How globalized is the world’s economy?
Can two unrelated events, in two different countries be, in fact, connected? There are two events that took place recently, one literally falling through media cracks, while the other was widely circulated.
The first one is Japan reducing its holdings of US Treasuries, which is quite telling for a country that ranks second among such holders. The second was Trump’s order to impose tariffs on aluminum and steel imported into the US.
This article will explore the reasoning behind both actions, to show how integrated the world economy of today is. The consequences of the tariffs announcement are not limited to what happens to the US domestic industries or their competitors in other countries, but extends its reach to 80 per cent of global transactions dominated by the dollar.
Before delving into the main argument, allow me to provide a historical context that is quite relevant to the subject.
One of the very first things that they taught us in economics was that when the US sneezes, the entire world catches a cold. This was most apparent in 2008, when worldwide investments in the US as well as the role of the dollar ensured that the ramifications of the failure of multiple US banks were felt across the globe.
The roots of such financial and economic connectivity go back all the way to the two World Wars, when the initial US entry was through war provisions and then extending debt to Europe. The flocking of European gold into the US, and more specifically Fort Knox (where that gold is kept, next to a military base though), transformed the world of finance and economics as we know it.
And at a certain point in its history, the US owned more than 60 per cent of all gold reserves in the world.
Nothing exemplifies the conventional wisdom at the time more than this quote by George Bernard Shaw: “You have to choose between trusting to the natural stability of gold and the natural stability of the honesty and intelligence of members of the government. And with due respect for these gentlemen, I advise you, as long as the capitalist system lasts, to vote for gold.”
Basically, here’s what happened. The US was paid in gold for its war provisions and for its loans, extending in return further debt facilities in US dollars that were pegged to gold at $35 for the ounce – yes, that’s the same gold that is today worth more than $1,300 per ounce.
In other words, if you held an ounce of gold back then, you could get $35 from the US for it. The availability of massive gold reserves in the US allowed the expansion of its dollar base, without a matching expansion in gold reserves.
The printing of US dollars to cover annual shortfalls between government revenues and expenses fueled the national debt level, which was further exacerbated by consumers borrowing and spending. Openness to trade increased consumption of imports that directly substituted American-made products, creating another shortfall in the amount of dollars coming into the economy versus dollars leaving it.
When countries in the late 1960s and early 1970s demanded gold for their dollar holdings, the US printed more dollars. Realizing that the US could not meet all of its dollar obligations, the convertibility of dollars for gold was suspended during the Nixon presidency, replacing gold with faith in the US economy, and its prospects.
The US today does top the world in its gold reserves, matched with a national debt level that exceeds $20 trillion.
Half a century later, the domestic situation in the US economy has a story of its own to tell. The Federal Reserve hiked its rates three times last year and intends to do the same this year.
With inflation at bay; the dollar is enjoying a broadly stronger position relative to other world currencies. A stronger dollar, and higher Fed rates, would attract investments into the US – inflows of dollars.
A stronger dollar would also help pay off US debts, the $20 trillion, and subsequently partly resolve the fiscal deficit issue. A stronger dollar also increases purchasing power that could translate into higher imports. And imports exceeding exports results in a trade deficit and an outflow of US dollars.
The introduction of tariffs? An action that takes direct aim at trade deficits to stem the outflow of dollars, despite the fact that imposing them on aluminum and steel would hurt US’ domestic industries as much as it would hurt international competitors. With that in mind, do you think the US cutting its corporate tax rates before imposing tariffs was a coincidence?
Now, how does the above historic context and what’s happening in the US economy today, including the newly introduced tariffs, fit into why Japan is trimming down its holdings of US Treasuries?
First, the levied tariffs target all countries that export aluminum and steel to the US, with Canada and Mexico exempted. Among those, Japan and China own more than 30 per cent of US Treasuries, perceptibly increasing their holdings since 2000. China and Japan, however, have reversed direction in the past five years, and their US Treasuries holdings have been trending downwards, reaching a historic low in November 2017.
The selling of US Treasuries does serve the general direction the US is following in raising Fed rates and strengthening the dollar. So how can the selling of US Treasuries be bad?
One, higher rates and a stronger dollar attract investments, desired and actioned upon by the US, and aided by the selling of US Treasuries by China and Japan. The relative net result: inflow of dollars into the US.
Two, a stronger dollar increases American purchasing power, part of which goes into buying additional imported products, culminating in a higher trade deficit. The relative net result: outflow of dollars.
Three, tariffs make imports of steel and aluminum more expensive, and directs consumer spending towards domestically made products, subject of course to how negatively affected are domestic industries by the tariffs. The relative net result: retaining dollars in the American economy.
All in all, the various actions taken by the US serves a singular interest of attracting and retaining investments - dollars - in the US economy to spur economic growth. Meanwhile, China and Japan’s selling of their US Treasurie’ holdings strengthen their own currencies and attract capital into their own economies.
In conclusion, the old financial system secured the US’ role in today’s financial and economic world. Faith in the US replaced gold as a guarantor of dollars owned and circulated worldwide, with holdings of US Treasuries being a reflection of that.
In a much more integrated financial and economic system compared to that of the 20th century, a corporate tax rate cut and/or introduction of tariffs in the US are actions that affect international markets and hence of individuals and their investments. Whether or not your country’s currency is pegged to the dollar, the strengthening or weakening of other currencies, through selling of US Treasuries for instance, directly impacts your own purchasing power.
What will be interesting to observe in the coming years is how various self-interest driven actions by different countries will play out in a global game that is no longer a zero sum one.
The last question that I want to leave you with: what happens if selling of US treasuries continues, joined by more major holders of the same?