The Geopolitics of the Reserve Currency: Part 1

One of the more interesting developments in this presidential political cycle has been the near total abandonment of free trade. Neither presidential candidate supports the Trans-Pacific Partnership (TTP) or the Transatlantic Trade and Investment Partnership (TTIP), the topic of last week’s report. The primary reason for this backlash against free trade is the fear that U.S. employment is adversely affected by trade.

Some of the earliest work in economics was on trade. For example, the trade theory of comparative advantage was developed by David Ricardo in 1817. With perhaps the exception of Marxism, most economists assume that trade is positive for economies. Most polls seem to suggest Americans still support free trade, but clearly the political class has concluded that supporting free trade is a risky stance. So, how did we get here?

 

Dollar
Photo by NikolayF (Pixabay)

[drizzle]We believe that the general misunderstanding of the U.S. superpower role is behind the backlash against free trade. In pure theory, it’s hard to argue against free trade. Most economists adhere to the position that efficiency is an undisputable good. However, the way trade works in the real world isn’t exactly how it works in the classroom. Often, political pundits will contend that the growing rejection of free trade is due to the fact that the benefits are broad but the costs fall disproportionately on workers who are adversely affected directly by import competition. Although this is a partial explanation, it is critical to understand that the global hegemon faces specific costs that are generally unappreciated.

In this report, we will begin with a narrative describing the use of the reserve currency in trade. Next, we will offer a short history of the dollar’s evolution as a reserve currency. In the next section, we will examine the reserve currency as a global public good, provided by the superpower. Next week, we will discuss the economics and geopolitics of the reserve currency and, as is our usual fashion , we will conclude with potential market ramifications.

The Reserve Currency in Trade Imagine that a chocolatier in Paraguay wants to purchase a ton of cocoa beans. He calls a dealer in Côte d’Ivoire for a price; the seller offers $2,675

per ton. The buyer in Paraguay notes he does not have U.S. dollars but does have Paraguayan guaraní. The seller does not want the Paraguayan currency because it would restrict his purchases to Paraguay only. The seller in Côte d’Ivoire would have a wider variety of goods he could buy from selling cocoa if he receives dollars instead.

So, how does the chocolatier in Paraguay get dollars? The most efficient way would be to export chocolate to a U.S. buyer, then use the dollars he receives to buy cocoa beans from Côte d’Ivoire. Because the reserve currency has widespread acceptance, non-reserve currency nations have an incentive o run trade surpluses with the reserve currency nation to accumulate the reserve currency , which allows them to pay for imports from around the world .

To read the rest of this report, click here weekly_geopolitical_report_10_24_2016

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