How does the US export inflation?

March 6th, 2007

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In our previous article, Marc Faber on why further correction is coming?Part 2, we mentioned that the glut of US dollars contribute to the expansion of global liquidity, which result in price inflation and asset bubbles all over the world. Today, we will discuss how it happens.

First, we will delve a little into international trade. Normally, when a country has a trade deficit with another, its currency will depreciate as there is a greater outflow (i.e. supply) of its currency to foreign markets. That will result in foreign imports becoming relatively more expensive (in term of its currency) and its exports relatively cheaper to foreigners. As a result, foreigners will then import more its goods and services, increasing the demand of its currency, which in turn will reverse the outflow of its currency. This will continue until equilibrium is reached.

For the US, because of the special status of its dollar being the world?s primary reserve currency, this conventional arrangement does not really apply (NOTE: there are doubts on whether the US dollar can retain its reserve currency status for long and some may argue that it is no longer so. For the purpose of this article, let us regard that today, the US dollar has, at the very least, some semblance of being the world?s primary reserve currency). Since foreign countries accumulate the US dollars as a form of ?savings,? the demand for US dollars is more than just an implicit demand for its goods and services. Hence, the ?saved? US dollars that foreign countries accrued have to be ?saved? somewhere by recycling them back to the US (usually via the purchase of US Treasury Bonds). We mentioned before in Awash with cash?what to do with it? that

The US, being in the enviable position of having its money as the world?s primary reserve currency, is not subjected (for now) to the same rules as the other countries?it can spend more than it earns simply by printing its own dollars to pay foreigners.

Through this convention, the US can expropriate resources from foreign countries by buying their goods and services with its own printed money. Since the exported glut of US dollars has to return home through the foreign purchases of its Treasury Bonds, they do not remain within the US economy to cause the problem of price inflation.

What about the case in foreign countries? When foreigners receive their US dollars, they have to convert these US dollars to their domestic currencies for domestic use. Where are the domestic currencies going to come from? If left to market forces alone, the glut of US dollars will bid up the price of domestic currencies, resulting in a sharp appreciation of the domestic currencies. An appreciation of the domestic currencies is highly disadvantageous to those foreign countries because that will cripple their export industries which they are highly dependent on. Furthermore, over the past decades, US industries are losing their competitive edge. Foreign countries have less of an incentive to use their surplus US dollars to purchase US goods and services. This have come to a point where they have so much excess US dollars that they do not know what to do with it. The only option then is for the foreign central bank to devalue their domestic currencies by printing them.

That is why when the US opens up their spigot of US dollars and engages in a global spending spree, foreign countries have to follow suit by inflating their own money supply so that their currencies will not be overly expensive relative to the US dollar. The result is worldwide synchronised price inflation and asset bubbles.