Starting a trade war as the global reserve currency

An apolitical guide

The current trade war has been tough to get a read on, as most commentary has been deeply colored by political or self-serving financial biases. More nuanced takes are exceedingly long. This is an attempt to find clarity in simplicity, by straightforwardly exploring the privileges of reserve currency status along with its drawbacks.

This tension historically leads to the same outcome: an attempt by the reserve nation to both have its cake and eat it too. Whether that's possible is unclear, but economic logic and history offer a good map of the territory.

Source: Smedley Financial

The spoils of reserve currency status

The global financial system naturally orbits around the dominant currency. International trade deals typically settle in your currency, even between countries not doing business directly with you. National governments hold your currency in their reserves, often at greater amounts than their local currency. Since debt is preferably issued in the reserve currency, your government enjoys unrivaled borrowing capacity and monetary flexibility. Even loans between foreign countries and institutions are frequently denominated in the reserve currency.

In the 16th and 17th centuries, the dominant Spanish Real was used heavily in trade across Europe, the Americas, and even in Asia.

It also means you can sanction other countries and hamper their ability to not only trade with you, but with anyone else, since you control the flow of the money. You can cripple enemies or compel political and societal change throughout the world without touching your military.

All of this creates an extra structural ‘bid’ or demand for your currency, increasing your citizens' purchasing power. Your citizens can buy foreign goods more cheaply than those who produce them. Their wages also tend to be higher than their foreign counterparts. Assets at home attract a premium due to the perceived strength and stability of the currency, so individual investment portfolios also tend to grow faster.

British elites in the 19th century enjoyed frequent travel, luxurious silks, and other rare imports. Even common British workers enjoyed cheaper imports, like tea and tobacco, thanks to the pound’s dominance. Source: Journal of Victorian Culture

Why would non-reserve countries grant this powerful status? It's more an implicit than explicit agreement which requires trust in the reserve power’s rule of law, fiscal prudence, and general stability. Military power cements and enforces this trust – the reserve nation's security suggests not only an ability to protect their own interests but to protect allies as well.

Is it a free lunch?

This extra demand for the reserve currency creates an imbalance - it becomes considerably cheaper to produce things abroad. Trade deficits explode. Labor and manufacturing leave home. Cities that relied on these industries hollow out. Know-how in industrial and manufacturing sectors start to dissipate, which starts to directly affect the quality of both public and private infrastructure.

Physical production of goods is gradually displaced by the creation and management of financial assets. Finance and banking sectors continue to grow, eventually becoming an outsized piece of the economy. This is not only to service domestic interests but foreign investment back into the economy. This shift exacerbates wealth inequality, which stokes domestic tensions.

Abandoned auto and train parts factory in Philadelphia. Similar abandoning of manufacturing happened both in the Netherlands and England as the economy became increasingly financialized. Source: Abandoned America

The reserve currency issuer often takes on expensive global security commitments to maintain the system that supports its currency. Ambitious politicians and hawkish policy makers can further compound this overextension, diverting resources from domestic priorities.

Trade war

The global reserve power becomes alarmed by increasing trade deficits, a worsening domestic situations for the lower and middle class, and frightening implications to national security caused by an industrial and manufacturing dearth. In response, they start to adopt increasingly protectionist or isolationist policies. This can be in the form of tariffs, currency manipulation, regulation, sanctions, or embargoes.

The transition to domestic production can take years and may face rising costs of input material. If domestic industry cannot quickly replace production across the supply chain, you face both slowing growth and rising prices – stagflation – an unenviable position for all stakeholders.

The UK’s1932 Import Duties placed a 10% general tariff on most imports (sound familiar?). It’s worth noting that manufacturing output, especially steel production, went up rapidly after the imposition of these tariffs in the pre-war years. Image Source: Punch Magazine UK

Affected countries will accelerate efforts to bypass the reserve currency, potentially dumping reserve holdings. Previously neutral or even adversarial nations may form cooperative trading blocs to exert stronger power in a shifting order. Foreign investment into real estate, equities, private business may fall as both political pressure and perception of instability rise.

Exerting power

However, it’s important to note the global reserve currency power retains significant leverage. Full-scale abandonment of its currency is unlikely in the near term. The entrenched dominance of its financial markets, the sheer volume of existing contracts denominated in its currency, and the lack of a credible alternative all act as stabilizing forces. Countries seeking to reduce reliance on the reserve currency may find that the costs of doing so - financial instability, trade inefficiency, and capital flight - outweigh the benefits.

The strength of the US Dollar (in black) has an inverse relationship with global export volume (in blue). Source: Center for Economic and Policy Research

It’s possible the reserve nation can maintain the benefits of reserve currency status while slowly accomplishing domestic goals. Balancing these objectives is difficult, bordering on the paradoxical. It’s a near certainty that to reduce the trade deficit the reserve currency itself must weaken. Weakening the reserve currency may boost domestic manufacturing and export power, but simultaneously incentivizes partners to abandon it. History provides little evidence this balance can be sustainably achieved, but success could include targeted use of reserve power leverage along with broad international coordination.

One lesson from history is clear: military war accelerates reserve nation decline. Britain’s heavy borrowing and reliance on the sterling's global dominance to finance wars and imperial ambitions left it vulnerable. Despite emerging victorious in two world wars, Britain not only lost its reserve currency status but its economic dominance as well. Prior to Britain, the consequences of overextension and war led France, the Netherlands, and Spain to meet similar endings to their reserve status. If the US hopes to balance on the high wire act of domestic renewal with reserve currency status, war can most certainly knock it down.

Acknowledgements

This essay was inspired by Lyn Alden’s recent interview on tariffs with Jack Farley. I find Lyn’s macro analysis refreshingly sharp and clear.

If you’d like more on this topic or others from me, please consider liking and commenting below.