Fraser Forum

Under threat—the lucrative export of U.S. dollar notes and U.S. Treasury securities

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President Donald Trump’s policies to balance trade and increase employment will likely fail because of an iron law of international economics: If a country spends more on goods and services than it produces, the difference must be imported. This equation summarizes the law: Imports – Exports ≡ (Investment - Savings) + (Government Spending - Taxes).

Steve Hanke at Johns Hopkins University showed that U.S. data are consistent with this identity. During the years 1975-2016, investment minus savings was $9.6 trillion, government spending minus taxes was -$20.0 trillion, which makes the right side of the equation come to -$10.4 trillion. Over the same period, imports minus exports—the left side of the equation—came to $11.2 trillion. The $0.8 trillion difference between the two sides of the equation represents statistical measurement errors.

The reason why President Trump’s import-reducing and export-increasing policies will likely not create balanced trade is that the existing overspending in the United States causes market forces to appreciate the dollar exchange rate, which leads to higher imports and lower exports until the trade deficit again matches the domestic overspending and the initial effect of these policies has disappeared.
Unfortunately, President Trump’s protectionist policies, combined with domestic overspending, has a possible serious-yet-rarely discussed negative effect on U.S. national income: It endangers the country’s lucrative export of U.S. dollar notes and U.S. Treasury securities because it threatens the confidence the users of dollar notes and Treasury securities have in the future stability and value of the exchange rate, credit-worthiness of the federal government, and the growth and relative size of the U.S. economy in the world.

As will be documented below, the size of the Eurozone and the stability of its economy in recent years, when the U.S. economy was unstable and growing slowly, already has increased the world demand for Euro notes and short-term government securities. If and when the growth and stability of the Chinese economy approaches that of the U.S., the world might replace U.S. dollar notes and securities with those of China.

The amount of currency notes exported cannot be observed directly. However, in a study published by the Federal Reserve Board of Governors, $550 billion worth of U.S. dollar notes (mostly in $100 denominations) were held abroad at the end of 2011. These dollar notes are used by foreigner as a store of value and in commercial transactions, many of which are likely to involve underground and illegal activities. Considering past growth rates, in 2017, the export of such notes probably was about $200 billion.

Since these notes cost virtually nothing to produce, their export adds to the profit of the Federal Reserve, which is transferred annually to the Treasury and thereby decreases the government deficit as if tax revenue had increased. The sum of $200 billion in 2017 was large enough to cover the cost of four of President Trump’s coveted Mexican border walls.

The story does not end there. According to the IMF, governments around the world in 2017 held official reserves worth $9.6 trillion, of which $6.1 trillion were in the form of short-term securities issued by the U.S. Treasury. These securities are very liquid and held by governments for propping up the value of their national currencies during crises.

U.S. income is created through the foreign holdings of these securities by the fact that they are short-term and require the Treasury to pay low interest rates while the money they raise can be used to buy longer-term bonds or make direct investment at home or abroad. Assuming that the short rate is one per cent and the long rate is five per cent, the $6.1 trillion of U.S. short-term securities held by foreign governments currently brings the Treasury an implicit annual return of $244 billion and reduces the deficit correspondingly.

In the 1960s Valéry Giscard d'Estaing, then the French minister of finance, suggested that the world’s use of dollar-denominated securities and currency notes conferred on the U.S. an “exorbitant privilege.” At the time, French politicians were particularly upset about direct U.S. investment in their country’s profitable industries, which they considered being financed by the same money they had provided America when they acquired U.S. short-term securities for their official reserves.

The profitable export of U.S. currency notes and securities is the result of the world’s need for a universally accepted standard of value, the efficiency-enhancing use of dollars in trade, and the properties of U.S. short-term securities that are highly liquid and have a low risk of default. These properties of the dollar developed spontaneously after the end of the Second World War together with the status of the U.S. as the world’s largest and most open economy with a solid record of political and economic stability. Protectionism and chronic domestic overspending bring the risk that these roles of the dollar will be diminished and ultimately lead to the use of other countries’ short-term securities in their reserve portfolios.

This development has already begun. Between the third quarter of 2016 and 2017, dollar-denominated reserves held by foreign governments rose 13.3 per cent from $5.4 trillion to $6.1 trillion. Over the same period Euro-denominated assets increased 18 per cent from $1.6 trillion to $1.9 trillion while reserves denominated in Yen, Pound Sterling, Australian and Canadian dollars together increased 20 per cent from $1.0 trillion $1.2 trillion.

Advice to President Trump from the preceding analysis: Do not pursue protectionist policies. They are unlikely to succeed and they threaten your government’s business of supplying the world with dollar notes and short-term securities. Remember that this business in 2017 brought a profit of $444 billion, which is more than enough to finance your Mexican wall and increase defence spending without having to raise taxes.


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