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On Dollars In Global Trade

Here’s a letter to a new correspondent; pardon the wonkiness:

Mr. K__:

Thanks for your kind words about my 2008 book, Globalization. Thanks also for your reasonable question about my argument that all dollars spent by Americans on imports will eventually return to America either as demand for American exports or as investments in America. Specifically, you write:

What I failed to understand is this: Why should the foreigners receiving US dollars spend those dollars only in the US? Since dollars are accepted globally, they can spend them on buying goods or services in other countries. Most countries hold US dollars as foreign reserves to fund their imports. So, dollars don’t have to be spent in the US.

The simple answer is that this worldwide willingness to accept dollars ultimately rests on worldwide confidence not only that these dollars can be spent or invested in America, but also that the global demand for American exports and investment opportunities is sufficiently high that these dollars eventually will be spent or invested in America.

Suppose that Hans, in Norway, exports $1 million worth of fish to Steve in America. Steve pays Hans in dollars. Suppose further that Hans himself wants nothing whatsoever from America. Are his dollar holdings then worthless to him? Of course not. Hans goes to his Norwegian bank and converts his one-million dollars into kroner, which he then spends or invests in Norway.

We must now ask: Why is Hans’s bank in Norway willing to hand over to Hans one-million dollars worth of kroner in exchange for one million monochrome portraits of George Washington? The answer must be that the owners of Hans’s bank – or, more likely, other customers of Hans’s bank – want to spend or invest at least one million dollars in America.

Now change the example a bit. Suppose that no one in Norway wants to buy or invest in America. Would Hans’s dollar holdings then be worthless to him? No. Hans will still be able to convert his dollars into kroner as long as (1) someone somewhere on the globe wants to spend or invest at least $1M in America, and (2) Norwegians want to buy at least $1M of imports from some country other than America.

Suppose, specifically, that Juanita in Mexico wants to invest $1M in a factory in Texas. To do so she needs one million U.S. dollars. To get this $1M Juanita exports $1M worth of tomatoes to Norway, which Norwegians happily purchase. She receives full payment in U.S. dollars – here, the same U.S. dollars that Steve earlier paid to Hans for the latter’s fish. Juanita now has the one-million dollars that she then invests in Texas.

In both examples, if a moment after Hans accepted payment of $1M of U.S. currency for his exports to America everyone outside of the U.S., including Hans, developed such an aversion to anything American that under no circumstances would any non-American want to spend or invest as much as a cent on anything American, Hans would find his $1M to be worthless. And had Hans anticipated this development, he of course would have refused to accept U.S. dollars as payment for his fish exports.

But in reality non-Americans continue willingly to accept U.S. dollars – practical proof that people worldwide continue to want to spend and invest in America.

The story gets somewhat more complicated – too complicated to explain here – when we recognize that the high global demand for U.S. dollars can result in large numbers of dollars remaining, either ‘circulating’ or stuffed figuratively into mattresses, outside of the U.S. indefinitely. In this case the purchasing power of those dollars nevertheless returns to the U.S., but it does so in the form of increased purchasing power of the dollars that remain in circulation in the U.S. The essence of the matter remains unchanged: We Americans need not fear that that our economy will suffer a deficiency of aggregate demand if we increase our imports and the particular foreigners from whom we import don’t immediately spend or invest all of those dollars in the U.S.

Donald J. Boudreaux
Professor of Economics
Martha and Nelson Getchell Chair for the Study of Free Market Capitalism at the Mercatus Center
George Mason University
Fairfax, VA 22030