By Randall W. Forsyth

This April marks the centennials of the publication of F. Scott Fitzgerald's masterpiece, The Great Gatsby. On Long Island, the setting for the novel, much has changed.

The fictional West Egg, the putatively less prestigious village just over the border from Queens, today is filled with mansions rivaling Gatsby's own along Manhasset Bay. On the bay's other side, in East Egg, where the green light shone at the end of Daisy Buchanan's dock, the few remaining legendary Gold Coast estates now are public museums or village facilities. The former old-money families, including the Guggenheims, Harrimans, and Vanderbilts, have been supplanted by entrepreneur billionaires who founded companies such as Home Depot and Arizona Iced Tea. And the hedonism of today's Roaring '20s has moved out east, to the Hamptons.

This month also marks a less-remembered centennial, the ill-fated decision of the British government to restore the value of the pound sterling to its pre--World War I gold parity. That forced deflation and depression on the United Kingdom economy in the late 1920s, and would probably be remembered as the greatest blunder in the career of Winston Churchill, then the Chancellor of the Exchequer, if not for his disastrous command of the Gallipoli campaign in 1915. That catastrophe will be marked by Anzac Day, on April 24, in Australia and New Zealand, whose Commonwealth troops suffered massive casualties out of proportion to their respective populations.

The 1925 decision to restore the pound's parity was favored by the City of London establishment, with economist John Maynard Keynes providing a rare dissent because of the damage he correctly anticipated to the British economy. Sterling would be restored as a major international reserve currency, but its global importance, and that of Great Britain, would never regain their former greatness.

The U.S. now may have reached a similar point: The status of the dollar as the world's premier reserve currency is being questioned because of the policy decisions of the Trump administration. Following so-called Liberation Day on April 2, the chaotic rollout of President Donald Trump's tariff policy has resulted in declines in the dollar and prices of longer-term U.S. government securities in tandem with declines in risky assets such as stocks -- a reaction contrary to the currency's and Treasuries' usual performance as havens during episodes of market volatility. Markets stabilized in the latest week but remain on edge.

Numerous technical explanations have been offered for the behavior of the dollar and U.S. bonds. The unwinding of complicated positions by hedge funds helped to push up long-term yields. Levered positions also had to be pared as volatility jumped because of "value at risk" rules imposed on traders. It's all inside-baseball stuff, to be sure.

The fundamental problem remains. While the U.S. attempts to reduce its trade deficit, its need for foreign capital, the flip side of the payments gap, is increasing. "A policy objective of reducing bilateral trade imbalances is functionally equivalent to lowering demand for U.S. assets, as well," wrote Deutsche Bank strategist George Saravelos in a recent client note.

The notion was also discussed in this space last year.

While the headlines are all about the latest flip-flop on trade and tariffs, the root causes of the imbalances are the huge and persistent budget deficit. The most recent fundamental change in international monetary arrangements -- the breakdown of the post--World War II Bretton Woods plan in the early 1970s -- resulted from U.S. fiscal profligacy. The end of the system in which currencies had fixed but flexible rates versus the dollar, which was anchored to gold at $35 an ounce, came undone from the fiscal stresses resulting from spending for the Vietnam War and the Great Society.

The connection between the so-called twin deficits -- budget and trade -- is simple accounting, not advanced economics. In a useful primer, Chris Brightman, CEO and chief investment officer of Research Affiliates, writes that the U.S. spends more than it earns, resulting in an external (trade) deficit. Domestic savings don't meet investment needs because of the budget deficit. Foreign capital, which funds the current-account gap, has to make up the difference.

The problem, Brightman explains, is that foreign capital doesn't fund useful capital spending, unlike in the 19th century, when European investments funded the U.S. railroads and industries. "We use it to fund consumption," he writes. "Our fiscal choices, chiefly persistent and growing federal budget deficits, enable and encourage us to consume more than we produce."

Tariffs do nothing to correct this basic imbalance, targeting the symptom instead of the root cause of the problem, he argues. Closing the current-account deficit of $1 trillion would mean domestic savings have to make up for that, including budget deficits running at a $2 trillion annual rate.

But the plan is instead to use tariff revenue to help pay for the extension of the 2017 Trump tax cuts, and more. That does nothing to solve the basic problem, but merely papers over some of the gap.

The budget legerdemain is mind-boggling. As Jack Hough details in his Streetwise column, Republicans made a seemingly technical change to the budget math, asserting that the Tax Cut and Jobs Act, which under current law expires on Dec. 31, is "current policy" that should be assumed to persist. Which it won't unless Congress acts, as it is likely to do. Sounds technical, but J.P. Morgan economists estimate that the switcheroo adds $7 trillion to budget deficits over 10 years.

And that's before the Christmas tree goodies likely to be added to the "big, beautiful bill" sought by the White House. Extending the TCJA, plus the extra stuff such as liberalization of the SALT (state and local tax) deduction and tax exemptions on tips, overtime, and Social Security payments, further expands the fiscal gap and the need for foreign capital.

There's another, less-noticed aspect of the U.S. payments situation. Although the U.S. became a "debtor nation" in the 1980s, with more foreign liabilities than assets, Americans actually profited: They garnered higher returns on their overseas investments than foreigners earned on their U.S. investments.

That's changing now, according to BCA Research. "Investors accepted lower risk-adjusted returns on U.S. liabilities in exchange for perceived safety, especially in Treasuries," the firm writes in a recent client note.

That safety trade is being undermined by the torrent of tariffs, however. The likely negative supply shock from levies on imports is expected to push up U.S. inflation, which bumps up yields on Treasury notes and bonds. As a result, Treasuries no longer serve as a good hedge against declines in risky assets, such as stocks, writes Freya Beamish of TS Lombard. Canceling that insurance protection removes a big reason to own U.S. government securities.

The perception of American exceptionalism, a major lure for global capital, has thus diminished. Buying the Magnificent Seven tech stocks means buying greenbacks. Similarly, the greenback was superstrong during the dot-com boom at the turn of the century.

Since the end of the Covid crisis, the best way for a money manager to perform has been to load up on U.S. stocks, dominated by those tech names. But the widely watched Bank of America global fund-manager survey released this past week found professional investors voting the opposite way, with a record number of respondents intending to sell U.S. stocks.

Ultimately, Beamish writes, there are two ways to undermine the dollar's status as the world's undisputed reserve currency. The first is to deter capital inflows, which may be accomplished by some weird arrangement such as schemes to force foreign official creditors to exchange their interest-bearing Treasury obligations for long-term zero-coupon bonds, so as to reduce Uncle Sam's interest tab.

That possibly would address the key underrecognized U.S. fiscal problem: Federal interest expenses have eclipsed both Medicare and military spending. As noted here previously, economic historian Niall Ferguson has written that the demise of great powers has resulted from paying more to service their debt than for the military.

Our esteemed former colleague Jim Grant writes that "the dominance of the pound also happened to coincide with the long era of British naval supremacy." Now, markets hardly notice, Jim adds, that "the U.S. Navy right now is playing second fiddle to China in the Pacific."

That gap won't be closed by an executive order or money printing, given the shriveling of the U.S. fleet and shipbuilding in recent years, he wrote recently in Grant's Interest Rate Observer.

The other way to destroy the dollar, according to Beamish, would be to tamper with the Federal Reserve. This past week, Trump posted on Truth Social that Fed Chair Jerome Powell's "termination can't come soon enough."

The obvious answer to the U.S. trade and fiscal deficits is the same advice that would be offered to any debtor: Spend less, save more. Instead, we are headed to more fiscal deficits, with politically popular goodies; to extracting tariffs that raise money but boost inflation and slow growth; and to ignoring the real problems of military and entitlement spending.

However, rising deficits have gone hand in hand with higher stock prices, as Michael Arone, chief investment strategist at State Street Global Advisors, wrote. For now, the parties continue among the guests of today's Gatsbys. To paraphrase Fitzgerald, we are careless people, willing to smash things up, including the status of the dollar.

Write to Randall W. Forsyth at randall.forsyth@barrons.com

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April 18, 2025 15:14 ET (19:14 GMT)

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