to trade. The dollar is useful to a Brazilian exporter not only because of the possibility of buying things in the United States, but also because the currency can be used to buy things from other countries throughout Latin America and Asia. It is precisely the external circulation of dollars in finance and trade, between countries other than the U.S., that makes the dollar so useful.

3. Euroland is a weak and vacillating power, toothless in defending itself against terror and asymmetrical warfare. The proto-confederation has a long way to go to become a credible world military force, free from dependence on the United States. The military budget of all Euroland combined is only one-fourth to one-third of military expenditures of the United States. Most countries in Euroland have been vanquished by foreign forces within living memory and have strong, anti-military biases. A murderous terrorist attack on the Spanish rail system (3-11) did not cause Euroland to rise up as a nation and vow to defeat a common terrorist enemy. Instead, the Spanish withdrew their troops from Iraq, while the rest of Euroland cowered. If the proto-confederation does not have the moral fiber to defend the lives of its citizens, who would believe that this “union” has sufficient political will to defend a common currency in time of crisis? If the terrorists had blown up the Banco de España, would the reaction have been any different?

4. Euroland has no common fiscal policy and is made up of countries with independent democratic governments, with deep socialist roots. The goal of a stable euro conflicts with individual country goals for high employment and social welfare. If due to hard times or excessive spending, a country develops a fiscal deficit beyond a certain limit, the union may impose sanctions and fines — essentially taxation without representation — and this could drive a country out of the union.

5. Euroland is a high-tax, high-unemployment, low-growth region with an aging population, socialist governments, and a shortage of land to support immigration. Currently, the influx of people needed to foster growth and offset the graying population comes from Muslim countries. Followers of Islam are expected to make up ten percent of the Europe within a decade. Today, the largest city in the European Union is Istanbul (which means “Islam abounds“) with more than twelve million inhabitants, exceeding the size of London, Paris, Berlin, or Madrid. Demographics, the antipathy of the French towards the United States, general anti-Americanism fanned by a liberal, anti-capitalist elite, and rampant anti-Semitism, have turned Euroland eastward, away from North America and distant relatives that emigrated one hundred years earlier, towards the Mid-East and Islam. This may eventually result in Euroland’s influence extending to the oil regions, but is unlikely to generate feelings of solidarity in the predominantly Christian nations of North and South America, or in the fifty-four English-speaking countries that were members of the British Empire.

In other words, the substitution of the dollar by the euro will require much more than merely setting up a currency union.

As long as the United States continues to support globalization and free trade, allowing foreigners to own real estate and bank accounts without complicated bureaucracy, maintaining reasonable financial stability, and keeping borders open to foreign students, workers, and immigrants, while demonstrating support for political freedom and the rule of law, the trade deficit may continue to be only an indication of creeping dollarization among members of the dollar trading block for years to come.

However, the future is unknown and economic and political discontinuities are a fact of life.

This entry was posted on Wednesday, December 1st, 2004 at 9:03 pm and is filed under Foreign Investors. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.

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