What Would The Dollar Devaluation Mean For The Global Economy?

Federal Reserve Bank Cleveland

What Would The Dollar Devaluation Mean For The Global Economy?

In times before a global pandemic, there were three theoretical reasons that a country would want to devalue its currency. 

  1. Firstly, it’s a great way to boost exports. By making your currency cheaper in comparison to other countries, you make all your goods cheaper too. The hope is that there is an influx of money coming from outside sources. 
  2. Secondly, countries can devalue their currency to reduce trade deficits because imports will start to lessen as they become too expensive. All the while exports continue to rise minimizing that trade deficit. 
  3. Lastly, some countries devalue their currency so as to make their fixed debt payments cheaper. Over time, if their currency is worth less, those fixed amounts become less of a burden to pay. 

However, these are all very simplified reasons, and in practice, there are many other forces at play that can materially reduce the impact that devaluing a currency can have. For example, other countries can follow suit and start to devalue their own currency which stops the efficacy of a weaker currency in the original country. This is very much a risk at the moment given the worldwide economic troubles that all countries are seeing. 

But what would happen if the US dollar started to lose its value? 

As the world’s reserve currency, when the Dollar is weaker, it can have big repercussions on the global economy and individual countries themselves. And what does it mean during a time when the world is trying to navigate itself out of a pandemic that is breaking global supply chains and putting the brakes on productivity?  

Even before the pandemic, there was worry enough that a number of countries were in difficulty. In particular, emerging market economies, which have to issue debt in overseas markets, were struggling to pay back previous issues. A number of emerging market economies had seen their exports increase due to a weakening of their own currency against the dollar. While this can be useful at times, it sadly has the effect that their debt burden increases. 

Now, the pandemic has made that situation even worse due to a collapse in productivity within countries. As a result, the IMF has seen a huge surge in applications for help and funding from many nations. 

The Fed’s Reaction To The COVID19 Crisis

Initially, though, the effect of the pandemic did do one thing, which helped many in financial difficulty. Given the unprecedented times, the US Federal Reserve undertook a huge financial aid package to help the US markets from seizing up and support its native businesses from going bust. The result was increasing the world’s supply of dollars. 

The knock on effect meant that more entities could buy the world’s reserve currency, which is the norm during a crisis. Dollars are bought to hedge against risk and are commonly seen as a flight to safety. 

What The Increase in Supply Of Dollars Can Mean

Being aware of the impact of the Dollar’s currency movements on the world stage, the Fed has had to continue to supply US dollars through short term lending facilities. This is to make sure that cheap dollars are available to countries to help them fund their ever increasing budget deficits. As demonstrated by the huge amount of applications to the IMF, the amount of countries witnessing an increase in their budget deficits will most likely cause a considerable drag on the global economy’s ability to grow. 

What Are The Bigger Implications Of A Devalued Dollar? 

Given that we have had a brief glimpse into what happens when the market is flooded with dollars in an attempt to stabilise markets, what would an even bigger decline on the dollar mean? While global economics is a complicated and intricate beast with many forces at play at any one time, a decline in USD may actually help the world’s economic output over a long horizon despite the impact it may have on inflation. 

For, the pandemic has been a seismic shock to the world in recent months and one that continues to rage. The magnitude of the economic crisis being felt around the world has exposed weaknesses in the IMF and its ability to help those that approach it for aid. For the global economy to grow again, a devaluing of the dollar can help countries continue to pay their debt obligations. Without it, default rates may increase with huge consequences to countries already struggling to cope with the practical implications of the coronavirus.

But the biggest implication of a much devalued dollar may be that other currencies may step into the limelight to try to take the title of the world’s reserve currency. This would be a huge shift in world economics, but it is possible. In fact, in some areas, it has already been seen by some countries who try to disassociate themselves from the dollar – notably, and perhaps predictably, Russia.

What Will Stop The Dollar From Being Materially Devalued?

There are a couple of things protecting the dollar from it losing its crown. Firstly, the turmoil in the markets at the moment has created enough worry that the demand for dollars is huge as investors seek safety. Secondly, the Fed has moved quickly in the crisis and at speeds that far outstripped their reaction in 2008. This has helped underline its power on the global stage.

Ultimately, however, the US may do all it can to stop the dollar devaluing by too much. It will want its dollar to remain strong so that it can pay off its own deficits and remain the superpower it is.

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