A correspondent asks: “I can see that the government might devalue a currency backed by gold by simply decreasing the amount of gold it will pay out in exchange for the banknotes, but how would it devalue a fiat currency? Also, what is meant by the fact that the dollar is the world’s premier reserve currency? What is a reserve currency? Why do foreigners need one? What do they do with it?”
The devaluation in effect becomes an even more straightforward (even a continuous) process, absent any formal peg or commodity backing. Simply put, the US keeps on, in so far as it can, encouraging excess credit creation, while signalling to its trade partners—as Secretary Snow has been doing—that it no longer wishes them to hold all the excess dollars they accumulate as a result of America’s trade imbalances. If the appetite of the holders declines and the supply is unabated, the price will surely follow —witness the past several months.
If this fails, the US Treasury can become more active and simply instruct the Fed to sell dollars and to buy others’ currencies on the open market, as was most notably done after the Plaza accord of 1986. This can happen without limit if need be! The term ‘reserve currency’ means that - absent gold - the USD has been seen, since WWII, as the least worst alternative and forms the basis for much pricing in the international trade in goods and commodities (notably oil, of course) and is thus held as a monetary asset by other central banks.
Foreign central banks—at the end of 2002—held over $1,750 billion USD out of total foreign exchange reserves of around $2,300 billion around the world. Five Asian nations alone have added another $340 billion to this latter number so far this year—well over $1 bln a da—of which the bulk (though not the totality) will have been in USD.
These banks issue domestic reserves against these dollars and so effectively import the inflation the US is exporting - for example, the Chinese, who now have 20% money supply growth, partly as a result, with all the arising Austrian School problems of asset booms and resource misallocation this brings, and which their authorities are belatedly trying to control.
