How does the US economic supremacy work? US dollar and confidence

How does the US economic supremacy work? US dollar and confidence.

No market view, just a few interpretations.

The world holds more than 60% of  its reserves in USD. That is because oil is traded in USD and consequently most of international trade is done in USD. China manufactures everything and sells in USD and then prevents it’s currency from appreciating, thereby accumulating more US dollar. China then invests these dollars in US treasuries, thereby lending to the customer after realization of sale proceeds. Therefore we can say that the production was done for the Americans and then the money is given to the Americans for safe keeping. Central to this cycle is the world’s confidence in the American political and financial system and the world’s requirement to hold USD for their own credibility.

In India we say that India has received foreign capital in the form of FDI and portfolio flows in a particular year, but then the central bank accumulates reserves (since 2013 at least) and then invests in US treasuries, therefore repatriating the capital back to the US in the form of US government lending. Thus it is just a credit swap wherein the US investor takes the risk of the Indian business succeeding and India takes the safety of the US government not failing.

This story goes around the world and ironically in spite of the US being a developed country and a lower growth country than let’s say an India or a China, the US remains a net receiver of capital from other countries, primarily through central bank reserve holdings. This allows the US to spend, more than the next 10 countries put together, on its defence budget, ensuring a global military supremacy which facilitates the confidence to attract more reserve flows. Making it a cycle (vicious or virtuous, is debatable).

Thus the US is uniquely placed in the world and its growth model is not similar to let’s say a China. China needs to manufacture more to keep its economy going. Manufacturing can grow only if China is able to export, which requires a weaker currency. Since no one lends to China the way they do to the US or since Chinese credit rating would be far lower if it were not for China’s USD 3 trillion + reserves, China needs the US to buy to remain credible. On the other hand the US has reserves of USD 120 bn only showing that it is not dependent on other currencies or assets (like gold) but it is dependent on the world’s confidence in the US dollar and the US machinery.

Thus the US need not be a factory to the world and make its citizens work for 14 hours a day like an Asian economy. Consequently the US is a service economy with 75%+ of the GDP contribution coming from services. The US can continue to maintain a current account deficit (and a wide one) as long as it maintains the reserve currency status. If you have a current account deficit by choice then from a growth perspective it’s important to have a stronger currency (in the GDP equation net exports is negative to the GDP sum or simply the opposite of the Chinese model!). This is what Mnuchin means when he says that a strong US dollar is important for the USA in the longer run. It is an enviable position for any other country as this ability to maintain deficit and still attract capital is what gives the US citizens a higher standard of living with lesser effort, relatively.

On the other hand a weaker dollar reduces the ability of the American consumer to spend and takes the inflation higher. A higher inflation is like a spanner in the growth wheel and rate hikes would soon follow to prevent the economy from growing. A weaker dollar after a point would also indicate reducing confidence in the American system which is counterproductive to attracting capital or the existing reserve holders who would start panicking.

With confidence going down in the EU post Brexit and before the 2017 elections in Netherlands, France and Germany (may be Italy too), the reserve currency status of the USD is stronger than it has been in the last decade. China doesn’t have the political fabric that (in my view) is a pre requisite to attract the same quantum of reserve currency allocation like the USD or even the Euro for that matter.

Thus at least in the visible future it’s unlikely that the US model changes and unlikely that the US makes its citizens work in factories when they need not. One President might feel so citing jobs as a problem (that’s an easily sellable problem), but the fact is that US is near full employment and has added more than 2 million jobs per year for the last 3 years with a strengthening dollar!