Will the US dollar have to devalue?

Posted by Allison on 4 April 2009, 09:58

The concept of the dollar declining, has never been one to preoccupy economists and financiers, throughout the history of the dollar.  Indeed throughout the later part of the 20th century, the dollar could do no wrong.  It simply went from strength to strength and was perceived to be the world's greatest currency.  This was particularly true after the Second World War, when it really was in its heyday.

The dollar, well it was dependable and stable.  When everything else was going wrong, you could be sure of one thing, the dollar would be OK.  The dollar was simply invincible.

Yes, it had experienced some bad times.  The Great Depression and the economic turbulence of the 1920s and 1930s had to posed a serious risk to the dollar.  But the US dollar showed that it was made of stern stuff and it wasn't going to be beaten by any depression.  No sir, this dollar did not need anti-depressants.  This dollar would fight back and then rise again like a phoenix from the ashes.

And indeed, the dollar did go from strength to strength after the Second World War.  Anyone who traveled to the Soviet Union in the days of the Cold War would remember men in leather coats approaching and asking you for dollars, or trying to sell you something and then whispering that you could pay in US dollars, anxiously and furtively looking around to see whether there were any KGB agents in the vicinity.  Yes, everyone wanted the US dollar, because it was just so dependable and strong.  After all it determined how much gold, oil and wheat costs.  It was the international yardstick for how well the rest of the world's economies were doing.  In fact the dollar really was the nation's darling, if not the darling of the world.

But then it all started to go wrong.  The sub prime lending bonanza came to a very sticky end as the credit crunch hit America.  The prices of oil, gold and wheat all suddenly went sky high and of course, the bottom fell out of the housing market.

The dollar found that suddenly, it was no longer the darling of the world.  It was beginning to look like a bit of a wilting wallflower, with very few friends indeed.  People who had been eager to court her in her heyday were no longer interested in her.  No, they had a new darling, very young and fresh faced and known as the euro.  They weren't interested in using the old Greenbacks any more, no they wanted this new currency.

Even Russia who had coveted and longed for the dollar for many, many years turned its back on the dollar and soon started buying up as many euros as she could.  Iraq also announced in 2007, that even though the United States had invaded it and are an occupying force, it didn't want dollars any more and was actually going to increase the diversity within its reserves, so that it would have more euros and other currencies as well.

And meanwhile, in the background, stood the IMF, the International Monetary Fund and they wanted to keep an eye on what was going on.

They too seemed to have fallen out of love with the dollar.  In 2004, long before the real impact of the sub prime crisis or the credit crunch, they had advocated that the US dollar should be devalued.

Fifty years ago, this concept would have simply been preposterous and indeed even in 2004, to many citizens of the USA, it seemed like a fairytale.  Devalue the dollar?  Had the IMF had a bump on the head?  Was it experiencing some kind of mental health issue? 

No one seemed to take it seriously.  Media coverage didn't really take it that seriously.  It just didn't seem as if this could ever actually become a reality.  So in effect there was nothing too much to worry about.  It would just go away and the dollar would soon the centre stage again.  After all, what was the euro, well just a 2 year old baby, that's what.  Life just went on.

Then things got pretty bleak indeed and the IMF hasn't gone away.  Indeed, if anything at all, the IMF seems to be keeping a very close eye on events and is mindful of the fact that it thinks the dollar should be devalued and it keeps saying so. 

The IMF's concerns

So what has made the usually very pro-USA IMF suddenly start to advocate that the dollar should be devalued?

The credit crunch was the most obvious thing that started to rattle the IMF.  It was concerned about the credit crunch not just in the USA, but the affects as they started to be felt in other parts of the world.  So the IMF started to see that this was not just a problem that would be contained in the USA, it was having an effect all over the world.

But other factors should also be taken into account.

First of all the US owned up to the fact that it had spent a little bit too much over the last few years.  Indeed the American debts can only be measured in trillions and once you get to trillions, it is all slightly academic because the US hasn't got the money to pay it back. 

It is the biggest debtor in the entire world and it doesn't even know when it is going to be able to pay the debt back.  Or is that an 'if' it can pay the money back?  America really does owe big time.  Its debts are in the region of just under $40 trillion, but it only raises 12.1 trillion as its GDP, so there is a little bit of a shortfall there.  Plus different figures seem to be being presented, particularly since the race for Presidential nominations began, so it is difficult to know how much the US really does owe.  So it is better to simply assert that it is trillions and it can't pay it back.

This made the IMF a little queasy.  Although to be fair to the US, the IMF should audit a country's accounts every year and give it some kind of report, so this should not have come as a shock to them.

In fact, it did not really come as a shock to the IMF.  It has been warning the US for years that it needs to get a grip on its spending and try to sort out the dollar being weak.  In addition, it has repeatedly warned that the US dollar needs to experience further depreciation so that the dollar has a chance to recover and also so that global imbalances can be corrected to restore some stability to global markets.

So in other words, the US dollar has to devalue to help out the rest of the world and to help herself.  And the IMF wants it to devalue and the IMF may even start increasing pressure to devalue.  Only time will tell on that one!

There is already as of 2008, a severe confidence crisis in the US and indeed globally, with regard to the US dollar.  Unfortunately, this makes it more difficult for the dollar to be able to recover and to start to pick up strength again.

However, devaluing the US dollar to any significant level, would send shock waves throughout the world.  Economists and financiers tend to advocate that devaluation should be a last ditch attempt to stabilise an economy.  They also point out that devaluing our currency has a significant psychological impact on a country and people will suddenly completely lose faith in their currency.  So a devaluation would not be a pleasant experience.

Can the IMF force the dollar to devalue?

Theoretically this question should be a very easy one to answer.  The IMF is the police officer, charged with policing economies around the world.  So in theory, yes the IMF can force the United States government to devalue the dollar but since the IMF actually has a large share of the voting rights allocated to the US, then it would effectively mean that the rest of the world practically, would have to gang up on the US, to make this happen.

So why doesn't the US government devalue the dollar?

Any decision to devalue the US dollar would be a very difficult decision indeed to take.  Politically, it would be suicide.  Although President Bush is coming to the end of his administration, were he to announce a devaluation of the United States dollar, then he would be remembered for two things: going to war in Iraq and devaluing the US dollar.

It is unlikely that he would wish his legacy to be these two items, so the issue is simply left hanging in the background.

However, in June 2008, the US government, through the Federal Reserve Bank started to indicate that because the dollar was so weak inflation was starting to creep up.  The chairman of the Federal Reserve Bank, Mr Ben Bernake gave a speech in which he admitted that inflation was higher than they had anticipated it would be and also that the dollar was weaker than it should be.

He also advocated that the United States should endeavour to have a strong dollar. 

However this may be easier to say rather than to do.  The chairman was confident that the dollar is about to rally and recover.  But, some financial experts believe that this was a way it of trying to instil confidence back into the dollar, so that people would perhaps spend a little more, thereby putting more money back into the economy.

It is almost as if he is trying to boost confidence and as confidence increases the dollar may actually rally. 

One way in which the Federal Reserve Bank may be able to avoid devaluing the dollar is actually by raising interest rates in order to defend the dollar.  It has actually cut interest rates seven times already and this has done little to alleviate the situation.  Indeed, the situation seems to be getting worse.  Partly this is down to straightforward economics.  The less interest that is paid on any currency the less attractive an option it looks, in terms of foreign investment.  So the Feds cut the interest rates to help out its citizens but as a result the dollar starts to lose even more foreign investors and also fewer countries want to have that currency as its reserves.  So there is a self fulfilling cycle.

But there really is a very big risk that if the Federal Reserve Bank raises interest rates and the dollar doesn't rally, then people will not just have lost faith in on the dollar but in the Federal Reserve Bank as well.  Once they have lost confidence in the Federal Reserve Bank, things actually look quite bleak indeed.

Indeed, this may actually lead to the IMF increasing its calls for the dollar to be devalued.  So if the Fed does raise interest rates, then the United States and indeed the rest of the world needs to hope that it works.

A more optimistic approach

Some economists in the United States feel that the current anxiety which is being felt about the dollar, is actually misplaced.  United States lived through the Great Depression and the recession of the 1930s.   Indeed, during the 1930s America looked very much as if she were teetering on the brink of collapse.  Yet by the end of the Second World War, the United States had actually accumulated most of the gold reserves in the entire world.

In other words, the United States had managed to come from the brink of collapse, to being a very strong, if not exceptionally strong economy within 15 years.

Economists tend to believe that the cycle of boom and bust is an integral part of the capitalist system.  The US has seen a number of boom years, so now it is facing a period of downturn, but this could be viewed as inevitable and simply part of the capitalist economy, that is essentially, the heart of the United States.

So not everyone feels that the dollar needs to be devalued and many people feel that it will actually recover as part of its natural cycle. 

Implications for the rest of the world

If the dollar were to be devalued, there would be huge implications for the rest of the world.  Historically, the dollar has been the currency used to stockpile as reserves, for nations all over the world.  These nations would find that their reserves would be devalued as a result of the dollar being devalued.

Obviously, this is not a situation that either the United States or any other country would wish to see happening.  Hence devaluation is basically the last chance saloon and the decision to devalue would only take place after the dollar had fallen significantly, from its value as of June 2008.

Devaluation would have an enormous effect on countries all over the world, who are reliant on the US in terms of subsidies and aid.  So it is not just the countries that have been wealthy enough to stockpile US dollars who would feel the effect, most countries in the world would also find it very difficult to cope with a dollar that has been devalued.

Devaluation will not happen

So it is fairly safe to predict that the dollar will experience some natural devaluation, as it remains fairly weak.  However, realistically, the US dollar will probably not be devalued by the government or the Federal Reserve Bank, they are likely to avoid this move at all costs.

Instead they will institute policies to try and encourage the dollar and help it to regain at least some of its strength.  In the interim, it probably will dip at least to some extent and this is where the natural devaluation comes in.

But to devalue the dollar as a deliberate, political act is simply not feasible.  The dollar may be weak, she may have lost a lot of her strength, but it is still the number one currency in the world and despite the fact that the euro is now a rival to the dollar, the dollar is still a very important currency.

So despite the predictions of gloom and doom and the warnings of the IMF, full devaluation of the dollar does indeed look unlikely.  However, there is one saying that does spring to mind and that is 'Never say never'.  And still there, almost unacknowledged is the little problem of US debts and how exactly, they are going to be repaid, if they ever can be.  If they can't then what happens to the people who made those loans in the first place?  These creditors may ultimately be the casualties in the battle of the dollar and they will certainly feel the pain.