In theory, floating exchange rates were supposed to allow economies to reduce trade deficits by letting the currency adjust. A weaker exchange rate would drive up the cost of imports and make exports more competitive, thus reducing deficits. Under fixed exchange rates, the economy would have to be constricted to eliminate imbalances, reducing imports and lowering prices to make exports more competitive. That's a more painful process than the seemingly benign adjustment of the exchange rate to bring things into balance.
That's what the textbooks said anyway. The reality has been more complicated.
It's the flow of money that dominates the flow of goods, not the other way around. Governments, moreover, manipulate the quantity or the value of money to their ends, which is also outside the textbook model.
The rest of the world holds dollars as investments. Foreign central banks use dollars predominantly for their reserves. Dollar-based financial markets are the deepest and biggest in the world. In other words, the liabilities of the U.S. are the main assets of the rest of the world.
This has conferred on the U.S. something that King Midas couldn't imagine. We can effectively print dollars and the rest of the world takes them. Imagine what you'd do with a money-printing press in your basement. You'd spend like crazy on stuff. Or you'd acquire real assets, such as houses.
Extend that notion globally. Since the rest of the world takes our paper money, we get to acquire their products or assets in exchange. As a result, America can spend more than it earns and save less than it invests. The difference is made up by foreigners accepting our dollars and lending them back to us.
The clearest example is China. Its massive trade surplus with the U.S. gives it boatloads of greenbacks. The textbook says that would make its currency, the yuan, rise, which would make Chinese exports dearer in world markets. That's the last thing Beijing wants as it tries to keep the economy growing at 8% to provide jobs and maintain social stability.
So, China's central bank accumulates billions and billions of dollars, which it invests in U.S. securities. Much of that money went into Fannie Mae and Freddie Mac securities, which in turn helped finance the U.S. housing boom. But the bulk of China's dollars went into U.S. Treasury securities, which helps fund the budget deficit.
Americans should realize that the nation's most successful export isn't Coke or Boeing airliners or Microsoft software or even Hollywood films. It's the dollar, which is accepted around the world as a store of value.
Under the current floating exchange-rate system, the U.S. wasn't limited by the gold in Fort Knox as to how many dollars it could issue. It was limited only by the willingness of the rest of the world to accept greenbacks in payment for their goods and services.
But, for the first time since the early 1970s, America runs the risk of being constrained by international considerations. Nixon could get around them simply by abrogating the promise to maintain the dollar's value in gold. Now, America's main creditors could impose the discipline on the U.S. that gold couldn't.
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Source:
http://online.barrons.com/article/SB123793604883731531.html#mod=rss_barrons_markets
Very good BUT you left out that the party which lost power now believes that its route back to power is to sink the US economy so they can say "I told you so" and get their people elected again. Yes, the economy is rough but we have now a group of leaders who truly want to solve the economic problems not just blame others for what they created.
Well, there goes the dumb blond stereotype!
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