The price paid for imported goods and services directly reflects the values placed on the currencies of the two countries involved. Oil is normally priced in dollars for example, so a country such as Britain pays a higher price in sterling for oil if the pound is weak against the dollar. Having a weak currency therefore makes a country’s imports more expensive but makes its exports more competitive.
Currency traders set the exchange rates between the two currencies, and there is an active market in currency futures. The futures market offers a way for a business to safeguard itself against the risk of a currency’s value changing between the time of placing an order and the time when payment must be settled. That risk is then transferred from the business to the currency trader, who must assess the relative strengths of the two currencies involved when forecasting what a future exchange rate might be. When trading within the Eurozone, using its common currency, this process is unnecessary, but trade between it and the rest of the world, and all other trade, is affected by the values of the currencies concerned.
If a country imports more than it exports, it is said to be running a trade deficit. Samuelson and Nordhaus explain the accounting for international trade in chapter 34 of Economics: the deficit must be financed by a debt to the supplier or by an inflow of foreign currency. Currency inflows can be in the form of inward investments, such as purchases of government bonds, or by going to currency traders to settle the transaction at the available foreign currency exchange rates.
America has run a trade deficit for many years, but it has received substantial foreign investment which has increased its prosperity. Dollars are still seen as safe. In many countries with weaker economies, though, a trade deficit is more of a problem. When most countries need to import goods and services, they may need to increase their money supply to pay for them – which is inflationary, as described in the previous sub-section (3.3.8.3). And the value of their currency will drift downwards in relation to other currencies (3.3.4.6) – so their imports become more expensive, further fuelling inflation.
If a country tries to correct a trade deficit by applying tariffs, in an attempt to stem the level of imports, that also increases inflation: it increases prices and reduces the standard of living for consumers. There is also a high risk of retaliatory tariffs and adverse effects on trade, as described later (3.5.4.2).
Some countries have had to apply to the International Monetary Fund (IMF) for a loan to stabilise their finances. This only provides a temporary respite and, as will be seen at the end of this chapter, there are other governance problems with these international transfers of funds (3.5.5).
Some governments try to control foreign currency exchange rates, to boost exports, but most now accept that currency values have to ‘float’ according to economic circumstances and are beyond direct political control. China’s policy of pegging the renminbi against the American dollar in the early 21st century was an egregious exception, but the resulting huge foreign currency inflows were described by The Economist as “An embarrassment of riches” – noting that the excess money supply might eventually cause inflation.
The Eurozone operates as if it were a single country within the framework of international trade, but the individual countries within it cannot unilaterally manage currency exchange rates or external tariffs – so several have got into difficulties. An Economist article, So hard to bend, described Spain's problems in April 2010: noting that “As a member of the euro, it cannot address that problem by devaluing the currency” .
(This is an archive of a page intended to form part of Edition 4 of the Patterns of Power series of books. The latest versions are at book contents).