by Bill O’Grady

This week, we continue our discussion on trade by examining the reserve currency issue.

What is the reserve currency?
When a country runs a trade surplus, it creates excess saving that must be either invested overseas or held as foreign reserves.  If a gold standard is being used, the excess saving/foreign reserves can be held as gold (or other precious metals).  In theory, reserve managers can hold just about any asset as foreign reserves.  However, if the ultimate goal of generating saving is to build the productive capacity of the economy, then the best foreign reserve assets should be safe and easily convertible, with broad acceptability in markets.

Here is an example we often use to describe why the reserve currency is important.  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 $1,800 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 limit his purchases to Paraguay because the guaraní isn’t widely accepted.  The seller in Côte d’Ivoire would be able to buy a wider variety of goods (or have wider avenues for investment) from selling cocoa if he receives U.S. 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 to run trade surpluses with the reserve currency nation to accumulate the reserve currency, which allows them to pay for imports from around the world.

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by Bill O’Grady

In this multi-part report, we offer several reflections on trade that we hope can provide some insight into how to use macroeconomics to judge the veracity of certain claims.  In Part I, we laid out the basic macroeconomics of trade.  This week, in Part II, we will discuss the impact of exchange rates and examine the two models of economic development, the “Japan Model”[1] and the “American Model.”[2]

The Japan Model of development calls for policies that drive up household saving.  This is usually done through financial repression and wage suppression.  This model is designed to provide cheap investment funds to build up the productive capacity of the country.

In contrast, the American Model of development relies on foreign investment.  In this arrangement, the trade deficit is an import of foreign saving for investment.

As a review from Part I of our report, the following saving identity means that the private investment/savings balance (I-S) plus the public spending balance (Govt-Taxes) is equal to the trade account, M-X (Imports less Exports).

(M – X) = (I – S) + (G – Tx)

If a nation’s saving equals its investment and it runs a balanced fiscal budget, then it will run a balanced trade account.  It doesn’t matter what the exchange rate is or what trade policy is in place; if the private and public sector balances, there will also be balanced trade.

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[1] We call this the Japan Model because it has been adopted by Asian nations for development.

[2] We call this the American Model because it is how the U.S. acquired saving during its industrial revolution, which began in earnest in 1870.