The new US administration will sail into uncharted waters to address the ongoing economic decline, as President-elect Donald Trump has repeatedly pointed out – the transformation of monetary policy that followed the end of the gold standard is the core of his announced Make America Great Again strategy.
The US’s “excessive monetary privilege” has enabled the superpower
(a) to “monetize” its debt, that is, to issue an unlimited amount of currency and then “absorb” the excess quantity into the international financial and trade system without risking inflationary explosions since, as in the case of “petrodollars”, the demand for the US currency is mandatory. It has been able to run fiscal and trade deficits without affecting growth.
(b) To use its currency as a geopolitical “weapon” and impose sanctions on any country it considers hostile.
However, this comes at a cost: Domestic production and investment become expensive and manufacturing, along with jobs, migrate to countries with cheaper labor costs.
The incoming administration of President-elect Donald Trump will likely seek to weaken the dollar’s exchange rate in order to reverse this trend.
But whether this will boost the competitiveness of U.S. exports and strengthen America’s trade balance is another matter.
The Federal Reserve’s Role
A brute force approach to weakening the dollar would involve the Federal Reserve backing the White House in rapidly easing monetary policy. Trump could fire Fed Chairman Jerome Powell and pressure Congress to amend the Federal Reserve Act to force it to discipline the executive branch.
The dollar’s exchange rate would weaken drastically, that’s probably what’s wanted. But the Fed wouldn’t be willing to discipline itself. Monetary policy is conducted by the 12 members of the Federal Open Market Committee (FOMC), not just its chairman.
Financial markets, even with a staunchly Republican Congress, would view the Fed’s independence being stripped away or the FOMC being filled with government-friendly members as an over-control of the economy – which they are prepared to punish.
And even if Trump were to “tame” the Fed, looser monetary policy would cause inflation to accelerate, offsetting any (positive) impact of a weaker dollar exchange rate. There would be no improvement in US competitiveness or the trade balance.
Alternatively, the Treasury could use the International Emergency Financial Powers Act to tax foreign official (i.e., governments) holders of Treasury securities by withholding a portion of their interest payments.
This would make it less attractive for central banks to accumulate dollar reserves, significantly reducing demand for the U.S. currency. The policy could be universal, or U.S. friends and allies, and countries that obediently limit further accumulation of dollar reserves, could be exempted.
The problem with this approach to weakening the dollar is that by reducing demand for U.S. bonds, it would raise debt yields—thus shifting the problem from monetary to fiscal policy by increasing interest payments.
This radical move could indeed lead to a drastic reduction in demand for U.S. Treasuries. Foreign investors could be led not just to slow their dollar accumulation but to liquidate their existing holdings entirely.
And while Trump could try to deter governments and central banks from liquidating their dollar reserves by threatening tariffs, a significant share of U.S. government debt abroad—about a third—is held by private investors, who are not affected by the level of tariffs.
In a more conventional approach, the Treasury could use dollars in the Exchange Stabilization Fund to buy foreign currencies. But increasing the dollar supply in this way would have inflationary effects.
The Fed would respond by “collecting” the same amount of dollars from the markets, negating the impact of the Treasury’s action on the money supply. Experience has shown that “sterile intervention,”* as this combined intervention by both the Treasury and the Federal Reserve is known, has very limited effects. These effects become pronounced only when the intervention signals a change in monetary policy, in this case in a more expansionary direction.
Given its declared stability in achieving the 2% inflation target, the Fed would have no reason to shift in a more expansionary direction—assuming its continued independence.
The Scenario – The (Historical) Mar-a-Lago Agreement like the 1985 Plaza Accord
Finally, there is talk of a Mar-a-Lago Agreement, an agreement between the US, the Eurozone and China, which would follow in spirit the historic Plaza Accord, to jointly engage in coordinated policy adjustments aimed at weakening the dollar.
The complementary steps taken by the Fed, the European Central Bank and the People’s Bank of China would lead to an increase in interest rates.
Either the governments of China and Europe could intervene in the foreign exchange market, selling dollars to strengthen their domestic currencies.
Trump could threaten tariffs as leverage, just as Richard Nixon used a rate hike to force other countries to revalue their currencies against the dollar in 1971, or as Treasury Secretary James Baker invoked the threat of US protectionism to seal the Plaza Accord in 1985.
In 1971, however, growth in Europe and Japan was strong, so rate adjustments were not a problem for policymakers in those countries. In 1985, inflation, not deflation, was the real risk, predisposing Europe and Japan to monetary tightening.
In contrast, the eurozone and China currently face the twin specters of stagnation and deflation. They would have to weigh the risk to their economies from monetary tightening against the damage from Trump’s tariffs.
Faced with this dilemma, Europe would likely back down, accepting a tighter monetary policy as the price for lifting Trump’s tariffs and maintaining defense cooperation with the US.
China, which sees the US as a geopolitical rival and seeks to decouple itself from the US economy, would likely follow the opposite course.
Thus, a supposed Mar-a-Lago Agreement would degenerate into a bilateral US-EU agreement that would not prove particularly positive for the US while causing significant damage to Europe.
- “Sterile intervention” in monetary policy is a strategy in which the effects of various types of foreign exchange transactions are minimized by limiting the amount of currency available for exchange with foreign currencies.
This approach is sometimes used as a means of preventing a currency from gaining additional strength and potentially harming that country’s export economy by discouraging transactions in that currency.
Sometimes, this approach has proven successful and helped reverse an undesirable economic development.
In other cases, the solution can do the exact opposite, sometimes leading to economic recession for the country issuing the “sterile” currency.
