US dollar depreciation will not fix debt dilemma

Edited and translated by People's Daily Online

As the U.S. debt dilemma evolves, market players speculate that the United States will try to solve its debt issue by depreciating the U.S. dollar once again. Will the United States launch the third round of quantitative easing? The Chairman of U.S. Federal Reserve Ben Bernanke has postponed the answer to this question until the latter part of September 2011. If the United States launches a new round of quantitative easing, the U.S. dollar will depreciate. However, can the U.S. debt issue be solved this way?

In the 1980s, the U.S. economy fell into stagflation and was troubled by both financial and trade deficits. In 1984, the trade deficit of the United States reached 109 billion U.S. dollar, of which half came from Japan. In September 1985, in order to re-energize the foreign trade, the United States reached a package agreement of international economic policy coordination in the New York Plaza Hotel with Japan, Germany, the United Kingdom and France to promote the orderly depreciation of the U.S. dollar against other major currencies. In the next three months, the U.S. dollar depreciated 20 percent against the Japanese yen.

It indeed re-energized the U.S. foreign trade, recovered the U.S. economy and meanwhile depreciated the actual value of the U.S. treasury securities held by Japan. By this means, the United States realized its aim of indirectly cheating its largest debtor Japan.

From the aforementioned example, it can be seen that U.S. dollar depreciation indeed worked in that historical situation, and the United States indeed benefited itself by harming others. However, the current situation is not what it was. The United States’ previously effective cure for debt has become a pill with a huge side effect, and if the United States repeats its old trick again, it will not get what it wants.

First, the devaluation of the U.S. dollar will only play a limited role in boosting the country's exports and economy. The United States maintained industrial hegemony after the middle of the late 20th century and was thus able to boost its exports and economic growth by devaluing its currency. However, it has gradually shifted its focus from the industrial sector to the financial sector since the end of 20th century.

As a result, financial services have overtaken traditional manufacturing industries as the leading contributor to U.S. economic growth. Although the U.S. Dollar Index has continued to drop over the past two years, U.S. President Barack Obama has not achieved his goal of doubling the country’s exports. The devaluation of the dollar will increase the burden on the public rather than boost the U.S. economy or solve its debt problems.

Second, the United States used to invest dollar funds in foreign countries and reclaim the funds through international trade, but now spends dollar funds on imported goods and services and reclaims the funds through debt issuance and other channels. This means that other countries in the world, especially emerging and developing countries are spending most of their dollar assets on U.S. government debt and other dollar-denominated financial products after increasing their foreign exchange reserves by exporting goods to the United States. Therefore, the weaker the U.S. dollar is, the heavier the U.S. debt burden will be, and the higher U.S. debt's share of GDP will be.

Third, the U.S. dollar devaluation will lead to a global currency devaluation race. Robert Mundell, credited as the intellectual "father" of the euro, said that as long as the international economic system is still in operation, countries are bound to ensure relatively stable currency exchange rates. Under the floating exchange rate system, any major fluctuation in the value of the U.S. dollar will cause other currencies to follow suit because other economies have to protect themselves by adjusting exchange rates.

A global currency devaluation race will definitely cause severe damage to international economic and financial activities, and the international monetary system may fall into a vicious circle of currency devaluation. If that really happens, other countries will become more eager to spend their dollar assets on U.S. government debt, shares and other dollar-denominated financial products. As a result, the United States will shoot itself in the foot and both the U.S. government and people will bear heavy debt burdens.

Lastly, the U.S. dollar depreciation will cause the devaluation of its credit. Under the current international monetary system, the U.S. dollar exchange rate is an indirect indicator of the U.S. credit rating. Thus, after carefully arranging the U.S. dollar depreciation, such as Standard and Poor's cutting the U.S. AAA credit rating, the U.S. government "endorses" its credit rating downgrade. Although it is hard to find an alternative in the current IMS, it is possible to find a new international reserve currency to replace the U.S. dollar in the credit economy time as long as the U.S. dollar continues to depreciate and fails to play its role in the stage. Until then, the U.S. has to bear the consequence of its debt problem.

In an era of globalization, in order to reduce debt risks, the U.S. government should put the development of the real economy as its top priority. Relying on depreciation to reduce the debt not only does no good but will also cause a very serious loss to the world economy.