Both Prongs Are Bent and Blunt

Whatever its merits, the glaring hole in a policy of devaluation is that every other aspect of Trump’s economic policy program militates against it. The extension of Trump’s 2018 Tax Cuts and Jobs Act (TCJA) alone, both as fiscal stimulus and because it implies an even larger budget deficit, will prove inflationary and attract more capital inflows, prompting the Federal Reserve to raise interest rates, strengthening the dollar in the process. Tariffs, both through their immediate effect on import prices and their indirect effect of lowering the value of other country’s exports, will only exacerbate the problem because they will weaken the value of other currencies relative to the dollar.

It is tempting to think of tariffs as a geopolitical cudgel through which the United States can extract currency revaluations as a concession. But this picture is complicated by the close ties that firms such as Apple and Tesla have to China, which is both home to much of their production and the primary target of trade levies. Shorn of its rhetoric, then, Trump-Vance was never actually a weak-dollar ticket, regardless of their actual intentions.

There are other ways the approach doesn’t add up. The key assumption is that other countries have gained an “unfair” competitive advantage in global trade by “manipulating” their exchange rates, skewing foreign-exchange markets to keep their currencies low against the dollar. With its capital controls, which restrict the flow of money in and out of the country, and aggressive currency interventions, in tandem with production subsidies and suppression of domestic demand, China is accused (not without basis) of “flooding” the market with excess capacity.

Apart from arbitrarily designating exchange-rate management — a staple of any competently run open economy, which has aided the lifting out of wretched poverty of hundreds of millions in China and elsewhere — as “manipulation,” this assumption indicates a misunderstanding of what drives the accumulation of dollar assets by foreign entities, the actual source of persistent demand for dollars both when the US economy is weak and and when it’s strong.

The Incessant Demand for Dollar Assets

The dollar’s role as the world’s key currency doesn’t just derive from the composition of central bank reserves (60 percent of which are dollar denominated) but primarily from the fact that just over half of global trade is invoiced in dollars. To finance these trade flows, foreign entities accumulate cross-border liabilities in dollars. Servicing and posting collateral for this mountain of dollar-denominated office debt requires a constant stream of dollar-denominated assets. The total value of this debt is, according to some accounts, as much as $60 trillion when including the liabilities of non-US shadow banks.

The United States does not have capital controls and boasts highly liberalized and integrated financial markets and deep, liquid markets in benchmark assets like US Treasuries. The eurozone, by contrast, issues too few debt securities to create significant demand for its currency, and China’s capital account remains closed.

The result is a world in which firms want to hold their balances, the proceeds of trade, in dollars. And an inevitable feature of this world are massive capital inflows to the United States, the flip side of the current account deficit so maligned by the Trump administration. During economic downturns, such as the recent overlapping crises that shook the world in the wake of the pandemic and Russia’s war against Ukraine, risk-averse investors rushed into dollar assets. This is one end of what analysts have called the “dollar smile“: the US has a currency that appreciates (and renders its trade less competitive) during times of weakness, while other currencies bleed.

While they misidentify the source of dollar strength, Trump and Vance et al. have inadvertently stumbled onto something real about the dollar system in its current iteration: in the long run, it doesn’t serve the interests of American workers.

This is not because a permanently weaker dollar would rejuvenate manufacturing; exchange-rate fluctuations, while they do affect the distribution of capital goods production globally over time, aren’t key to explaining US decline. What is more, trade and capital flows are driven less by exchange rates and interest-rate differentials and more by demand. However, a persistent capital account surplus — that is, more money coming into a country than leaving it — causes a number of other distortions over time.

A Weaker Dollar Would Be Stabilizing . . .

For one thing, the nature of the offshore dollar system is one of the key reasons for the 2008 financial crisis. The incessant demand for dollar-denominated assets, driven by the growth of global trade and the “savings glut” of the global rich, and the structure of global wholesale money markets explain how what started as an asset bubble in the US real estate market escalated into a global financial crisis. This demand facilitated rampant real estate credit fraud and fed the securitization food chain of the banks that ended up hawking mortgage-backed assets to the world. The resulting crisis (and the insufficient fiscal response to it) left devastating and lasting scars on the US economy that even the big fiscal programs of the early Biden administration couldn’t paper over.

The distributional effects of the dollar system are particularly devastating for developing countries, whose dependence on access to global capital markets for trade integration confines them in a straitjacket of wage suppression, fiscal austerity, and high debt-servicing costs. The stronger the dollar, the higher the cost for these countries to service dollar-denominated debt and accumulate dollar reserves to prop up their own currencies and financial sectors. The surge of the dollar in recent years hit emerging markets’ balance sheets especially hard.

But the effects are also felt at home. While it might be hyperbole to describe the dollar’s supremacy as an “exorbitant burden” (instead of an “exorbitant privilege”), it has other deleterious effects. One of them is the inflation of nontradable goods as a result of capital inflows. This is implicated in the “cost disease” that has befallen much of the service sector in the advanced economies and that has outmatched benefits derived from the deflation in the prices of imported consumer goods. In addition to the inflation of housing and retail rents in most urban areas, the cost of educational and health care services in particular have strained the social fabric of a country already suffering from secular decline.

This might not seem obvious when one looks at how the dollar fluctuated over time. In real trade-weighted terms, the dollar has had its ups and downs over the last decades. Thus, blaming dollar strength per se might seem misguided. The information conveyed by the exchange rate alone, however, is misleading. Rather, it is a question of how the dollar is overvalued relative to economic fundamentals. The ostensible benefit of floating currencies is that, as countries develop, their exchange rates can appreciate to reflect fundamentals, primarily gains in wages and productivity growth. If US productivity growth were to keep up with that of its trading partners, the dollar exchange rate would remain flat. This hasn’t happened. The implication is that the real dollar is more expensive than it should be.

But the Odds Are Stacked Against It

There are various proposals on how to achieve a permanently weaker dollar. Increasing the deficit with a low-multiplier (i.e., not very growth-enhancing) fiscal stimulus (in the form of large, regressive tax cuts) is one way. There is a sense among some experts that the demand for safe dollar-denominated assets cannot be infinite given ever-ballooning trade and budget deficits and higher debt-servicing costs. But the recent economic stress that aided Trump’s reelection was associated with supply-shock-induced inflation in tandem with monetary tightening. And Trump’s tariffs and migration policy both imply a self-inflicted supply shock. It will thus be hard for him to commit to a Reaganite fiscal policy without producing a Paul Volcker–esque (hawkish) monetary policy response.

It is not surprising, therefore, that Trump has committed to appointing a very dovish Federal Reserve chair once Jerome Powell’s term ends in 2026. Such an appointment might delay any interest-rate response, and if markets are concerned the central bank is keeping rates lower than cyclically warranted, their reaction would certainly put pressure on the dollar.

If the primary drivers of dollar appreciation are global portfolio flows, perhaps the most obvious solution lies in tackling the capital account surplus directly. One idea that merits attention is the proposal of economists like Michael Pettis, championed by Republican senator Josh Hawley. Here the aim is to reduce capital inflows by levying a tax on them. The problem with this proposal is that the primary beneficiaries of these inflows consist of the most powerful sectors in the country, chief among them Wall Street and the drunk-on-venture-capital tech sector. Overcoming this coalition is akin to storming the heavens.

(Such a revolution would also, by creating a tax on onshore dollars, likely lead to a rush into offshore “eurodollars,” US dollars held outside of America, of which one of the centers is London’s real estate market, which the author of this piece doesn’t want to be priced out of.)

A more elegant and plausible way to weaken the dollar might be to create a sovereign wealth fund. At first glance, this seems like an odd proposition: the United States with its “twin deficits” has more sovereign debt than sovereign wealth. But as economist Brad Setser notes, the example of France (with its own dual deficits) and its de facto strategic investment fund, the Caisse des dépôts et consignations, shows that such a fund needn’t be financed with foreign exchange reserves. The US could sell debt and service the debt with the returns on the fund’s investment, creating a supply of dollar assets while offsetting the effects of capital inflows. This proposal, though technically plausible, would depend on some tricky congressional arithmetic and on the Federal Reserve exposing its balance sheet to these debt liabilities.

What is ultimately most likely to succeed in bringing about a weaker dollar is some grand bargain of global monetary cooperation, akin to the Plaza Accord in 1985, where the most important central banks agreed to depreciate the dollar relative to their currencies through foreign-exchange interventions. It is worth noting this agreement was preceded by a policy mix similar to the one that might result from President Trump and Fed chair Powell: namely expansionary fiscal policy and monetary austerity, which led to an unsustainable strengthening of the dollar.

Despite the subsequent Louvre Accord in 1987, aimed at stabilizing the dollar after its vertiginous decline, it only reversed its course in 1995 with the ascent of Robert E. Rubin to the Treasury and the Clinton-era elimination of the budget deficits. As Steven Solomon demonstrated in his seminal book on that era of central bank politics, The Confidence Game, the period between Plaza and Rubin — as today, a period of “twin deficits” — was one of persistent dollar weakness despite aggressive rate hikes and concomitant higher Treasury yields. This raises the question of whether the days in which markets react to higher deficits by selling off dollars (unthinkable in recent memory) might make a return. If such were the case, Trump and Vance might end up getting what they claim they want — just not the way they want it.