Most countries hold their reserves in dollars, which is a safe – haven of sorts, and that is why the dollar is known as the – reserve currency – of the world.
To counter deflation’s bad effects, and to stimulate the economy – the US plans to spend billions of dollars over the next few years.
Since, the US runs a large deficit, it can finance this stimulus in only two ways:
1. Issuing Debt
2. Printing Money
As the global recession tightens its grips on countries across the world, the appetite for US debt is getting smaller. The yields on US government debt are already at all time lows, and then there is the small matter of – the stimulus that other countries need.
Countries like China, India, Japan, Russia etc. also need to stimulate their domestic economies. They plan to do this by using their dollar reserves, and buying more debt at this time is hardly feasible.
The other option for US to finance this debt is by printing money. Many countries ranging from Germany to Argentina to Zimbabwe have already done this throughout the history of the world. While, you may not see a 100 billion dollar US banknote, inflation is the natural consequence of printing money or quantitative easing and is unavoidable in the current circumstances.
Domestic Inflation effectively reduces the ability of American consumers to buy Chinese goods, Russian oil and Indian software, among other things. As prices rise, people can afford lesser goods and services.
More importantly, domestic inflation reduces the ability of the Chinese, Indian and Russian exporters to sell their stuff to US, and keep their own domestic economy going.
Inflate or Die
Faced with the increased supply of dollars in the market, other countries have two options:
1. Let the values of their own currencies rise, relative to the dollar.
2. Print more domestic currency to match the depreciating dollar.
If the central bankers allow their domestic currencies to rise, then many exporters will lose their competitive edge, and ultimately shut shop.
What if they let the dollar fall?
Developed countries like Canada who are also major exporters to the US can in fact, let the dollar fall, and allow their domestic currencies to rise. This will contain inflation, although it will impact exports, and slow the growth of their economy. Since, Canada is already a developed and rich country – it can allow that.
Countries in the developing world can’t allow a hit on their growth – because that will have severe social and political consequences.
So, there you have it, inflation export – from one country to another – due to the tightly integrated financial markets, and the reserve currency of these markets – dollar.