Fiat Currency and Trade Deficit

The United States has one of the largest trade deficits in the world. Many critics have been of the opinion that it is only because of the existence of fiat currency that such huge imbalances are possible. These critics believe that if the world were to return to a gold standard, these imbalances would resolve themselves completely. Some others believe that the trade imbalances will be small and manageable under a gold standard. However, almost everyone agrees that trade fiat currency does have a major role to play in these trade deficits.

The Link between Fiat Money and Trade Deficits

Many economists are wary of the supremacy of the United States dollar in the post-World War era. The US dollar was delinked from gold in 1971. President Nixon took the world off the gold standard which meant that the dollar was no longer different from other currencies. In fact, all the currencies of the world had to compete.

However, United States was the dominant economic and military power of the time. As a result, all countries needed to trade with or invest in America. In order to do so, they first had to convert their local currencies or gold reserves into American dollars. The demand for American dollars therefore skyrocketed.

Hence, America could continue to print huge sums of money and yet not feel the effects of inflation. This is because foreigners tend to take away a huge share of these dollars and store them as “reserves”. If another country printed as much currency as America is doing right now, their economy would be ruined by hyperinflation. However, America’s economy has been insulated from inflationary shocks because of the high demand for US dollars. This is the reason that their economy is functioning unhampered even though the US is not following prudent policies.

America has been receiving this exorbitant privilege for many years. Other countries of the world have to produce goods and services. They then sell these goods and services to America. America just has to print money to pay for these goods and services. Hence, America is simply exchanging green pieces of paper for valuable goods and services. Hence, it would be correct to say that fiat currency is fuelling these massive trade deficits. If the world were on a gold standard, America would not be able to consume goods and services of the same magnitude. This is because the United States would be unable to produce gold and pay for them.

It is important for America that the dollar stays in demand. If foreign countries no longer need dollars, they will try to redeem them by buying goods and services from America. If all the countries do this at once, the flood of dollars that has been stashed abroad will return to the United States all at once. This is likely to cause hyperinflation in the United States. This hyperinflation will be sudden and hard to predict making it impossible to mitigate this risk.

This is the reason why it is very difficult for America or any other country to go back to the gold standard without causing absolute mayhem in the markets.

Would There Be No Deficits Under a Gold Standard?

It would be incorrect to say that there would be no deficits under a gold standard. Temporary trade deficits will be possible. However, it would be impossible for these deficits to persist for a long period of time.

For instance, if America were to indeed return to the gold standard, a lot of companies would want to set up their factories in the nation. Hence, in the short run, it would appear like a lot of tractors, machines and goods are flowing into the United States. The world would continue to call this a trade deficit. However, this deficit would not be bad for the economy. This is because the factories and other capital goods will enable the production of goods at a later date and the deficit will be reversed. Hence, the trade deficit would only be temporary and manageable.

Under a gold standard, Americans would not be able to perpetually import consumer goods such as electronics and apparel. This is because they will have to pay for them with gold. Since these items are consumption items, America will not be able to continue making payments. Sooner or later, they will run out of gold. This will happen before the deficit blows out of proportion like it currently has.

How Gold Standard Corrects Deficits

Under the gold standard system, the country that exports maximum goods receives increased quantities of gold. As a result, the price level and inflation in such a country also increases by leaps and bounds. This makes it less competitive and as the prices rise, the exports become expensive and therefore less attractive. Hence, this system tends towards equilibrium. Excessive imports, as well as excessive exports, are automatically corrected. This prevents countries from having their financial futures entangled with other countries that may not be following prudent financial policies.

Hence, from the point of view of trade deficits, a gold standard is a much more stable as well as robust system as compared to fiat money.

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