Global demand for dollars as the reserve currency forces the U.S. to run persistent trade deficits to supply them. This strengthens the dollar and boosts import power but hollows out the domestic industrial base. A future decline in dollar demand would create a painful economic transition.

The danger to the U.S. dollar is not a dramatic replacement by the Euro or RMB, but a slow erosion of its primacy. This is visible in central banks increasing gold reserves, greater hedging activity, and China’s de-dollarization campaign. This gradual shift ultimately raises borrowing costs for the US government and American consumers.

Unlike exchange rate movements, tariffs are fully passed to consumers because they are an explicit tax on top of a dollar price that is already sticky. Exporters, like those in China, maintain stable dollar prices because their own imported inputs are also priced in dollars, leaving them little room for adjustment.

While U.S. fiscal deficits remain high, new tariffs are reducing the trade deficit. This means fewer U.S. dollars are flowing abroad to foreign entities who would typically recycle them into buying U.S. assets like treasuries. This dynamic creates a dollar liquidity crunch, strengthening the dollar.

A weakening dollar reduces the credit risk for dollar-borrowers, which encourages more dollar-denominated lending. This credit is the lifeblood of intricate global supply chains. As a result, exports of sophisticated goods, like semiconductors, can thrive even during periods of dollar weakness.

Despite China's growing trade surplus, its currency is unlikely to become the world's reserve currency. A closed capital account, weak government bond yields, and an incentive to keep the Yuan weak to fuel exports prevent it from being seen as a global safe-haven asset.

Despite political tensions, China's policy of managing its currency exchange rate compels it to intervene in markets, often buying hundreds of billions of dollars a month. This makes China an unintentional, yet massive, force reinforcing the US dollar's global role, not dismantling it.

While the U.S. has a monetary trade deficit, it receives a surplus of physical goods and services due to the dollar's strength. This concept, like getting a great haircut for a low price, illustrates a fundamental benefit of global trade that protectionist policies often overlook.

The common assumption that a trade deficit must cause currency depreciation is flawed. A collapse in a country's domestic demand can also correct the imbalance by reducing imports. This explains the weak correlation between real exchange rates and trade balances, as both relative prices and demand levels are key factors.