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Trade deficit and reserve currency 

by on 14/04/2021

Asked lately why trade deficit of the US economy is connected to being the US dollar a reserve currency, here is my explanation. Reserve currency means, that the currency is saved in other countries, than the country of reserve currency’s origin. The saving can be done by private corporations or public entities, or even private individuals, who prefer to hold the reserve currency, as media of savings, because of higher trust the world population has in value holding capacity of the reserve currency, compared to the local currency. By doing so, the country holding foreign currency reserves, creates demand for reserve currency itself, disconnected from the need for money for immediate commerce with the country of reserve currency origin. It makes the reserve currency a commodity by itself. 

The reserve currency is an item of value, because of the trust people all over the world relate to it. This trust is result of long history of reserve currency origin country’s military dominance, democratic political system, free competitive market economy, trustful private and public institutions and unchallenged right for private property and wealth. China, even with its size of economy, (a bigger economy than that of US, in production capacity terms) doesn’t have a reserve currency, because it couldn’t create the trust in its sincerity in most of the above mentioned issues. Europe was successful only partly in making the Euro a reserve currency, because of its history of world wars it initiated, it’s member countries with loose political connections, with nationalistic tendencies.  All these have their consequences on trust in European currency. Even 70 years of peace in Europe, was not enough time to create enough trust in Europe’s currency, to give it enough relative value, comparable to trust given to US, with a long history of continuous respect for the values mentioned above.

The need for holding reserves of reserve currency exists in many countries with doubtful economic performances, history of inflation and monetary mismanagement. In these countries, to create trust in local currencies, the governments and central banks need to create enough reserves from the reserve currency. Just as in the past precious metals like gold or silver, made the currencies trustworthy, today holding US dollars makes local currencies trustworthy.

The exchange rate of reserve currency, in relation to other currencies represents the potential promise for exchange of the currency for goods and services from the country of origin of the reserve currency and also the promise of stability of its relative exchange rate compared to other currencies. But, if there is demand for reserve currency, not as media of exchange, but as value holding item, its price, or exchange value will be influenced by this demand, without the question, if exists enough additional production capacity to satisfy the value of potential demand, that reserve currency promises. As result of it, the relative prices in the country of origin of reserve currency, have to be higher than in countries that accumulate the reserve currency. Technically it is done by creating surplus in trade with country of reserve currency origin. To be capable to accumulate these reserves, the country holding the reserves must create enough production capacity to be capable to produce more than it consumes, and this more to sell to the country of origine of the reserve currency.  Such a surplus can be created only if the local currency value of the net exporting country is undervalued relatively to the reserve currency, meaning, in the reserve currency origin country, the prices are relatively higher. Then the other side of this surplus of the net exporting country has to be trade deficit of the reserve currency origin country. This trade deficit is sustainable only if the net exporting country continues with its policy of low relative prices. 

Such relation of continuously existing net exporter and net importer country, causes adoptation of production capacity, meaning the net exporting countries have to create increased production capacity compared to the net importer country. 

Another consequence of this state of net exporter – net importer countries is relatively higher saving rates in net exporter countries. Does relative higher saving rates  in net exporting countries mean also increased wealth of its population. It is not. Wealth accumulation is a long term process, while trade surplus and deficit are short term events. Trade surplus results a trend of balancing wealth between countries of deficit and countries of surplus. 

This trend of relative enrichment and relative impoverishment, causes in countries with the trade deficit feeling of loss, and political dissatisfaction of those parts of the population who pay the price. The result is political phenomena of anti votes, as it happened in US when electing D.Trump and in Great Britain voting for brexit. In both these countries, with reserve currency and trade deficit, parts of the population employed in production processes feel to be impoverished, as compared to those employed in financial services, that are involved in processes sustaining the position of US dollar, respectively the British pound as reserve currency. 

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