Why the world needs a weaker dollar

By Guest Contributor
October 8, 2010

IRAN-CURRENCY/RATE/Kathleen Brooks is research director at forex.com. The opinions expressed are her own.

Ever since the last Federal Reserve meeting when the prospect of further policy stimulus for the US gripped the market, dollar weakness has been the dominant theme in FX. The Fed action is considered in some quarters as a backdoor form of currency devaluation, and there has been talk of a global “currency war” as a result.

But is a weak dollar really that bad for the global economy? Those countries who argue yes tend to concentrate on self-preservation since a weak dollar makes higher yielding economies’ exports less competitive. Since everyone wants to be able to sell to the US – the biggest single consumer market in the world – when the dollar moves in any significant direction the world takes notice.

Already Brazil and South Korea, whose currencies have risen strongly this year, have embarked on capital constraints to try and dissuade “hot money flows”, amid fears that a strong currency will derail economic growth. Chinese premier Wen Jiabao even went so far to say that a rapid strengthening of the renminbi against the dollar would be a “disaster for the world.”

Is it really as dramatic as the Chinese premier seems to think? There is a strong case for a weaker dollar and it all has to do with the spectre of deflation that hangs over the developed world. The current average inflation rate amongst the G10 economies is on the low side at 1.5 per cent. If you strip out Australia and the UK – both economies with high levels of inflation- the rate drops to a meagre 1.2 per cent. Combined with a weak growth outlook, especially for western economies facing fiscal austerity, this keeps the threat of deflation alive and well.

The problem with deflation is that most economies are unprepared for it. It can depress demand as consumers delay purchasing in the hope of lower prices in the future, this, in turn, causes unemployment. It also depresses asset values, which weighs on investor confidence creating a negative spiral of low or anaemic growth that can last for a long time (read Japan’s lost decade).

A weaker dollar is a crude cure for deflation. Since commodity prices from food stuffs to oil and industrial metals are all priced in dollars, a weak greenback means commodity prices go higher. This puts upward pressure on inflation and, more importantly, it helps keep consumers’ price expectations in positive territory, which avoids the negative growth spiral I mentioned before. It should also eventually lead to higher stock prices, which boosts investor confidence.

Granted, deflation is not an issue for most of the emerging world. Inflation in India is rising at nearly 10 per cent annually, Argentina 11 per cent and Turkey 9.2 per cent. Higher commodity prices would most likely require higher interest rates, thereby putting more upward pressure on their currencies.

But short-term pain can be long-term gain. Deflation would depress demand in the developing world, which is negative for exporting emerging economies. It’s in their interest to want strong developed markets, and a weaker dollar is one way to get this. Hopefully, the IMF meeting this weekend will see the world’s top finance ministers find a cordial solution to the “currency war” that takes note of the fact that developed economies need a weak dollar to re-flate their economies.

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