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Why You Should Care
Even if you don’t plan a trip to Europe or to buy a Japanese-manufactured automobile in the future, currency fluctuations can affect you, especially in the long term. The proliferation of U.S.-based factories for Japanese cars is driven (pardon the pun) by the long-term decline of the dollar against the yen. The abundance of cheap Chinese manufactured goods, supported by the Chinese government exchange rate “fix,” helps tame U.S. inflation, but perhaps at the expense of long-term U.S. economic strength. Currency rates can be both a result of and a cause of economic change, and you should keep your finger on the pulse of such change.
93. CURRENCY DEVALUATION AND DEPRECIATION
When thinking in an economic frame of mind, the term “devaluation” suggests bad things—less value, less worth, less productivity, less to be had or shared by all. The term “depreciation” also suggests long-term, inexorable decay. These two words, in fact, describe deliberate economic policy a nation might employ to reduce the exchange rate of its currency on the world market. While often indicating heavy medicine for a very sick economic patient, such actions aren’t always as bad as they sound.
What You Should Know
In the previous entry the role of currency exchange in the long-term economic prospects of a nation—and vice versa—were described. The distinction between floating and fixed, or controlled, exchange rates was also examined. Some countries take a more active role than others in controlling their exchange rates for clear political and economic reasons—to stimulate exports, to stimulate capital investments in their countries, and to achieve price stability within the country.
When a country fixes or closely manages its exchange rate, a central monetary authority (like a central bank) can decide to formally adopt a new fixed rate with respect to a foreign currency, usually but not always the U.S. dollar. That rate can be set by mandate or more often by government intervention in the currency markets. When a country chooses to lower its currency against the reference currency, that is known as devaluation. When a country chooses to intervene in the markets or adopt other policies that lead to a lower exchange rate, that’s depreciation.
Devaluation is overt and is carried out publicly with fixed rate control; depreciation is carried out without specific declaration or obvious action. Both actions serve to make a currency, and thus the economy behind it, more attractive on the world stage, either for foreign purchases of goods and services or for foreign capital inflows or both.
Done right, a devaluation can help an economy, but done wrong or without warning, it can be quite disruptive. Currency devaluation caused an economic crisis in Mexico in 1994. The government decided to devalue to stem the tide of imports and keep a healthy trade balance, but did it suddenly and without warning. Those who had made investments in Mexico suddenly panicked over the value of their investments, withdrew capital, and sent the economy into a short tailspin. Untimely interventions also helped cause the Asian currency crisis in 1998.
Many economists are concerned by the U.S. Federal Reserve’s apparent attempt to depreciate the dollar against other currencies. This is being accomplished by lowering interest rates and printing money in the interest of economic stimulus, and many regard it as a last-ditch effort to restore a healthy trade balance for American goods and services. But it could backfire if inflation takes root and causes America to lose its “safe haven” status for foreign investment. Similarly, and more recently, Japanese policies to reduce the value of the yen to stimulate trade and the internal economy have been met with skepticism—will they really work (especially in a “currency wars” environment where other major economies are depreciating their currencies too), and will it lead to excessive inflation later? Economists and world leaders thus watch any moves toward devaluation or depreciation very carefully.
Why You Should Care
Devaluation and the more covert depreciation can be used as short-term tools to stimulate an economy and balance it properly on the world stage. But they can also be used to stimulate an economy for short-term political gain. Such actions can be disruptive in the short term, and more importantly, can signal longer-term economic woes and unintended consequences to come. The economic forces and realities that caused these actions are often more important than the actions themselves.
94. FOREIGN DIRECT INVESTMENT
What do Pebble Beach Golf Links, Rockefeller Center, and the new Honda assembly plant in Greensburg, Indiana, have in common? They are owned, or have been owned, by foreign companies. When foreigners own U.S. property or business interests, it is known as foreign direct investment (FDI). It is the flip side of U.S. individuals or businesses owning foreign assets. The amount of—and flow of—such investment holdings can be important indicators of economic health and prosperity.
What You Should Know
Foreigners can and do buy investment interest in U.S. businesses and properties. Technically, it happens when a foreign enterprise, or its affiliate, buys at least a 10 percent interest in a U.S. corporation or asset. Foreign direct investments do not include purchases of U.S. government securities or other similar investments—another huge inflow of investment funds.
The amount and balance of FDI has changed dramatically over the years. The relatively weak U.S. dollar and the continued status of the United States as a “safe haven” against world politics and economic events have caused a steady growth in FDI. The proximity of U.S. production resources to markets, as exemplified by automotive assembly, is another factor.
According to the U.S. Bureau of Economic Analysis, FDI flows into the United States ranged from $231 million to $58 billion a
This sounds bad, and it’s easy to think that Americans are selling themselves to foreigners one floor or golf hole at a time to pay off our debts. But the reality is a bit different; in fact, during much of this period, U.S. FDI in other nations was at similar or even higher levels. As a result, the growth in cross-border direct investment signals greater globalization (see #91), and indirectly, shifts of capital flows to the locations of greatest return.
Why You Should Care
Rather than taking umbrage when you find out that the Japanese or Chinese own your favorite golf course or restaurant or car company, consider cross-border investments to be natural. After all, we own those Starbucks outlets in China and Europe, right? The need for foreigners to finance U.S. debt is the bigger problem.
95. BALANCE OF TRADE
The balance of trade, much like the balance of your own household budget, measures the difference between goods and services purchased from foreigners and the goods and services purchased by foreigners from the United States. More concisely, the balance of trade is what we export minus what we import.
What You Should Know
The trade balance, or trade deficit, has been in the news a lot during the past thirty years, mainly because it has grown substantially as we buy more goods from overseas (especially China), more raw materials (oil from the Middle East and other nations), and other goods. On the services side, as we’ll see in a minute, the United States runs a net surplus.