Tariffs, reserve currency and globalization
Daily Thoughts 5 Apr 2025 (Free)
From Tuomas Malinen on Geopolitics and the Economy.
Today I think that I need to return to my original role of a macroeconomist for a short while. There are massive misconceptions revolving around the “tariff-wars” unleashed by President Trump. These misconceptions pertain to the position of the U.S. in the global economy and the potential impact of tariffs. Allow me to explain what is going on.
Let’s start with the warning we at GnS Economics published on 6 February:
What makes such an outcome (a trade-war leading to an economic collapse) more likely is the fact that the power structure of the world has changed. For example BRICS have showed that the world is much less unipolar, also economically, than it was during President Trump’s first term. Sanctions targeting Russia have also hastened the development of this ‘multipolarity’. Countries may feel less threatened and respond in kind to U.S. tariffs, like Canada, China and Mexico are (were) planning to do. In the worst-case, President Trump may end up hurting the U.S. and global economies in a serious manner.
This is essentially, where we are now with, e.g., China enacting heavy retaliatory tariffs. The situation President Trump now finds himself in is far from optimal. Everything starts from the extra-ordinary position of the United States in the world economy.
The “problem” the U.S. has is that she has the reserve currency. This means she can print nearly an infinite amount of USD without crashing the dollar's value, providing the U.S. a clear advantage among the countries of the world. The status also means that the U.S. is the recipient of major capital inflows. Everybody wants to hold dollars, which means that they also invest in USD-denominated assets. Between 2022 and 2023, the U.S. received 41 percent of all capital flows in the world. This is a highly disproportionate figure, as the U.S. gross domestic product (GDP) is only around 26% of the GDP of the world.
There’s also the so-called Triffin’s paradox, which implies that to sustain the reserve currency status, the country holding it needs to supply the world with its currency. We can simplify the matter by stating that U.S. citizens and corporations must spend excessively to maintain the unique status of their currency. Such behavior naturally leads to a trade deficit. There are two ways to view President Trump's efforts to improve the flow of trade and support the U.S. economy.
Consider that you are the head of the only very wealthy family in a small, closed community. Other people produce goods, which your family buys. You get stuff, while others get money to live. If you try to take over the manufacturing side of your small community, you will impoverish everyone in it. Your community can't afford your goods, so your efforts to manufacture them will be in vain. You may establish a self-sufficient family, but now you make things you used to buy (using your time), and your community is being impoverished. And poverty is the strongest motivation behind revolutions. So, at the end of this endeavor, impoverished members of your community will rise up against you and rob you.
This is a simplification, naturally, but it shows what would happen if the reserve currency holder tries to drain the world's manufacturing production. This approach will ultimately impoverish everyone, including yourself. Moreover, you’re likely to end up destroying your position as a provider of global demand (recipient of “limitless” capital flows).
Depending on how you calculate it, we have been in the fourth or fifth wave of globalization. Many consider that the first wave of globalization occurred in the late 1700s, driven by the industrial revolution, and ended by the Napoleonic Wars. The second wave was in the early 1900s, when people, e.g., traveled across Europe without passports, which ended with the First World War. The third one is considered to have occurred in the 1920s, when the U.S. rose as a global banker and a manufacturing hub. The Great Depression brought an end to that. The fourth wave started in the 1970s and ended with the financial crashes of commodity producers (developing economies) also including Finland and Japan. The dot-com bubble started the fifth wave, which ended with the Corona lockdowns and the Russo-Ukrainian war. The current tariff-wars look to finalize this.
The point is that the U.S. has dominated the three waves of globalization since the 1920s. If the trade war, which probably has now started, does not end quickly with deals, it could bring an end to the century-long U.S. economic hegemony. A long trade war would force other countries to trade in their own currencies, causing the USD to lose its special status.
I wholeheartedly understand the point President Trump is making that the U.S. is being treated unfairly in trade. Yet, this is an almost inevitable consequence of having a reserve currency. The ability to create and receive financial wealth practically without boundaries comes with a cost. That cost is an inevitable trade deficit and outsourcing of manufacturing jobs, with other countries shielding their industries with tariffs. If President Trump’s tariffs are also an effort to bring down yields, there’s a much easier and less risky way to do it: to vehemently cut federal spending. Disrupting global supply chains carries significant risks, including accelerating inflation and reversing globalization.
A few simple observations can summarize the idea of globalization, which has brought all of us so much economic prosperity:
“We all inhabit this small (economic) planet.” We all seek economic prosperity. We all cherish the (economic) future of our children, and we are all born poor.
Prosperity always comes from cooperation between people and nations.
Have a prosperous weekend!
Tuomas
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