The Trump administration will to be radical. Making America Great Again, again, looks like it includes plans to make the dollar less great. That will create new enemies and huge risk, within and without the USA. Trump II agenda will frighten central banks, businesses and governments worldwide. While it may not initially hurt investment returns, the long-term consequences are highly unsettling, including previously unimaginable ‘reform’ proposals to the institutional architecture of the dollar. This is deliberate; a response to the long-running misery to working Americans wrought by the currency’s ‘exorbitant privilege’. Many will be sceptical that these proposals are instituted, even more sceptical they will successful. Even their articulation opens a new challenge to dollar dominance. And this is the point. They have a chance of success. But they come with great risk. An adjustment to dollar dominance may be good for America, but equally it could encourage a general loss of confidence with highly destabilising effects, especially in bond markets. Tinkering with an unstable but essential structure is a high-risk venture.
If the Trump II aim is rebalancing the dollar, many of the policies espoused will initially strengthen the dollar, which appears contradictory. Whether through tax-cutting boost to business, undermining of central bank autonomy, support for crypto, the benefit of increased US global economic influence, especially manufacturing is hoped to offset the cost of reducing the dollar’s reserve status. The dollar’s ‘exorbitant privilege’ is deployed to harm its own dominance, deliberately in the hope of better balance in the US economy. This is the political prerogative of a hegemon and responds to a long-running export of US manufacturing capacity in exchange for reserve dominance. But wow! The risks are huge. Damage may be felt by Treasury markets and other currencies and assets, all of which rely, eventually and irrevocably, on stable, globally accepted reserve dollar. Until now.
The two main policies of tariff increases, and tax-cuts are linked, with revenue from tariffs pencilled in to provide space for tax cuts. It’s an unorthodox economic approach, but it has support from the evidence of first Trump term. While tariffs are often seen as a tax on consumers, they are rarely seen as direct substitute sources of revenue. But they were in 2018-19 and there appeared to be little impact on domestic inflation or consumption, contrary to conventional wisdom. There seems considerably less certainty about the revenue generating capacity of tariffs this time around; because the ambition is bigger and the imbalances are higher.
If the first term Trump presidency was a prototype, the second term may move into full scale production. They aim to divert the cost onto third parties, either by directly absorbing the cost, or via currency adjustment or substitution of tax for tariff. A “universal” tariff of perhaps 20 percent on imported goods is mooted, and a 60 percent tariff (or more) on Chinese imports. Specific mid-range tariffs may apply to the EU, which has been described as the ‘mini-China’ by the president-elect.
Consequences follow such massive tariffs; not all of them obvious. While the public encouragement of US enterprise over foreigners may be an easy sell to domestic audience, the balance of payments and trade effects are highly complex, especially with unequal tariff imposition which opens many routes for circumvention.
The balance is fragile. Reducing reserve status, and its perceived drawbacks, through industrial policy, may help manufacturing in theory, but an ‘unscheduled disassembly’ of the Treasury yield curve would cause many more problems.
To date, the trade balance is indirectly tied to the success of US equity prices, and Treasury funding by foreigners. The ‘consumer of last resort’ epithet awarded to the USA is simply the obverse of ‘investment of first resort’ for global money managers. This applied both the reserve assets (Treasuries) and to foreign investment in American shares.
Even if Trump reduces foreign imported goods, foreign investors are not, initially, likely to reduce their desire to hold US equities. In fact, the demand for US assets may increase with rising tariffs, on the assessment that America fiscal policy support and the likely gains from a trade war mean the country continues to dominate the industries of the future. That appears to be the conclusion of investors since the election result. The optimistic mercantilism which encouraged foreigners to invest in China 20 years ago could be repeated by America – and thereby reversed in China. If that transpires, the dollar is likely to continue its recent rally. But a policy error, too much success in reducing the reserve status will lead to exactly the opposite problem – with wholesale liquidation of US asset holdings by foreigners.
This apparent perversity (and danger) fits with the established Trump doctrine; question all conventional logic, sometimes with the hasty creation of new ‘truth’. Robert Lighthizer, almost certain to fill an important economic role in the administration, adopted a convincing version of this attack when he cited U.S. International Trade Commission studies on tariffs from the first Trump presidency. “They found that domestic production increased in every single industry — a result in the real economy that these (traditional economic) models all assume could never happen.” Just because experts say it shouldn’t work doesn’t mean it won’t be tried. Proving experts wrong is often the main aim.
Fiscal policy will certainly remain stimulative from a government keen to demonstrate its support for economic growth. This is industrial policy. The deficit is unlikely to fall much below 6% and may rise. Continued government spending is likely to keep Federal Reserve rates and dollar at higher levels than otherwise.
Add all this together makes heads spin and may make portfolios spin. We are in a place that angels have feared to tread. Which means the new administration is probably in need of mitigation strategies.
The proven and most effective mitigation for macro-strategy invariably involves intervention by the central bank. Ironically, Donald Trump has shown no sign of attempting to make friends here. Perhaps he relies on the implicit guarantee offered by the Fed as ultimate guardian of the currency. They will step in automatically no matter what state of relationship between White House and FOMC.
The suggestion of extending political control over the central bank is risky. And Trump’s stated aims are by no means the most extreme in his entourage. Others suggest apparent support for its abolition. If this is an attempt to exert pressure towards lower interest rates, it may result in exactly the opposite.
At a recent press conference Jay Powell, Fed chairman, sharply put down the possibility that he may be sacked by the incoming president: ‘not permitted by the law’, he said. The Fed chairman can only be removed with ‘cause’ which would ultimately be decided by the Supreme Court. Conflict between POTUS and Fed will complicate monetary matters considerably. The mere attempt at influence by Trump would be damaging to the Fed’s credibility which is an essential support to the sanctity of Treasury debt. To some extent that is already given. Treasury yields are already at higher levels than otherwise. Official rates may follow. Especially as new policies prove, against expectations from Team Trump, to be inflationary.
The consequences both of the dollar’s privilege, and the threat to that privilege are growing. Far from foreign threats to the dollar emerging, the greatest advocate for change now comes from inside the United States, and is the more convincing because of this. The global dominance of US equity and bond markets has reached levels never seen before. The new approach by Trump to financial and fiscal stability by US institutions threaten all investors. This is what making the sole reserve currency ungreat looks like.