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The currency game

At the latest meeting of G-20 finance ministers, there was much discussion about currencies. Many countries are worried about U.S. intentions to stimulate its economy with monetary measures that will result in a devaluation of the greenback. This political decision aims in part to counter China’s refusal to support the yuan. The fact that the U.S. is choosing to stimulate the domestic economy with a weaker dollar is upsetting many countries, to the point where many experts fear a trade war in which these countries would be forced to adopt protectionist measures, which could seriously threaten the global recovery.

The U.S. dollar is still the principal currency of the world economy. Its devaluation has an impact around the globe. The greenback's value is determined, first, by supply and demand. Like any other commodity, when there are more dollars in circulation, the supply increases, and the dollar's value versus other currencies falls. A decrease in demand for the dollar produces the same effect. The supply of a currency can be easily manipulated by the central bank, which can print more money or electronically create easily accessible bank credit. At the beginning, no one notices any difference. The new money or the new purchasing power simply circulates through the economy. However, with time, an imbalance inevitably develops where there is too much purchasing power for the goods in circulation. To restore balance, the supply of available goods will have to be increased – which is not possible in the short term – or the currency will have to be devalued, so that it will take more money to buy the same product.

Demand for a currency is not a purely local phenomenon. Foreign governments or companies need local currencies to make transactions in local markets. For example, when a foreign company wants to buy an American company or American assets, it must obtain U.S. dollars to do so, thereby increasing demand for the greenback. Conversely, if foreign interest in doing business in the United States decreases, the U.S. dollar loses value. The U.S. market is attractive because it is diversified, liquid, big, and not very regulated.

The greenback is in a unique situation. It is the principal trade or reserve currency or anchor currency that all governments and all institutions hold in great quantities in order to have an international reserve. In addition, all commodities, including gold and oil, are traded in U.S. dollars around the globe. The greenback is the most liquid currency in the world. The exchange rate of all currencies, except for the pound sterling, is expressed in U.S. dollars. That is why demand for the U.S. dollar remains very strong.

There are certain advantages to adopting a weak currency policy. The most obvious is that it makes local products more competitive on foreign markets, thereby boosting exports, while making foreign products and imports more expensive. Countries like Japan and China have prospered greatly because of a weak currency. Devaluing one's currency by increasing its supply stimulates consumption and investment, while combating unemployment and recession.

In the long term, however, this strategy entails substantial risks. History is full of examples of governments that pushed this strategy too far, to the point where their currency lost all value. A good example is Germany from 1918 to 1923. In 1918, 5.21 marks bought one U.S. dollar. Three years later, when the German central bank had the printing presses running at full steam to stimulate the economy, it took 65 marks to buy one U.S. dollar, then 150 marks in early 1923 and, finally, 4.2 trillion marks in late 1923! Obviously, this situation is not likely to recur, especially not in the United States. Still, the global tendency to stimulate local economies by adopting a weak currency policy is worrisome. For the U.S., the stakes are high, because the dollar could lose its status as the global reserve currency.

The author

Marc Desnoyers

Marc Desnoyers

B.Sc., M.B.A., C.F.A