Special thanks to Jeff Epstein of Activist MMT for his assistance with this article. If you want to listen to Jeff and I discuss this article on his podcast, please visit here for Part 1 and here for Part 2 of our interview.
Why would anyone want to save in another country’s currency, and what impact does this desire have? We must answer this question before we can make any predictions or recommendations about economic policy. If we don’t know why people desire or find value in another country’s money, then we tend to accept whatever explanation we hear from the people in charge. In other words, without a satisfactory answer to this question, we can only make predictions and recommendations that reflect the institutional incentives of those in power, rather than those that reflect the best way to mobilize a country’s resources.
Many economists believe that, for the United States, net saving is due to the petrodollar; this petrodollar theory contains elements of truth, but ultimately falls short of a comprehensive explanation. The reason why anyone would want to save in another country’s currency is so simple on its face that the mind rejects it, and that rejection prevents a deeper exploration that would reveal a complex, yet intuitive and empirically true description: People want to save in another country’s currency because they think they might need it to buy that country’s Cool Stuff with it later.
Defining Cool Stuff
“What is Cool Stuff?”, you ask. Good question! A country’s Cool Stuff consists of all of the goods that
A country makes in greater numbers than most other countries, and
Would be difficult for most other countries to start making.
So, a country’s Cool Stuff includes all of the goods that it is somewhat unique in being able to make and are desired by others. In other words, it’s the stuff that would be more difficult to buy if you didn’t have access to that country’s currency. The larger a country’s market share for a particular type of Stuff and the more difficult that Stuff is to make, then the Cooler it is. For example, out of 218 countries, the United States of America manufactures and exports more aircraft, spacecraft, and parts for aircraft and spacecraft (“ASPs”) than any other country. According to the Observatory for Economic Complexity, out of 96 product categories, ASPs are the 33rd-most complex kind of Stuff to manufacture and export. Consequently, the US’s Cool Stuff includes ASP.
On the other hand, out of 218 countries, Venezuela produces the 177th-most ASPs, so Venezuela’s Cool Stuff doesn't include ASPs. On the other hand, the USA is also the top exporter of refined petroleum, but in another product index containing 961 products, refined petroleum is only the 748th-most complex to manufacture and export, so the USA’s Cool Stuff does not include refined petroleum. In fact, because refined petroleum is not relatively difficult to produce according to this metric, it’s not included in any country’s collection of Cool Stuff. A country that produces a lot of Cool Stuff is a Cool Country, and a country that doesn’t produce a lot of Cool Stuff is an Uncool Country.
Now you know what Cool Stuff is, but how do you buy it? We need a country’s currency to buy its Cool Stuff because the people who make it are paid that currency, and those who sell it need to pay the people who make it. The makers and sellers need that currency because they have bills to pay in that currency – including their tax bill. Therefore, the sellers of Cool Stuff tend to demand their own country’s currency in payment. At some point, ASP manufacturers in the USA will need US Dollars to pay their taxes or other debts, so they generally price their products in US Dollars and accept US Dollars in payment. I call this particular aspect of MMT the Cascade of Liabilities. It means that if you want to buy American ASPs today, you also need US Dollars, and if you want to ensure that you can buy American ASPs down the road, you need to save US Dollars. You could save Mexican Pesos, but then your ability to buy US ASPs tern years from now depends on the exchange rate; if Pesos decline against the Dollar, then you will not be able to buy as much as you planned. (You could also get lucky and be able to buy more, most people don’t want to take that gamble.)
Our hypothesis suggests that we should see people accumulating and saving some amount of foreign currency to decrease transaction costs and to protect themselves against exchange rate fluctuation, and empirically, this is exactly what we see. Businesses maintain accounts in several currencies for exactly these reasons. In contrast, we should not expect people to save in the currency of a country which produces Uncool Stuff because Cool Stuff is difficult to get, while Uncool Stuff can be obtained in many places.
Trade between Cool and Uncool Countries
Now we know why someone might want to save in a foreign currency, but what happens when everyone wants to save a particular country’s currency because its Stuff is especially Cool? We should expect people in Uncool countries to sell their Stuff to the Cool Country to get the Cool Country's currency. The people in Cool Country probably have much less desire to save in the Uncool Countries’ currencies. This means fewer goods – Cool or not – will be sent to the Uncool Countries. When taken together, the difference between these two groups of transactions is reflected in the balance of trade.
Said another way, when people in Uncool Countries want to save Cool Currency more than people in Cool Countries want to save Uncool Currency, the Cool Country will naturally run a trade deficit, and the Uncool Country will naturally run a trade surplus. However, if the government of the Cool Country enacts policies to favor balanced trade or a trade surplus, we will see a different result.
Contrary to popular belief, a large trade deficit can provide evidence of the strength of an economy, although it is only one of many pieces of evidence that must be considered. However, it’s critical to note that neither a trade deficit nor a trade surplus are inherently good or bad. As people in the Uncool Countries accumulate Cool Currency, they will save some of it and spend some of it now. The Cool Country needs to have the productive capacity to meet that spending desire. This means that a Cool Country’s exports do not need to match the amount of the currency it sends to the Uncool Countries, but it does need to match the current desire of the Uncool Countries to spend the currency it sends them.
For example, say Canada sends 100 Canadian Dollars (CAD) to Japan, and the Japanese recipients save 25% of it and spend the other 75%. This means Canada needs to export 75 CAD’s worth of goods. This is only a problem if Canada cannot produce enough goods to satisfy this export need and its own people’s needs. If Canadians want to buy 125 CAD’s worth of goods and Japanese people want to buy 75 CAD’s worth of goods, then the Canadian economy needs to produce 200 CAD’s worth. If it cannot, then one of three things will happen. Imagine that the Canadian economy can only produce 150 CAD worth of goods. Either:
The Japanese buyers will buy 75 CAD worth of goods, leaving 75 CAD worth of goods for the Canadians to buy, resulting in domestic price increases because they want to buy 125 CAD worth of goods and there is not enough to go around;
The Canadian buyers will buy 125 CAD worth of goods, leaving 25 CAD worth of goods for the Japanese buyers, resulting in a depreciation of the CAD in the foreign exchange market because it no longer buys what it was supposed to be able to buy; or
Both the Canadian buyers and the Japanese buyers will buy fewer goods than they desired resulting in both domestic price increases and currency depreciation. (Perhaps the Canadian buyers will buy 100 CAD worth of goods and the Japanese buyers will buy 50 CAD worth of goods.).
In any case, it is not the trade deficit itself that causes the price increases or depreciation but the inability of the domestic economy to produce enough goods to meet the desire to buy its Cool Stuff. (Please note that this is only one of many reasons why currencies depreciate; much currency movement is the product of financial speculation. See the Note below for more details)
Should we run a trade surplus?
So far, we’ve learned that a country which produces a lot of Cool Stuff may naturally run a trade deficit, which is not necessarily bad, but the governments of most countries want a trade surplus or at least balanced trade, so let’s explore what that would mean. India currently has a trade deficit of around $20 billion. To close this deficit, they can encourage exports (such as through subsidies), discourage imports (such as through tariffs), or some combination of the two. Each of these strategies result in fewer domestic goods available for Indian buyers, which will put upward pressure on the price level for consumer goods. If the Indian government subsidizes exports, more goods flow out of the country, leaving fewer goods for Indians to buy. If the Indian government discourages imports, Indians have less access to foreign goods and are forced to buy domestic goods, leaving fewer domestic goods available for purchase. Consequently, the effort to achieve balanced trade will often result in domestic prices rising which is usually harmful.
We know that attempting to force a reduction in the trade deficit can be harmful, but which countries can run persistent trade deficits safely? If the Cool Stuff Hypothesis is correct, we should expect that the countries running large trade deficits (and not going through economic crises) will consist of the Coolest Countries with the Coolest Stuff. This is indeed what we see. Of the ten countries running the largest trade deficits, eight are in the upper half of the Economic Complexity ranking. Of the remaining two, Bangladesh and Pakistan, the latter is going through a currency crisis.
It is mostly countries with a high degree of economic complexity that can maintain trade deficits without negative consequences. This leads us to an important insight about the Cool Stuff Hypothesis, which is that the more Cool Stuff a country can export, (the Cooler a country is), the less it needs to export. We see this empirically (as discussed above), but the Hypothesis predicts this as well: the Cooler a country's stuff is, the greater the desire to save in that currency will be. If the desire to save is high, the desire to spend must necessarily be low, and consequently, the country can maintain trade deficits.
The mere fact that a country might import more goods than it exports is immaterial. Instead, what matters is whether a country sends out more of its currency than the rest of the world is willing to save, and whether that country can produce enough to meet that total desire to spend its currency.
Application to the Petrodollar Concept
Many economists and commentators believe the United States can run persistent trade deficits only because oil is priced in US dollars. According to them, if the US ran trade deficits without forcing countries to sell oil in USD, foreigners would accumulate dollars that they had no desire to spend or save, and the value of the dollar would plummet, causing hyperinflation in the United States. In other words, they suggest that the United States economy is only “propped up” by the petrodollar. However, according to the Cool Stuff Hypothesis, what matters is the decision to save in a currency, and the ability to purchase oil abroad is only one factor affecting the desire to save in USD. In other words, the Cascade of Liabilities has many branches, and oil is only one branch. Even if you could not use USD to purchase oil outside the United States, the US would still be the world’s top exporter (and a net exporter) of products such as aircraft, spacecraft, and parts thereof (ASPs), medical instruments, combustion engines, chemical products, refined petroleum, and arms and ammunition, and it would still be among the top exporters of other products, such as integrated circuits and unpackaged medicaments.
A mass flight from the dollar would imply that no one in the world had any desire to save dollars. This would mean there was no more interest in affordably purchasing these critical items, some of which are the most difficult and complex to manufacture. Global demand would be concentrated in other countries, since everyone would be buying only from non-US sellers, effectively reducing supply and driving up prices for those items. For example, if no one outside the US bought planes from the US, then many people would have to buy them from the next-largest producer, France. French planes would consequently become more expensive. This state of affairs cannot continue indefinitely; eventually people will decide that they don’t want to pay the artificially inflated prices for Airbus planes from France and will again start buying Boeing planes from the US. Consequently, the loss of the petrodollar would not tank the US economy even if it continues to run trade deficits. Why? Because the US simply produces too much Cool Stuff.
That being said, the purpose of this article is not to convince you that the United States is a great country. In the age of climate crisis, being the best producer of weapons and refined petroleum, products that are killing our ability to live on the planet, is decidedly not a good thing. Rather, the purpose is to give readers a framework to think about how every country can create the best economy. If the Cool Stuff Hypothesis is true, then countries shouldn’t try to force trade surpluses, nor should they assume that their economy is weak if they run a trade deficit. Instead, they should determine the global desire to save in their currency and do their best to meet that desire without exceeding it – because there’s no other way to maximize the wellbeing of their citizens. Exactly how to do that is a separate question which will be the focus of a future article.
Note: Exchange Rates
The Cool Stuff Hypothesis (CSH) does not state that exchange rates are primarily determined by trade or current account deficits. Most movements in foreign exchange rates are products of speculative capital flows as investors seek higher returns, so-called "hot money". However, the need to save in a given currency to buy Stuff of the country that issues that currency can provide a partial buffer or anchor to capital flows. If firms or individuals have long-term contracts to purchase Stuff from a given country, they can only sell so much of that country’s currency. Consequently, although movements of hot money are the most important source of large exchange rate movements, a country that produces a lot of Cool Stuff is much less vulnerable to destabilizing runs on its currency. The CSH attempts to describe the part of currency valuation that is not explained by hot money; in other words, it discusses the value of "cold money." In addition, in a country with a zero-interest rate policy (ZIRP), by definition, holding that currency yields a return of zero or perhaps a negative real return. This implies that for countries with a zero-interest rate policy (ZIRP), there is very little or no hot money, only cold money. There are no investors seeking a quick return in other currencies, only people seeking of real goods and services, so any growth in currency holdings is much more likely to be a reflection of the CSH. Therefore, countries which wish to increase the international desire to save their currency while running ZIRP and eschewing hot money can and indeed must do so by producing Cooler Stuff.