Understanding the Link Between the Trade Deficit and the Dollar’s Role

The news outlets talk a lot about the trade deficit and the strength of the dollar, but the way they interact is more important—and more complicated—than it might seem at first. Since the 1970s, the U.S. dollar has held its place at the center of global finance. That status brings real advantages, but it also comes with long-term tradeoffs—especially for domestic manufacturing and capital flows.

The Dollar at the Center of Global Finance

Since the end of the Bretton Woods system in 1971 (a post-WWII monetary system that pegged currencies to the U.S. dollar, which was convertible to gold), the global financial system has operated with the U.S. dollar at the center. Most cross-border trade is priced in dollars. Most international loans are made in dollars. And most foreign reserves are held in U.S. dollars—especially in the form of Treasuries.

This setup creates consistent demand for dollars (if not a constant overvaluation of the dollar). For instance, if a German company sells machinery to an Indian firm, the transaction is usually priced in dollars. Those dollars eventually reach Germany’s central bank or institutional investors, who often reinvest them in U.S. assets like Treasuries. The same applies to dollar-denominated loans between foreign entities. At this point, the world holds over $13 trillion in such debt, most of which is between non-U.S. parties. That debt needs to be serviced in dollars, which adds to global demand for the currency. In effect, the U.S. exports the global monetary base.

How Dollars Are Supplied to the World

A natural question that follows is: where do these dollars come from? The main answer is through the U.S. trade deficit. When the U.S. imports more than it exports, dollars flow abroad in exchange for goods and services. Those dollars are then used globally and often cycle back into U.S. capital markets.

This isn’t necessarily the result of any deliberate policy—it’s more of a structural outcome. The strong global demand for dollars tends to keep its value elevated compared to other currencies. That, in turn, makes U.S. exports less competitive and encourages imports, which feeds into a self-reinforcing trade imbalance. A strong dollar is typically good for Wall Street, but doesn’t serve Main Street as well.

As a result, it’s tough for the U.S. to compete in low-margin, globally tradable manufacturing sectors. What usually does well in this environment we’ve created is industries like financial services, tech, pharmaceuticals, and defense. Meanwhile, industrial capacity has increasingly moved to places like China, where manufacturing conditions are more favorable. So benefitting areas like Silicon Valley, New York City, and Washington —while hollowing out traditional manufacturing towns and the blue-collar communities that once depended on them.

What the U.S. Sells in Return

In return for the goods it imports, the U.S. essentially sells ownership in its financial system. Foreign investors buy Treasuries, stocks, corporate bonds, and occasionally real estate or private equity (the U.S. exports paper and imports labor.). Over time, this dynamic has led the U.S. to trade appreciating assets—like shares in its companies and claims on future government outlays—for depreciating goods and services (chines products and clothing for example).

As it stands today, foreign investors hold around $26 trillion more in U.S. assets than Americans hold abroad. That imbalance shows up in the country’s negative net international investment position. One way to think of it is instead of just a number, is a map of who does what in the global economy, and also whose starting to have control of who.

Political and Strategic Implications

This pattern has been in place for decades, but it’s becoming more visible in both economic and political discussions.

Domestically, many regions—especially parts of the industrial Midwest—have seen their manufacturing sectors decline. That’s contributed to political shifts and a renewed focus on reshoring production. Internationally, concerns have grown around the U.S.’s ability to manufacture key defense and medical supplies at scale. Whether it's artillery production or basic medical equipment, some of these gaps have become harder to ignore.

Rebuilding that capacity won’t happen overnight. It would require investment in energy infrastructure, supply chains, and skilled labor. Meanwhile, countries like China have continued to expand their manufacturing ecosystems, including workforce training and logistics networks. Trump was arguably the first president in a generation to treat trade policy as an extension of national security, not just economics.

It’s also fair to acknowledge that globalization helped suppress inflation for many years. Cheaper overseas labor combined with efficient global trade routes helped keep consumer prices relatively low, even as U.S. manufacturing declined. That came with both economic benefits and long-term costs.

The Latest Tariffs and What They Could Mean

These longstanding structural issues are now what Trump is trying to realign. Right now, the United States has implemented tariffs of up to 145% on Chinese imports.

U.S. imports from China have averaged around $500 billion per year over the past decade. A 145% tariff on that amount would equate to a$700+ billion tax increase, which would be a major hit to the economy and markets if fully implemented. That said, the likely intent is to use this figure as a negotiation starting point rather than a long-term policy.

China has responded with retaliatory tariffs and could take additional steps, such as selling U.S. Treasuries or using its leverage in rare earth minerals, which are essential to many high-tech and defense products.

It seems unlikely that the full impact of these tariffs will materialize. Trade volumes would likely shrink under that pressure, and supply chains take years to shift. Some categories—like phones, computers, and other electronics—have already been exempted. More exemptions may follow.

If the remaining tariffs stay in place, companies may look to reroute Chinese goods through third countries to avoid the full tariff load. That adds costs but could help maintain supply chains.

Strategic Goals and Policy Direction

Stephen Miran, Chair of the Council of Economic Advisors, recently outlined several ways other countries might help “share the burden” of maintaining global stability—whether by accepting tariffs, increasing purchases of U.S. goods, investing in domestic factories, boosting defense procurement from the U.S., or even contributing directly to the Treasury.

It marks a clear shift: rather than bearing the full weight of defense and dollar leadership alone, the U.S. is now asking allies to take on more responsibility. The underlying logic is that maintaining both global security and reserve currency status is difficult without a stronger industrial base and more dependable funding sources.

Two points are worth highlighting.

First, much of the public narrative focuses on unfair trade practices, which are worth addressing—but it doesn’t fully acknowledge that trade deficits are what supply the world with dollars in the first place. Some economists argue that the reserve system is sustained in part by ongoing U.S. trade deficits, which help circulate dollars globally. Miran has previously written about this nuance, including ideas like taxing excess foreign reserves or supporting a more multipolar currency system. So it’s not that the complexity is unknown—it’s just not the centerpiece of the current messaging since that’s a tough message to explain and campaign on.

Second, expecting other countries to go along with this approach without friction may be a tough assumption. For example, China exports more than $3.6 trillion annually, and only around $500 billion of that goes to the U.S. That gives them room to maneuver. The current U.S. strategy seems to be focused on rallying other countries to collectively pressure China—but building that kind of coalition won’t be easy, especially when other countries have their own economic dependencies on China.

How the U.S. chooses to navigate this—between sustaining global demand for the dollar and preserving its own economic resilience—will shape not just financial markets, but the country’s long-term strategic footing.

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