Devaluing currencies can set off chain reactions that are damaging to a global economy.
In Southeast Asia and some other parts of the world, it seems as though the value of individual currencies has been falling like a stack of dominoes.
It's happening because the countries in these regions rely heavily on foreign trade to fuel production, feed their populations, and create foreign exchange reserves to maintain purchasing power. Using a two-country model, we can illustrate how this leads to a type of domino effect when a country devalues its currency.
If country "A" devalues its currency, for example, imports from country "B" will be more expensive. This will not become such a big problem for country "A" if it has readily available substitutes for the now more-expensive imports from "B." That is, if "A" has the labor and raw materials necessary to produce the goods itself.
Under this scenario, "B" will no longer be able to export to "A," losing any revenue associated with those sales. The short-term result will be a loss of per capita income in "B" - all because a trading partner devalued its currency. And if "A" continues to import the more expensive goods, it will either buy fewer of them or cut back on its consumption of domestic goods to offset the higher cost of imports. The country whose trading partner devalues its currency will face a decline in exports. One way to counter this is to devalue their own currency, thus ensuring that transaction costs for traded goods remain the same as before. Another domino down.
The country that devalues first may not be able to afford some imports that are crucial to the well-being of its citizens. Higher import prices increase inflation, thus lowering consumers' purchasing power. Lower consumption, in turn, dampens output.
Another downside to currency devaluation is that consumers may dip into savings to maintain their buying patterns. When this happens, the amount of money available for investing decreases, thus driving up interest rates and driving down investment.
At times like this, the government is often tempted to increase the money supply - which drives down interest rates in the short term and drives up inflation. Rising inflation further exacerbates the effects of a steep drop in the value of a currency by increasing interest rates and lowering consumer purchasing power. The domestic currency problem becomes a crisis when a society loses faith in its currency and the cost of basic transactions increases.
Countries are most likely to devalue their currency when there is a decrease in the demand for products that have a strong export potential produced by key industries that provide jobs and foreign exchange to support other domestic programs.
In the two-country model used above, the impact is felt immediately if one country over-expands and creates an output requirement that can't be met by the collective demand of both.
In a multi-country model, the impact is not as immediate if substitute markets can be found. But when transportation costs and the kind of relationships that are developed over time lead to a heavy emphasis on regional trade, the economies in a particular area of the world are often closely tied to one another. Thus, the domino effect.
The latest round of currency devaluations could lead to an even greater global crisis if the leaders of the major trading countries are not able to stabilize the markets. And intervention is not the only option. Stabilization can also mean adjusting operating procedures to free up resources to flow to those parts of the world that can provide the greatest return on investment.
Regardless of the approach taken, first and foremost there must be an approach. To do nothing is to stand by and watch while the impact grows from local to regional to global.
Unless the underlying problems are addressed by the major industrial powers, as well as the home countries, the situation will only worsen. Since the home countries are likely to take a short-term approach, the United States must step up to the plate during the next six to nine months.
Now is when our leaders are being put to the test. Let's see how they rise to the challenge.