How Does American Currency Devalue?
Other People Are Reading
-
Supply and Demand
-
The value of currencies is based on the forces of supply and demand. When the supply of something increases--or the demand for it decreases--its value falls. When these dynamics regarding a currency occur due to a concerted effort on the part of a government or central bank, it is called devaluation. The supply of a currency is easily changed by either printing more physical notes or creating electronic bank credits, which are then lent out into the economy. Initially, this new money is perceived to have the same value as preexisting currency, but--as it circulates--the value of all the currency is dragged down by the forces of supply and demand.
Similarly, demand for a currency is determined largely by foreign governments or corporations who need the local money to conduct transactions. If the willingness of these entities to conduct business in the currency recedes, the resulting decrease in demand causes a devaluation of the currency. Devaluation is apparent in the prevailing exchange rates between different currencies. It is felt by the individual consumers reliant on the currency as a decrease in buying power and a rise in prices.
What is a Dollar Worth?
-
The U.S. dollar has the unique situation of being the world's reserve currency. After World War II, the U.S. was in a dominant financial position, having profited immensely by financing the war efforts of the allied nations. It's large industrial and manufacturing economy created demand for U.S. goods, keeping the dollar strong. The United States, at that time, also held the vast majority of the world's gold. Dollars were still redeemable in gold at that time at a fixed rate of $35 per ounce.
To fuel its growing Cold War budget, however, the U.S. inflated its money supply by printing more dollars to the point where foreign countries began to redeem the paper bills for gold rather than hold the notes.
The massive depletion of the country's gold supply prompted the Nixon administration to "close the gold window" in 1973. Since then, currency values have been based entirely on the floating international exchange rates. The dollar remained supreme, however, because it was the sole currency in which crude oil and several other commodities were priced on all markets worldwide. This created an artificial demand for dollars that allowed it to retain its value relative to other currencies.
Over the same period, however, the U.S. manufacturing base was increasingly outsourced overseas, undercutting real demand for dollars. Since 1973, consumer prices have increased dramatically, and the price of gold has increased by a factor of more than twenty.
-
Benefits and Risks
-
Though it might sound counter intuitive, there are some benefits to currency devaluation. An export economy, like the one in Japan, thrives on a weak currency. Devaluation makes the price of exports cheaper to foreign buyers, creating a competitive advantage, while the cost of domestic resources remains the same. Similarly, an increase in domestic money supply can stimulate an economy by encouraging consumption and investment, fighting unemployment and recession.
Devaluation as a long-term strategy, however, carries significant risks, the most important of which is inflation. As the dollar loses value, imports become more expensive, a major reason why many called for the devaluation of China's currency (China is a major importer into the United States).
At extreme levels, devaluation can destroy a currency entirely. History is riddled with the tales of governments who inflated their currency into complete worthlessness. Weimar Republic Germany, where a wheelbarrow full of paper currency was required just to buy a loaf of bread, is a classic example. More recently, Zimbabwe has also experienced hyperinflation of an astounding 231 million percent.
Hyper-stagflation?
-
Among the principal concerns of Americans in the wake of the credit crisis and recession that began in 2008 is a rare phenomenon tentatively called hyper-stagflation. This occurs when a currency is supremely devalued while the underlying economy remains subject to high unemployment. This is particularly painful because, as prices skyrocket, workers find it more difficult to find work or wages that keep up with the cost of living. As the government creates more and more money to stimulate the economy, prices rise higher and higher, exacerbating the problem. But another nightmare scenario also looms.
The U.S. government spends far more each year than it takes in, an estimated budget deficit of $1 trillion in 2009 alone. The Treasury relies on the purchase of its bonds (in dollars) by foreign governments to finance these expenditures, promising future tax revenues as repayment. If foreign governments were to substantially pare back their purchase of U.S. debt, federal spending could grind to a halt. At best, future generations will be saddled with the debt. In the meantime, the likely shift away from pricing of crude oil in U.S. dollars threatens such a drop in demand for U.S. currency.
-
