The world is eying US policy in regards to dealing with the current recession, and is now thinking about opting out of their stakes. Such movement could fundamentally change the economic structure of the world for good.
Emerging in the aftermath of World War II, the United States become the economic leader of the free world. Due to its industrial superiority over war torn Europe, it used this advantage to liberalize barriers trade where US products could favorably compete. The superiority of US manufacturing, and later, hi-tech, ensured the continued reign of global domination. In 1971, the US Dollar was taken of the fixed gold standard, and so become the primary reserve currency used in international finance.
To understand how the game is changing, we have to first try to understand what’s been happening. The value of currency, like all goods and services, is determined by the relative differences between the supply and demand. It may be weird to think of currency as having a price, but currencies are traded on the global market place – and traditionally valued with respect to the dollar.
There is one main way by which a country can affect the value of its currency; that’s by changing the supply in its domestic or global markets. By printing more money, the marginal value of each unit lessens. The process of adding money – but not value – to the economy is known as inflation. But why would a country want to devalue its currency in the first place?
Consider China, with which the US has the famous trade deficit. China doesn’t actually devalue its currency by inflation, but instead sells its currency, the Yuan, at below the market value. Because the value of the Yuan is officially tied to the dollar, when the Yuan is devalued, products and labor that’s priced in Yuan – goods produced in China – become cheaper by comparison. The result partly accounts for the trade imbalance.
The dollar floods into to Chinese markets, to buy cheap Chinese goods, and the Chinese people exchange dollars for yuan. If this was the end of the story, the US would be in good shape. Because the US dollar is valued overseas, we get to ship little bits of green people in exchange for products.
However, the Chinese government doesn’t want to just hang onto dollars. As more dollars come in, the value goes down and there reserves are worth less. What they have done over the past decade is take their US reserves and invest in US treasury bonds. This gives the US treasury the ability to engage in deficit spending and it lets the Chinese make a profit on their reserves. This is all profitable under the assumption that the US will not default on their bonds – an inconceivable notion only a year ago.
The problem, now, is that through Treasury money which the housing bubble was partially fueled – abetted by low Federal Reserve interest rates – expanding the amount of credit available to lend to homeowners. The problem continues, because the Treasury needs Chinese reserves to fund Obama’s and Congress’s trillion dollar spending plans.
The only way to pay this money back is if the US economy experiences real growth and taxes are levied. However, there is an increasing risk that the treasury bonds are junk, and will need to turn on the printing presses to repay the mounting debt. Obama has been promising that deficits will be cut after his first term, but this presumption is only true if he can actually reinflate the economy through deficit spending – a dubious claim, because his spending policies are actually hindering the economy’s ability to restructure its assets to more profitable ventures.
The entire US economy has been inflated with debt and now the current administration is trying to save it with more debt. It’s no wonder that Chinese officials are floating the idea of a new international reserve currency and European leaders are chastising the US for its deficit spending. The world is rethinking how it views the US dollar in the context of global finance. If the US economy suffers because we have given the government inordinate amount of control our currency and economy, we’ll get exactly what we deserve.
