Have you ever wondered how billionaires continue to get RICHER, while the rest of the world is struggling?

I study billionaires for a living. To be more specific, I study how these investors generate such huge and consistent profits in the stock markets — year-in and year-out.

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Country A trades $10 billion of goods and services with Country B, which does $10.01 billion of trade with Country A.  The two nations agree to a trade pact that enables the two nations to trade currencies directly, that is, without converting the payments for trade into a third currency such as the dollar.

Once the bilateral trade is settled, a modest $10 million remains as a surplus/trade deficit.  The owner of the surplus (Country B, in this example) can trade that excess currency on the global foreign exchange (FX) market, use it to buy goods or services, or hold it. The modest $10 million is a tiny slice of the two trading nations’ money stock and gross domestic products (GDP), and it has little effect on either global or domestic finance. The $10 million is a small claim against the currency of the nation running the trade deficit (Country A, in this case).

The main takeaway is that billions of dollars of trade transactions may yield very little surplus/deficit.

Trading currencies are examples of the transactional  nature of money: money enables transactions.

A reserve currency, on the other hand, is an example of money as a store of value. nations hold reserve currencies as stores of value that can be sold to support their own currency if the need arises.

A reserve currency is quite different from a trading currency an it must meet these minimum requirements to function as a reserve currency:

1. It must be liquid  — that is, it can be readily bought and sold on the global foreign exchange market in size. i.e. large quantities, without affecting the value of the currency;

2.  Its value must be relatively stable  — that is, it trades in a narrow range with other currencies, and

3.  Its value is set by supply and demand  — i.e. capital flows and market forces, rather than an arbitrary peg.

Many observers greet the announcement of recent bilateral or multi-lateral currency agreements as evidence the U.S. dollar is weakening.  But this is mixing apples and oranges: the U.S. doesnt gain much by issuing a currency that serves transactional needs — it offers no profit to the U.S. if trade between other nations is conducted in yen, renminbi, euros or quatloos.

The demand for transactional currency is temporary. Transact the trade, and then the cash moves on to the next transaction.

The demand for reserve currency is not transactional. A nation that wants to build reserves must  acquire the reserve currency and hold it.

Nations that issue reserve currencies must issue enough of their currency to satisfy the global demand for reserves, and the only way to do this is run substantial *and* permanent trade deficits.

Triffin’s Paradox/Dilemma

This brings us to Triffin’s Paradox, which has two basic parts:

1.  Any nation that issues the reserve currency must run a trade deficit to supply the world with surplus currency to hold in reserve and as a result,

2.  The issuing nation faces the paradox that the needs of global trading community are generally different from the needs of domestic policy makers.

The global trading community requires that the issuer of the reserve currency run trade deficits large enough to satisfy the demand for reserves, while domestic audiences want a strong export sector, i.e. a trade surplus.

You can’t have it both ways: if you want to issue a reserve currency, you have to run a trade deficit that is commensurate in size with the global demand for your currency.

Since supply and demand set price, this push-pull affects the value of the U.S. dollar: U.S. exporters want a weak dollar to spur foreign demand for their products, while foreign holders of the USD want a strong dollar that holds its value/purchasing power.

It is impossible for any nation to maintain the reserve currency and  run trade surpluses. If you run trade surpluses, you cannot supply the global economy with the currency it needs for reserves, payment of debt denominated in the reserve currency and domestic credit expansion.

Why Hold Reserves?

Why do countries need reserves in the first place?  The answer can get complicated, but the basic dynamic is supply and demand: if Nation A prints vast quantities of its own currency (let’s call it the quatloo) and uses the cash to buy goods and services without creating an equivalent amount of goods and services to sell to other nations, it will run a large trade deficit.

The supply of quatloos will soon exceed the demand: everybody who accepted freshly printed quatloos for their exports wants to trade them for goods or unload them as soon as possible. As a result, the value of quatloos on the global FX market falls, and Nation A is in danger of plunging into a currency crisis: as the value of the quatloo declines, the price of imports rises within Nation A, and soon people can no longer afford imports from other nations—for example, grain and oil.

One way Nation A can support the value of its quatloos is to sell its reserve currency and use the cash to buy quatloos, soaking up the excess supply that is depressing the quatloo’s value. So currency reserves act as a stabilizing anchor for the nation’s own currency.

There is another often-overlooked role for currency reserves: they act as the asset base for the expansion of credit within the domestic economy.  A central bank with substantial reserves can issue credit in the domestic currency commensurate with its holdings of assets such as gold or currency reserves.

The Supply and Demand for Dollars

There are number of reasons why nations might choose to buy or sell U.S. dollars, or assets denominated in dollars such as Treasury bonds. Let’s start by noting that the dollar is not the only reserve currency; the USD is roughly 62% of global currency reserves, the euro is about 25% and other currencies make up the balance.

Nations might sell dollars and buy another reserve currency to diversify their holdings, hedge against a decline in the dollar relative to other reserve currencies, or perhaps as a form of geopolitical weapon or protest against American hegemony or specific policies.