Capital Flows and Currency Exchange

Posted by PITHOCRATES - March 10th, 2014

Economics 101

(Originally published July 30th, 2012)

Before we buy a Country’s Exports we have to Exchange our Currency First

What’s the first thing we do when traveling to a foreign country?  Exchange our currency.  Something we like to do at our own bank.  Before leaving home.  Where we can get a fair exchange rate.  Instead of someplace in-country where they factor the convenience of location into the exchange rate.  Places we go to only after we’ve run out of local currency.  And need some of it fast.  So we’ll pay the premium on the exchange rate.  And get less foreign money in exchange for our own currency.

Why are we willing to accept less money in return for our money?  Because when we run out of money in a foreign country we have no choice.  If you want to eat at a McDonalds in Canada they expect you to pay with Canadian dollars.  Which is why the money in the cash drawer is Canadian money.  Because the cashier accepts payment and makes change in Canadian money.  Just like they do with American money in the United States.

So currency exchange is very important for foreign purchases.  Because foreign goods are priced in a foreign currency.  And it’s just not people traveling across the border eating at nice restaurants and buying souvenirs to bring home.  But people in their local stores buying goods made in other countries.  Before we buy them with our American dollars someone else has to buy them first.  Japanese manufacturers need yen to run their businesses.  Chinese manufacturers need yuan to run their businesses.  Indian manufacturers need rupees to run their businesses.  So when they ship container ships full of their goods they expect to get yen, yuan and rupees in return.  Which means that before anyone buys their exports someone has to exchange their currency first.

Goods flow One Way while Gold flows the Other until Price Inflation Reverses the Flow of Goods and Gold

We made some of our early coins out of gold.  Because different nations used gold, too, it was relatively easy to exchange currencies.  Based on the weight of gold in those coins.  Imagine one nation using a gold coin the size of a quarter as their main unit of currency.  And another nation uses a gold coin the size of a nickel.  Let’s say the larger coin weighs twice as much as the smaller coin.  Or has twice the amount of gold in it.  Making the exchange easy.  One big coin equals two small coins in gold value.  So if I travel to the country of small coins with three large gold coins I exchange them for six of the local coins.  And then go shopping.

The same principle follows in trade between these two countries.  To buy a nation’s exports you have to first exchange your currency for theirs.  This is how.  You go to the exporter country with bags of your gold coins.  You exchange them for the local currency.  You then use this local currency to pay for the goods they will export to you.  Then you go back to your country and wait for the ship to arrive with your goods.  When it arrives your nation has a net increase in imported goods (i.e., a trade deficit).  And a net decrease in gold.  While the other nation has a net increase in exported goods (i.e., a trade surplus).  And a net increase in gold.

The quantity theory of money tells us that as the amount of money in circulation increases it creates price inflation.  Because there’s more of it in circulation it’s easy to get and worth less.  Because the money is worth less it takes more of it to buy the same things it once did.  So prices rise.  As prices rise in a nation with a trade surplus.  And fall in a nation with a trade deficit.  Because less money in circulation makes it harder to get and worth more.  Because the money is worth more it takes less of it to buy the same things it once did.  So prices fall.  This helps to make trade neutral (no deficit or surplus).  As prices rise in the exporter nation people buy less of their more expensive exports.  As prices fall in an importer nation people begin buying their less expensive exports.  So as goods flow one way gold flows the other way.  Until inflation rises in one country and eventually reverses the flow of goods and gold.  We call this the price-specie flow mechanism.

In the Era of Floating Exchange Rates Governments don’t have to Act Responsibly Anymore

This made the gold standard an efficient medium of exchange for international trade.  Whether we used gold.  Or a currency backed by gold.  Which added another element to the exchange rate.  For trading paper bills backed by gold required a government to maintain their domestic money supply based on their foreign exchange rate.  Meaning that they at times had to adjust the number of bills in circulation to maintain their exchange rate.  So if a country wanted to lower their interest rates (to encourage borrowing to stimulate their economy) by increasing the money supply they couldn’t.  Limiting what governments could do with their monetary policy.  Especially in the age of Keynesian economics.  Which was the driving force for abandoning the gold standard.

Most nations today use a floating exchange rate.  Where countries treat currencies as commodities.  With their own supply and demand determining exchange rates.  Or a government’s capital controls (restricting the free flow of money) that overrule market forces.  Which you can do when you don’t have to be responsible with your monetary policy.  You can print money.  You can keep foreign currency out of your county.  And you can manipulate your official exchange rate to give you an advantage in international trade by keeping your currency weak.  So when trading partners exchange their currency with you they get a lot of yours in exchange.  Allowing them to buy more of your goods than they can buy from other nations with the same amount of money.  Giving you an unfair trade advantage.  Trade surpluses.  And lots of foreign currency to invest in things like U.S. treasury bonds.

The gold standard gave us a fixed exchange rate and the free flow of capital.  But it limited what a government could do with its monetary policy.  An active monetary policy will allow the free flow of capital but not a fixed exchange rate.  Capital controls prevent the free flow of capital but allows a fixed exchange rate and an active monetary policy.  Governments have tried to do all three of these things.  But could never do more than two.  Which is why we call these three things the impossible trinity.  Which has been a source of policy disputes within a nation.  And between nations.  Because countries wanted to abandoned the gold standard to adopt policies that favored their nation.  And then complained about nations doing the same thing because it was unfair to their own nation.  Whereas the gold standard made trade fair.  By making governments act responsible.  Something they never liked.  And in the era of floating exchange rates they don’t have to act responsibly anymore.

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Bretton Woods System, Quasi Gold Standard, Inflation, Savings, Nixon Shock and Monetizing the Debt

Posted by PITHOCRATES - February 4th, 2014

History 101

(Originally published 2/5/2013)

The Bretton Woods System was a quasi Gold Standard where the U.S. Dollar replaced Gold

Government grew in the Sixties.  LBJ’s Great Society increased government spending.  Adding it on top of spending for the Vietnam War.  The Apollo Moon Program.  As well as the Cold War.  The government was spending a lot of money.  More money than it had.  So they started increasing the money supply (i.e., printing money).  But when they did they unleashed inflation.  Which devalued the dollar.  And eroded savings.  Also, because the U.S. was still on a quasi gold standard this also created a problem with their trade partners.

At the time the United States was still in the Bretton Woods System.  Along with her trade partners.  These nations adopted the U.S. dollar as the world’s reserve currency to facilitate international trade.  Which kept trade fair.  By preventing anyone from devaluing their currency to give them an unfair trade advantage.  They would adjust their monetary policy to maintain a fixed exchange rate with the U.S. dollar.  While the U.S. coupled the U.S. dollar to gold at $35/ounce.  Which created a quasi gold standard.  Where the U.S. dollar replaced gold.

So the U.S. had a problem when they started printing money.  They were devaluing the dollar.  So those nations holding it as a reserve currency decided to hold gold instead.  And exchanged their dollars for gold at $35/ounce.  Causing a great outflow of gold from the U.S.  Giving the U.S. a choice.  Either become responsible and stop printing money.  Or decouple the dollar from gold.  And no longer exchange gold for dollars.  President Nixon chose the latter.  And on August 15, 1971, he surprised the world.  Without any warning he decoupled the dollar from gold.  It was a shock.  So much so they call it the Nixon Shock.

To earn a Real 2% Return the Interest Rate would have to be 2% plus the Loss due to Inflation

Once they removed gold from the equation there was nothing stopping them from printing money.  The already growing money supply (M2) grew at a greater rate after the Nixon Shock (see M2 Money Stock).  The rate of increase (i.e., the inflation rate) declined for a brief period around 1973.  Then resumed its sharp rate of growth around 1975.  Which you can see in the following chart.  Where the increasing graph represents the rising level of M2.

M2 versus Retirement Savings

Also plotted on this graph is the effect of this growth in the money supply on retirement savings.  In 1966 the U.S. was still on a quasi gold standard.  So assume the money supply equaled the gold on deposit in 1966.  And as they increased the money supply over the years the amount of gold on deposit remained the same.  So if we divide M2 in 1966 by M2 in each year following 1966 we get a declining percentage.  M2 in 1966 was only 96% of M2 in 1967.  M2 in 1966 was only 88% of M2 in 1968.  And so on.  Now if we start off with a retirement savings of $750,000 in 1966 we can see the effect of inflation has by multiplying that declining percentage by $750,000.  When we do we get the declining graph in the above chart.  To offset this decline in the value of retirement savings due to inflation requires those savings to earn a very high interest rate.

Interest Rate - Real plus Inflation

This chart starts in 1967 as we’re looking at year-to-year growth in M2.  Inflation eroded 4.07% of savings between 1966 and 1967.   So to earn a real 2% return the interest rate would have to be 2% plus the loss due to inflation (4.07%).  Or a nominal interest rate of 6.07%.  The year-to-year loss in 1968 was 8.68%.  So the nominal interest rate for a 2% real return would be 10.68% (2% + 8.68%).  And so on as summarized in the above chart.  Because we’re discussing year-to-year changes on retirement savings we can consider these long-term nominal interest rates.

Just as Inflation can erode someone’s Retirement Savings it can erode the National Debt

To see how this drives interest rates we can overlay some average monthly interest rates for 6 Month CDs (see Historical CD Interest Rate).  Which are often a part of someone’s retirement nest egg.  The advantage of a CD is that they are short-term.  So as interest rates rise they can roll over these short-term instruments and enjoy the rising rates.  Of course that advantage is also a disadvantage.  For if rates fall they will roll over into a lower rate.  Short-term interest rates tend to be volatile.  Rising and falling in response to anything that affects the supply and demand of money.  Such as the rate of growth of the money supply.  As we can see in the following chart.

Interest Rate - Real plus Inflation and 6 Month CD

The average monthly interest rates for 6 Month CDs tracked the long-term nominal interest rates.  As the inflationary component of the nominal interest rate soared in 1968 and 1969 the short-term rate trended up.  When the long-term rate fell in 1970 the short-term rate peaked and fell in the following year.  After the Nixon Shock long-term rates increased in 1971.  And soared in 1972 and 1973.  The short-term rate trended up during these years.  And peaked when the long-term rate fell.  The short term rate trended down in 1974 and 1975 as the long-term rate fell.  It bottomed out in 1977 in the second year of soaring long-term rates.  Where it then trended up at a steeper rate all the way through 1980.  Sending short-term rates even higher than long-term rates.  As the risk on short-term savings can exceed that on long-term savings.  Due to the volatility of short-term interest rates and wild swings in the inflation rate.  Things that smooth out over longer periods of time.

Governments like inflationary monetary policies.  For it lets them spend more money.  But it also erodes savings.  Which they like, too.  Especially when those savings are invested in the sovereign debt of the government.  For just as inflation can erode someone’s retirement savings it can erode the national debt.  What we call monetizing the debt.  For as you expand the money supply you depreciate the dollar.  Making dollars worth less.  And when the national debt is made up of depreciated dollars it’s easier to pay it off.  But it’s a dangerous game to play.  For if they do monetize the debt it will be very difficult to sell new government debt.  For investors will demand interest rates with an even larger inflationary component to protect them from further irresponsible monetary policies.  Greatly increasing the interest payment on the debt.  Forcing spending cuts elsewhere in the budget as those interest payments consume an ever larger chunk of the total budget.  Which governments are incapable of doing.  Because they love spending too much.

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A Weakening Dollar is giving Boeing a Trade Advantage over Airbus

Posted by PITHOCRATES - June 23rd, 2013

Week in Review

Before you can buy from a foreign country you have to exchange your currency fist.  For example, if you’re in China and want to buy some aircraft from Boeing or Airbus, you have to exchange you currency first.  Exchange Chinese yuan for U.S. dollars.  Or exchange Chinese yuan for euros.

Now if both Boeing and Airbus have a plane that meets all of their needs leaving price as the only consideration, they have two things to consider.  Price, obviously.  And the current exchange rate.  For if the U.S. dollar is weaker compared to the euro they will get more dollars than euros when exchanging their currency.  Giving the Americans a trade advantage.  Because if the dollar is weaker than the euro the Chinese yuan will buy more from Boeing than it will from Airbus.  A situation that actually exists now.  And it concerns Airbus (see Airbus CEO Concerned Over Euro/USD Exchange Rate Affecting Exports by David Pearson posted 6/20/2013 on 4-traders).

Airbus Chief Executive Fabrice Bregier Thursday said he remains concerned about the strength of the euro against the U.S. dollar which could limit the European plane-maker’s export-reliant growth despite strong demand for passenger jets particularly from Asia.

The CEO has previously expressed concern that the euro’s rise against the dollar could force the company to seek extra cost cuts or savings.

The aircraft market is a world market.  An aircraft manufacturer’s export sales will be greater than their domestic sales.  So a weak currency benefits them.  Which is why governments like to weaken their currencies.  Especially if they depend on robust export sales.  But the down side to that is that a weaker currency will raise prices everywhere else.  So, yes, exports will grow.  But people will lose purchasing power.  As their money won’t buy as much as it once did.

Because the Chinese yuan will buy more from Boeing than it will from Airbus they have to somehow lower the price of their planes to offset that advantage Boeing has. Which means they will have to find costs they can cut.  Find savings elsewhere.  Or watch Boeing sell more planes.

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Currencies, Exchange Rates and the Gold Standard

Posted by PITHOCRATES - June 17th, 2013

Economics 101

Money is a Temporary Storage of Value that has no Intrinsic Value

Giant container ships ply the world’s oceans bringing us a lot of neat stuff.  Big televisions.  Smartphones.  Laptop computers.  Tablet computers.  The hardware for our cable and satellite TVs.  Toasters.  Toaster ovens.  Mixers and blenders.  And everything else we have in our homes and in our lives.  Things that make our lives better.  And make it more enjoyable.  These things have value.  We give them value.  Some have more value to one than another.  But these are things that have value to us.  And because they have value to us they have value to the people that made them.  Who used their human capital to create things that other people wanted.  And would trade for them.

When we first started trading we bartered with others.  Trading things for other things.  But as the economy grew more complex it took a lot of time to find someone who had what you wanted AND you had what they wanted.  So we developed money.  A temporary storage of value.  So we could trade the valuable things we created for money.  That money held the value of what we created temporarily while we looked for something that we wanted.  Then we exchanged the money we got earlier for something someone had.  It was just like trading our thing for someone else’s thing.  Only instead of spending weeks, months even years meeting hundreds of thousands of people trying to find that perfect match we only needed to meet two people.  One that exchanges money for the thing we have that they want.  And another who has what we want that they will exchange for our money.  Then that person would do the same with the money they got from us.  As did everyone else who brought things to market.  And those who came to market with money to buy what others brought.

Money is a temporary storage of value.  Money itself doesn’t have any intrinsic value.  Consider that container ship full of those wonderful items.  Now, which would you rather have as permanent fixtures in your house?  Those wonderful things?  Or boxes of money that just sit in your house?  You’d want the wonderful things.  And if you had a box of money you would exchange it (i.e., go out shopping) for those wonderful things.  Because boxes of money aren’t any fun.  It’s what you can exchange that money for that can be a lot of fun.

Devaluing your Currency boosts Exports by making those Goods less Expensive to the Outside World

So there is a lot of value on one of those container ships.  Let’s take all of that value out of the ship and place it on a balancing scale.  Figuratively, of course.  Now the owner of that stuff wants to trade it for other stuff.  But how much value does this stuff really have?  Well, let’s assume the owner is willing to exchange it all for one metric ton of gold.  Because gold is pretty valuable, too.  People will trade other things for gold.  So if we put 1 metric ton of gold on the other side of the balancing scale (figuratively, of course) the scale will balance.  Because to the owner all of that stuff and one metric ton has the same value.  Of course moving a metric ton of gold is not easy.  And it’s very risky.  So, instead of gold what else can we put on that scale?  Well, we can move dollars electronically via computer networks.  That would be a lot easier than moving gold.  So let’s put dollars on the other side of that scale.  Figuratively, of course.  How many will we need?  Well, today gold is worth approximately $1,380/troy ounce.  So after some dimensional analysis we can convert that metric ton into 32,150 troy ounces.  And at $1,380/troy ounce that metric ton of gold comes to approximately $44.4 million.  So that container ship full of wonderful stuff will balance on a scale with $44.4 million on the other side.  Or 1 metric ton of gold.  In the eyes of the owner they all have the same value.

Moving money electronically is the easiest and quickest manner of exchanging money for ships full of goods.  These ships go to many countries.  And not all of them use American dollars.  But we can calculate what amounts of foreign currency will balance the value of that ship.  Or one metric ton of gold.  By using foreign exchange rates.  Which tell us the value of one currency in another currency.  Something that comes in pretty handy.  For when, say, an American manufacturer sells their goods they want American dollars.  Not British pounds.  Danish kroner.  Or Russian rubles.  For American manufacturers are in the United States of America.  They buy their materials in American dollars.  They pay their employees in American dollars.  Who pay their bills in American dollars.  Go shopping with American dollars.  Etc.  For everyday American transactions the British pound, for example, would be un-useable.  What these American manufacturers want, then, are American dollars.  So before a foreigner can buy these American exports they must first exchange their foreign currencies for American dollars.  We can get an idea of this by considering that container ship full of valuable stuff.  By showing what it would cost other nations.  The following table shows a sampling of foreign exchange rates and the exchanged foreign currency for that $44.4 million.

foreign currencies and exchange rates

If we take the US dollars and the Exchanged Currency for each row and place them on either side of a balancing scale the scale will balance.  Figuratively, of course.  Meaning these currencies have the same value.  And we can exchange either side of that scale for that container ship full of valuable stuff.  Or for that metric ton of gold.  Why are there such large differences in some of these exchange rates?  Primarily because of a nation’s monetary policy.  Many nations manipulate their currency for various reasons.  Some nations give their people a lot of government benefits they pay for by printing money.  Which devalues their currency.  Some nations purposely devalue their currency to boost their export sector.  As the more currency you get in exchange for your currency the more of these exports you can buy.  Most of China’s great economic growth came from their export sector.  Which they helped along by devaluing their currency.  This boosted exports by making those goods less expensive to the outside world.  But the weakened yuan made domestic goods more expensive.  Because it took more of them to buy the same things they once did.  Raising the cost of living for the ordinary Chinese.

The Gold Standard made Free Trade Fair Trade

Some economists, Keynesians, approve of printing a lot of money to lower interest rates.  And for the government to spend.  They think this will increase economic activity.  Well, keeping interest rates artificially low will encourage more people to buy homes.  But because they are devaluing the currency to keep those interest rates artificially low housing prices rise.  Because when you devalue your currency you cause price inflation.  But it’s just not house prices that rise.  Prices throughout the economy rise.  The greater the inflation rate (i.e., the rate at which you increase the money supply) the higher prices rise.  And the less your money will buy.  While the currencies at the top of this table will have exchange rates that don’t vary much those at the bottom of the table may.  Especially countries that like to print money.  Like Argentina.  Where the inflation is so bad at times that Argentineans try to exchange their currency for foreign currencies that hold their value longer.  Or try to spend their Argentine pesos as quickly as possible.  Buying things that will hold their value longer than the Argentine peso.

Because printing fiat money is easy a lot of nations print it.  A lot of it.  People living in these countries are stuck with a rapidly depreciating currency.  But international traders aren’t.  If a country prints so much money that their exchange rate changes every few minutes international traders aren’t going to want their currency.  Because a country can’t do much with a foreign currency other than buy exports with it from that country.  A sum of highly depreciated foreign currency won’t buy as much this hour as it did last hour.  Which forces an international trader to quickly spend this money before it loses too much of its value.  (Some nations will basically barter.  They will exchange their exports for another country’s exports based on the current exchange rate.  So that they don’t hold onto the devalued foreign currency at all.)  But if the currency is just too volatile they may demand another currency instead.  Like the British pound, the euro or the American dollar.  Because these stronger currencies will hold their value longer.  So they’ll buy this hour what they bought last hour.  Or yesterday.  Or last week.  There is less risk holding on to these stronger currencies because Britain, the European Central Bank and the United States aren’t printing as much of their money as these nations with highly devalued currencies are printing of theirs.

This is the advantage of gold.  Countries can’t print gold.  It takes an enormous expense to bring new gold to the world’s gold supply.  It’s not easy.  So the value of the gold is very stable.  While some nations may devalue their currencies they can’t devalue gold.  A nation printing too much money may suffer from hyperinflation.  Reducing their exchange rate close to zero.  And when you divide by a number approaching zero the resulting amount of currency required for the exchange approaches infinity.  Weimar Germany suffered hyperinflation.  It was so bad that it took so much money to buy firewood that it was easier and less expensive to burn the currency instead.  This is the danger of a government having the ability to print money at will.  But if that same country can come up with a metric ton of gold that person with the container ship full of wonderful stuff would gladly trade it for that gold.  Even though that person will not trade it for that country’s currency.  This was the basis of the gold standard in international trade.  When nations backed their currencies with gold.  And kept them exchangeable for gold.  Forcing nations to maintain stable currencies.  By maintaining an official exchange rate between their currency and gold.  If that nation devalued its currency the market exchange rate will start to move away from the official exchange rate.  For example, say the official rate was $40/troy ounce.  But because they printed so much of their currency they devalued it to where it took $80 to buy a troy ounce on the open market.  So a nation could take $80 dollars of that devalued currency and exchange it for 2 troy ounces of gold from that nation.  The official exchange rate forcing the nation to give away 2 troy ounces of gold for $80 when the real market exchange rate would only have given them 1 troy ounce.  So devaluing your currency would cause gold to flow out of your country.  And the only way to stop it would be to decrease the size of your money supply.  Undoing the previous inflation.  To bring the market exchange rate back to the official exchange rate.  Which is why the gold standard worked so well for international trade.  Nations could not manipulate their currency to get a trade advantage over another nation.  Making free trade fair trade.  Something few say today.  Thanks to currency manipulators like China.

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Bretton Woods System, Quasi Gold Standard, Inflation, Savings, Nixon Shock and Monetizing the Debt

Posted by PITHOCRATES - February 5th, 2013

History 101

The Bretton Woods System was a quasi Gold Standard where the U.S. Dollar replaced Gold

Government grew in the Sixties.  LBJ’s Great Society increased government spending.  Adding it on top of spending for the Vietnam War.  The Apollo Moon Program.  As well as the Cold War.  The government was spending a lot of money.  More money than it had.  So they started increasing the money supply (i.e., printing money).  But when they did they unleashed inflation.  Which devalued the dollar.  And eroded savings.  Also, because the U.S. was still on a quasi gold standard this also created a problem with their trade partners.

At the time the United States was still in the Bretton Woods System.  Along with her trade partners.  These nations adopted the U.S. dollar as the world’s reserve currency to facilitate international trade.  Which kept trade fair.  By preventing anyone from devaluing their currency to give them an unfair trade advantage.  They would adjust their monetary policy to maintain a fixed exchange rate with the U.S. dollar.  While the U.S. coupled the U.S. dollar to gold at $35/ounce.  Which created a quasi gold standard.  Where the U.S. dollar replaced gold.

So the U.S. had a problem when they started printing money.  They were devaluing the dollar.  So those nations holding it as a reserve currency decided to hold gold instead.  And exchanged their dollars for gold at $35/ounce.  Causing a great outflow of gold from the U.S.  Giving the U.S. a choice.  Either become responsible and stop printing money.  Or decouple the dollar from gold.  And no longer exchange gold for dollars.  President Nixon chose the latter.  And on August 15, 1971, he surprised the world.  Without any warning he decoupled the dollar from gold.  It was a shock.  So much so they call it the Nixon Shock.

To earn a Real 2% Return the Interest Rate would have to be 2% plus the Loss due to Inflation

Once they removed gold from the equation there was nothing stopping them from printing money.  The already growing money supply (M2) grew at a greater rate after the Nixon Shock (see M2 Money Stock).  The rate of increase (i.e., the inflation rate) declined for a brief period around 1973.  Then resumed its sharp rate of growth around 1975.  Which you can see in the following chart.  Where the increasing graph represents the rising level of M2.

M2 versus Retirement Savings

Also plotted on this graph is the effect of this growth in the money supply on retirement savings.  In 1966 the U.S. was still on a quasi gold standard.  So assume the money supply equaled the gold on deposit in 1966.  And as they increased the money supply over the years the amount of gold on deposit remained the same.  So if we divide M2 in 1966 by M2 in each year following 1966 we get a declining percentage.  M2 in 1966 was only 96% of M2 in 1967.  M2 in 1966 was only 88% of M2 in 1968.  And so on.  Now if we start off with a retirement savings of $750,000 in 1966 we can see the effect of inflation has by multiplying that declining percentage by $750,000.  When we do we get the declining graph in the above chart.  To offset this decline in the value of retirement savings due to inflation requires those savings to earn a very high interest rate.

Interest Rate - Real plus Inflation

This chart starts in 1967 as we’re looking at year-to-year growth in M2.  Inflation eroded 4.07% of savings between 1966 and 1967.   So to earn a real 2% return the interest rate would have to be 2% plus the loss due to inflation (4.07%).  Or a nominal interest rate of 6.07%.  The year-to-year loss in 1968 was 8.68%.  So the nominal interest rate for a 2% real return would be 10.68% (2% + 8.68%).  And so on as summarized in the above chart.  Because we’re discussing year-to-year changes on retirement savings we can consider these long-term nominal interest rates.

Just as Inflation can erode someone’s Retirement Savings it can erode the National Debt

To see how this drives interest rates we can overlay some average monthly interest rates for 6 Month CDs (see Historical CD Interest Rate).  Which are often a part of someone’s retirement nest egg.  The advantage of a CD is that they are short-term.  So as interest rates rise they can roll over these short-term instruments and enjoy the rising rates.  Of course that advantage is also a disadvantage.  For if rates fall they will roll over into a lower rate.  Short-term interest rates tend to be volatile.  Rising and falling in response to anything that affects the supply and demand of money.  Such as the rate of growth of the money supply.  As we can see in the following chart.

Interest Rate - Real plus Inflation and 6 Month CD

The average monthly interest rates for 6 Month CDs tracked the long-term nominal interest rates.  As the inflationary component of the nominal interest rate soared in 1968 and 1969 the short-term rate trended up.  When the long-term rate fell in 1970 the short-term rate peaked and fell in the following year.  After the Nixon Shock long-term rates increased in 1971.  And soared in 1972 and 1973.  The short-term rate trended up during these years.  And peaked when the long-term rate fell.  The short term rate trended down in 1974 and 1975 as the long-term rate fell.  It bottomed out in 1977 in the second year of soaring long-term rates.  Where it then trended up at a steeper rate all the way through 1980.  Sending short-term rates even higher than long-term rates.  As the risk on short-term savings can exceed that on long-term savings.  Due to the volatility of short-term interest rates and wild swings in the inflation rate.  Things that smooth out over longer periods of time.

Governments like inflationary monetary policies.  For it lets them spend more money.  But it also erodes savings.  Which they like, too.  Especially when those savings are invested in the sovereign debt of the government.  For just as inflation can erode someone’s retirement savings it can erode the national debt.  What we call monetizing the debt.  For as you expand the money supply you depreciate the dollar.  Making dollars worth less.  And when the national debt is made up of depreciated dollars it’s easier to pay it off.  But it’s a dangerous game to play.  For if they do monetize the debt it will be very difficult to sell new government debt.  For investors will demand interest rates with an even larger inflationary component to protect them from further irresponsible monetary policies.  Greatly increasing the interest payment on the debt.  Forcing spending cuts elsewhere in the budget as those interest payments consume an ever larger chunk of the total budget.  Which governments are incapable of doing.  Because they love spending too much.

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Farming, Food Surplus, Artisans, Trade, Barter, Search Costs, Money, Precious Metals, Pound, Dollar and Gold Standard

Posted by PITHOCRATES - October 9th, 2012

History 101

Food Surpluses allowed Everything that followed in the Modern Age

Humans were hunters and gatherers first.  When the environment ruled supreme.  Then something happened.  Humans began to think more.  And started to push back against their environment.  First with tools.  Then with fire.  Bringing people closer together.  Eventually settling down in civilizations.  When the human race embarked on a new path.  A path that would eventually usher in the modern age we enjoy today.  We stopped hunting and gathering.  And began farming.

Throughout history life has been precarious.  Due to the uncertainty of the food supply.  Especially when the environment ruled our lives.  That changed with farming.  When we started taking control of our environment.  We domesticated animals.  And learned how to grow food.  Which lead to perhaps the most important human advancement.  The one thing that allowed everything that followed in the modern age.   Food surpluses.  Which made life less precarious.  And a whole lot more enjoyable.

Producing more food than we needed allowed us to store food to get us through long winters and seasons with poor harvests.  But more importantly it freed people.  Not everyone had to farm.  Some could do other things.  Think about other things.  And build other things.  Artisans arose.  They built things to make our lives easier.  More enjoyable.  And when these talented artisans and farmers met other talented artisans and farmers they traded the products of all their labors.  In markets.  That became cities.  Enriching each other’s lives.  By allowing them to trade for food.  For things that made life easier.  And for things that made life more enjoyable.

We settled on using Precious Metals (Gold and Silver) for Money for they were Everything Money Should Be

As civilizations advanced artisans made a wider variety of things.  Putting a lot of goods into the market place.  Unfortunately, it made trading more difficult.  Because while you saw what you wanted the person who had it may not want what you had to offer in trade.  So what do you do?  You look for someone else that has that same thing.  And will trade for what you have.  And when the second person doesn’t want to trade for what you have you look for a third person.  Then a fourth.  Then a fifth.  Until you find someone who wants to trade for what you have.

This is the barter system.  Trading goods for goods.  And as you can see it has high search costs to find someone to trade with.  Time that people could better spend making more things to trade.  What they needed was a temporary storage of value.  Something people could trade their things for.  And those people could then use that temporary storage they received in trade to later trade for something they wanted.   We call this ‘something’ money.

We have used many things for money.  Some things better than others.  In time we learned that the best things to use for money had to have a few characteristics.  It had to be scarce.  A rock didn’t make good money because why would anyone trade for it when you could just pick one up from the ground?  It had to be indestructible and hold its value.  A slab of bacon had value because bacon is delicious.  But if you held on to it too long it could grow rancid, losing all the value it once held.  Or you could eat it.  Which would also remove its value.  It had to be divisible.  A live pig removed the problem of bacon growing rancid.  However, it was hard making change with live pigs.  Which is why we settled on using precious metals (gold and silver) for money.  For they were everything money should be.

The Key to Economic Activity is People with Creative Talent to make Things to Trade

Money came first.  Then government monetary systems.  Traders were using gold and silver long before nations established their own money.  And when they did they based them on weights of these precious metals.  The British pound sterling represented one Saxon pound of silver.  The U.S. dollar came from the Spanish dollar.  Which traces back to 16th century Bohemia.  To the St. Joachim Valley.  Where they minted private silver coins.  The Joachimsthaler.  Where the ‘thaler’ (which translated to valley) in Joachimsthaler became dollar.  The German mark and the French franc came into being as weights of precious metals.  People either traded silver or gold coins.  Or paper notes that represented silver or gold.

We used silver first as the basis for national currencies.  Then with new gold discoveries in the United States, Australia and South Africa gold became the precious metal of choice.  Using precious metals simplified trade by providing sound money.  And it also made foreign exchange easy.  For when the British made their pound represent 1/4 of an ounce of gold and the Americans made their dollar represent 1/20 of an ounce of gold the exchange rate was easy to calculate.  The British pound had 5 times as much gold in it than the U.S. dollar.  So the exchange rate was simply 5 U.S. dollars for every British pound.  Which made international trade easy.  And fair.  Because everything was priced in weights of gold.

The pure gold standard, then, was part of the natural evolution of money.  The state did not create it.  It does not require an act of legislation.  Or political decree.  The pure gold standard existed before the state.  And states based their currencies on the monetary system that already existed.  Using weights of precious metals as money.  That is, a pure gold standard.  Central banks and fiat money are only recent inventions of the state.  And bad ones at that.  For the thousands of years that preceded the last hundred years or so there were only traders mutually agreeing to trade their goods for precious metals.  Using these precious metals as a temporary storage of wealth.  To temporarily hold the value of the things they made.  So the key to economic activity is people with creative talent to make things to trade.  And a sound money like gold and silver to facilitate that trade.  Not a central bank.  Or monetary policy.

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Federal Reserve System, Great Depression, Banking Crises, Gold Reserves, Gold Exchange Standard, Interest Rates and Money Supply

Posted by PITHOCRATES - July 31st, 2012

History 101

The Gold Exchange Standard provided Stability for International Trade

Congress created the Federal Reserve System (the Fed) with the passage of the Federal Reserve Act in 1913.  They created the Fed because of some recent bad depressions and financial panics.  Which they were going to make a thing of the past with the Fed.  It had three basic responsibilities.  Maximize employment.  Stabilize prices.  And optimize interest rates.  With the government managing these things depressions and financial panics weren’t going to happen on the Fed’s watch.

The worst depression and financial panic of all time happened on the Fed’s watch.  The Great Depression.  From 1930.  Until World War II.  A lost decade.  A period that saw the worst banking crises.  And the greatest monetary contraction in U.S. history.  And this after passing the Federal Reserve Act to prevent any such things from happening.  So why did this happen?  Why did a normal recession turn into the Great Depression?  Because of government intervention into the economy.  Such as the Smoot-Hawley Tariff Act that triggered the great selloff and stock market crash.  And some really poor monetary policy.  As well as bad fiscal policy.

At the time the U.S. was on a gold exchange standard.  Paper currency backed by gold.  And exchangeable for gold.  The amount of currency in circulation depended upon the amount of gold on deposit.  The Federal Reserve Act required a gold reserve for notes in circulation similar to fractional reserve banking.  Only instead of keeping paper bills in your vault you had to keep gold.  Which provided stability for international trade.  But left the domestic money supply, and interest rates, at the whim of the economy.  For the only way to lower interest rates to encourage borrowing was to increase the amount of gold on deposit.  For with more gold on hand you can increase the money supply.  Which lowered interest rates.  That encouraged people to borrow money to expand their businesses and buy things.  Thus creating economic activity.  At least in theory.

The Fed contracted the Money Supply even while there was a Positive Gold Flow into the Country

The gold standard worked well for a century or so.  Especially in the era of free trade.  Because it moved trade deficits and trade surpluses towards zero.  Giving no nation a long-term advantage in trade.  Consider two trading partners.  One has increasing exports.  The other increasing imports.  Why?  Because the exporter has lower prices than the importer.  As goods flow to the importer gold flows to the exporter to pay for those exports.  The expansion of the local money supply inflates the local currency and raises prices in the exporter country.  Back in the importer country the money supply contracts and lowers prices.  So people start buying more from the once importing nation.  Thus reversing the flow of goods and gold.  These flows reverse over and over keeping the trade deficit (or surplus) trending towards zero.  Automatically.  With no outside intervention required.

Banknotes in circulation, though, required outside intervention.  Because gold isn’t in circulation.  So central bankers have to follow some rules to make this function as a gold standard.  As gold flows into their country (from having a trade surplus) they have to expand their money supply by putting more bills into circulation.  To do what gold did automatically.  Increase prices.  By maintaining the reserve requirement (by increasing the money supply by the amount the gold deposits increased) they also maintain the fixed exchange rate.  An inflow of gold inflates your currency and an outflow of gold deflates your currency.  When central banks maintain this mechanism with their monetary policy currencies remain relatively constant in value.  Giving no price advantage to any one nation.  Thus keeping trade fair.

After the stock market crash in 1929 and the failure of the Bank of the United States in New York failed in 1930 the great monetary contraction began.  As more banks failed the money they created via fractional reserve banking disappeared.  And the money supply shrank.  And what did the Fed do?  Increased interest rates.  Making it harder than ever to borrow money.  And harder than ever for banks to stay in business as businesses couldn’t refinance their loans and defaulted.  The Fed did this because it was their professional opinion that sufficient credit was available and that adding liquidity then would only make it harder to do when the markets really needed additional credit.  So they contracted the money supply.  Even while there was a positive gold flow into the country.

The Gold Standard works Great when all of your Trading Partners use it and they Follow the Rules

Those in the New York Federal Reserve Bank wanted to increase the money supply.  The Federal Reserve Board in Washington disagreed.  Saying again that sufficient credit was available in the market.  Meanwhile people lost faith in the banking system.  Rushed to get their money out of their bank before it, too, failed.  Causing bank runs.  And more bank failures.  With these banks went the money they created via fractional reserve banking.  Further deflating the money supply.  And lowering prices.  Which was the wrong thing to happen with a rising gold supply.

Well, that didn’t last.  France went on the gold standard with a devalued franc.  So they, too, began to accumulate gold.  For they wanted to become a great banking center like London and New York.  But these gold flows weren’t operating per the rules of a gold exchange.  Gold was flowing generally in one direction.  To those countries hoarding gold.  And countries that were accumulating gold weren’t inflating their money supplies to reverse these flows.  So nations began to abandon the gold exchange standard.  Britain first.  Then every other nation but the U.S.

Now the gold standard works great.  But only when all of your trading partners are using it.  And they follow the rules.  Even during the great contraction of the money supply the Fed raised interest rates to support the gold exchange.  Which by then was a lost cause.  But they tried to make the dollar strong and appealing to hold.  So people would hold dollars instead of their gold.  This just further damaged the U.S. economy, though.  And further weakened the banking system.  While only accelerating the outflow of gold.  As nations feared the U.S. would devalue their currency they rushed to exchange their dollars for gold.  And did so until FDR abandoned the gold exchange standard, too, in 1933.  But it didn’t end the Great Depression.  Which had about another decade to go.

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Capital Flows and Currency Exchange

Posted by PITHOCRATES - July 30th, 2012

Economics 101

Before we buy a Country’s Exports we have to Exchange our Currency First

What’s the first thing we do when traveling to a foreign country?  Exchange our currency.  Something we like to do at our own bank.  Before leaving home.  Where we can get a fair exchange rate.  Instead of someplace in-country where they factor the convenience of location into the exchange rate.  Places we go to only after we’ve run out of local currency.  And need some of it fast.  So we’ll pay the premium on the exchange rate.  And get less foreign money in exchange for our own currency.

Why are we willing to accept less money in return for our money?  Because when we run out of money in a foreign country we have no choice.  If you want to eat at a McDonalds in Canada they expect you to pay with Canadian dollars.  Which is why the money in the cash drawer is Canadian money.  Because the cashier accepts payment and makes change in Canadian money.  Just like they do with American money in the United States.

So currency exchange is very important for foreign purchases.  Because foreign goods are priced in a foreign currency.  And it’s just not people traveling across the border eating at nice restaurants and buying souvenirs to bring home.  But people in their local stores buying goods made in other countries.  Before we buy them with our American dollars someone else has to buy them first.  Japanese manufacturers need yen to run their businesses.  Chinese manufacturers need yuan to run their businesses.  Indian manufacturers need rupees to run their businesses.  So when they ship container ships full of their goods they expect to get yen, yuan and rupees in return.  Which means that before anyone buys their exports someone has to exchange their currency first.

Goods flow One Way while Gold flows the Other until Price Inflation Reverses the Flow of Goods and Gold

We made some of our early coins out of gold.  Because different nations used gold, too, it was relatively easy to exchange currencies.  Based on the weight of gold in those coins.  Imagine one nation using a gold coin the size of a quarter as their main unit of currency.  And another nation uses a gold coin the size of a nickel.  Let’s say the larger coin weighs twice as much as the smaller coin.  Or has twice the amount of gold in it.  Making the exchange easy.  One big coin equals two small coins in gold value.  So if I travel to the country of small coins with three large gold coins I exchange them for six of the local coins.  And then go shopping.

The same principle follows in trade between these two countries.  To buy a nation’s exports you have to first exchange your currency for theirs.  This is how.  You go to the exporter country with bags of your gold coins.  You exchange them for the local currency.  You then use this local currency to pay for the goods they will export to you.  Then you go back to your country and wait for the ship to arrive with your goods.  When it arrives your nation has a net increase in imported goods (i.e., a trade deficit).  And a net decrease in gold.  While the other nation has a net increase in exported goods (i.e., a trade surplus).  And a net increase in gold.

The quantity theory of money tells us that as the amount of money in circulation increases it creates price inflation.  Because there’s more of it in circulation it’s easy to get and worth less.  Because the money is worth less it takes more of it to buy the same things it once did.  So prices rise.  As prices rise in a nation with a trade surplus.  And fall in a nation with a trade deficit.  Because less money in circulation makes it harder to get and worth more.  Because the money is worth more it takes less of it to buy the same things it once did.  So prices fall.  This helps to make trade neutral (no deficit or surplus).  As prices rise in the exporter nation people buy less of their more expensive exports.  As prices fall in an importer nation people begin buying their less expensive exports.  So as goods flow one way gold flows the other way.  Until inflation rises in one country and eventually reverses the flow of goods and gold.  We call this the price-specie flow mechanism.

In the Era of Floating Exchange Rates Governments don’t have to Act Responsibly Anymore

This made the gold standard an efficient medium of exchange for international trade.  Whether we used gold.  Or a currency backed by gold.  Which added another element to the exchange rate.  For trading paper bills backed by gold required a government to maintain their domestic money supply based on their foreign exchange rate.  Meaning that they at times had to adjust the number of bills in circulation to maintain their exchange rate.  So if a country wanted to lower their interest rates (to encourage borrowing to stimulate their economy) by increasing the money supply they couldn’t.  Limiting what governments could do with their monetary policy.  Especially in the age of Keynesian economics.  Which was the driving force for abandoning the gold standard.

Most nations today use a floating exchange rate.  Where countries treat currencies as commodities.  With their own supply and demand determining exchange rates.  Or a government’s capital controls (restricting the free flow of money) that overrule market forces.  Which you can do when you don’t have to be responsible with your monetary policy.  You can print money.  You can keep foreign currency out of your county.  And you can manipulate your official exchange rate to give you an advantage in international trade by keeping your currency weak.  So when trading partners exchange their currency with you they get a lot of yours in exchange.  Allowing them to buy more of your goods than they can buy from other nations with the same amount of money.  Giving you an unfair trade advantage.  Trade surpluses.  And lots of foreign currency to invest in things like U.S. treasury bonds.

The gold standard gave us a fixed exchange rate and the free flow of capital.  But it limited what a government could do with its monetary policy.  An active monetary policy will allow the free flow of capital but not a fixed exchange rate.  Capital controls prevent the free flow of capital but allows a fixed exchange rate and an active monetary policy.  Governments have tried to do all three of these things.  But could never do more than two.  Which is why we call these three things the impossible trinity.  Which has been a source of policy disputes within a nation.  And between nations.  Because countries wanted to abandoned the gold standard to adopt policies that favored their nation.  And then complained about nations doing the same thing because it was unfair to their own nation.  Whereas the gold standard made trade fair.  By making governments act responsible.  Something they never liked.  And in the era of floating exchange rates they don’t have to act responsibly anymore.

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The Gold Standard

Posted by PITHOCRATES - March 12th, 2012

Economics 101

As long as Imports equal Exports the Balance in the Trade Account is Zero and there is no Trade Deficit or Surplus 

Imagine two wine shops in an affluent suburb.  Let’s call one Fine Wines.  And the other The Wine Shoppe.  They both feature a wide selection of wines from around the world.  And each specializes in wines from a specific region.  So they sell much of the same wines.  But some of the most exclusive and most expensive wines can only be found at one store or the other.  Now wine retailers typically have a loyal clientele.  There is a relationship between proprietor and customer.  To enhance the wine drinking experience.  So proprietors will cater to their customers to keep them as customers.  And provide whatever wine they wish.  Even if they don’t stock it.  Or don’t have a normal purchasing channel to the wine they wish to buy.

Both stores have similar relationships with their clientele.  And they share something else in common.  The wines one seller doesn’t sell the other seller sells.  Which produces a special relationship between these two stores.  They buy and sell wines from each other as needed to meet the needs of their customers.  So customers at either store can purchase any wine they sell in both stores.  Allowing each store to maintain their special proprietor-customer relationship.  Without losing customers to the other store.

Most of the time the value of the wine they buy and sell from each other in these inter-store sales net out.  Sometimes one store owes the other.  And vice versa.  But it usually isn’t much.  And the stores take turns owing each other.  The overall cost for this inter-store trade is negligible.  And pleases customers at both stores.  So maintaining this trade is a win-win.  With no negative impact on either store’s business.  As long as ‘imports’ equal ‘exports’.  And the balance in this ‘trade account’ is kept close to zero.  So they continue to ‘trade’ bottles of wine.  Without exchanging any money.  Most of the time, that is.  Until a trade deficit develops.  

If the Currency is Backed by Gold the only way to create new Dollars is to put more Gold into the Vault 

Let’s say for whatever reason Fine Wines runs a trade deficit.  Fine Wines sells more of The Wine Shoppe wines than The Wine Shoppe sells of theirs.  Which means Fine Wines imports more from The Wine Shoppe than they export to The Wine Shoppe.  Creating the trade deficit.  They’re not trading bottles for bottles anymore.  Fine Wines delivers one case of wine to The Wine Shoppe and returns with 3 cases.  And now has an outstanding balance owed to The Wine Shoppe.  Which they must settle by sending money to The Wine Shoppe.  If sales continue like this Fine Wines will become a net importer and run chronic trade deficits.  While The Wine Shoppe will become a net exporter.  And have a running trade surplus.

If the clientele of Fine Wines keeps buying the imported wine from The Wine Shoppe instead of the ‘domestic’ Fine Wines, Fine Wines will have cash problems.  Because they owe their distributors for the wine they bought and stocked.  But when they sell The Wine Shoppe’s wine it doesn’t bring any cash into their store.  Because Fine Wines has to give that money to The Wine Shoppe.  For it was, after all, The Wine Shoppe’s wine that Fine Wines sold.  That they sold as a courtesy to their customers.  To keep them loyal customers.  So a portion of their total sales doesn’t even count as income (income = total sales – imports).  And if Fine Wines divides their income by the total number of bottles they sold they see a sad truth.  The impact of those imports has lowered the average price per bottle of wine.  This price deflation will make it very difficult to pay the bills they incurred before this deflation.  As they are now selling wine at lower prices than they paid for it from their distributors.

And that’s similar to how the gold standard works.  We back the money in circulation (i.e., the money supply) by gold.  Which we lock away in some vault.  To increase the money supply you need to increase the gold supply.  To decrease the money supply you need to decrease the gold supply.  This makes it very difficult for governments to be irresponsible and print money.  Because if the currency is backed by gold the only way to create new dollars is to put more gold into that vault.  Ergo, responsible government spending.  And an automatic mechanism to fix trade deficits.

Fixed Exchange Rates based on Gold made International Trade Simple and Fair

This is where our wine stores example comes in.  If a government runs a trade deficit under the gold standard gold moves between countries.  Just like money did between the two wine stores.  And a net exporter of gold (a net importer of goods paying for the resulting trade deficit with gold) will see a reduction in price levels.  Just like Fine Wines did.  (And the net importer of gold will see the opposite).  But here’s what else happens.  Those lower prices now make the importer more cost competitive.  (And the higher prices make the exporter less competitive).  Because people prefer buying less expensive things.  So the net importer’s sales increase thanks to lower prices.  While the net exporter’s sales decrease because of higher prices.  Moving the balance in the trade account back towards zero.  Where it will always try to be under normal market conditions. 

This built-in responsibility didn’t stop governments from misbehaving, though.  And some have printed more money than they had the gold reserves to back it.  For governments like to spend money.  Especially when they’re trying to buy votes.  So they have turned on those printing presses at times.  And increased the money supply.  Without putting more gold into the vault.  The result?  A larger money supply backed by the same amount of gold?  It depreciated the currency by inflating the money supply.  Which can be a problem when the money is backed by gold.  Especially when you have an exchange rate based on gold.

To buy goods from a foreign country you first exchanged your currency for theirs.  Because you buy foreign goods in the foreign currency.  And you based this exchange rate on gold.  And fixed each currency to an amount of gold.  Which made this currency exchange simple.  And fair.  Unless someone was depreciating their currency by printing it without putting more gold into the vault.  But if they did other nations would find out.  And stop exchanging their currency for the depreciated currency which would buy less.  They, instead, exchanged the foreign currency they had for gold instead.  So they could buy more.  Exchanging a depreciated currency at an exchange rate based on a non-depreciated currency.  Leaving the nation with a swollen money supply full of a depreciated currency.  And no gold.  Giving the nation runaway inflation.  And a crashed economy.  A very strong incentive not to depreciate your currency while on a gold standard.

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Printing Money and Screwing Friends

Posted by PITHOCRATES - November 12th, 2010

My Coworker, the Cheap Canadian Bastard

I worked with a Canadian once.  A real cheap bastard.  Yeah, he had some financial issues.   But they weren’t my issues.  And I got tired of subsidizing his problems by driving him to lunch every day.  And I got tired of the conversations.  He brought up every negative story about America.  Belittled our president.  Chastised America for not signing on to the Kyoto Protocol.  And said that we did not honor our trade agreement concerning softwood lumber (that his government was subsidizing in order to undersell their American competitors).

What really bothered me was that he was a Canadian that lived near the border but worked in the U.S.  He criticized America but he chose to work in America instead of Canada.  Why?  Because he could get paid more in America.  And there were the perks of crossing the border every day.  He gassed his car up in the United States.  And his wife’s car.  Why?  Because our gas prices were cheaper.  Yeah, he would criticize America until he was blue in the face, but he took every opportunity to escape the taxes that paid for all those things that made his country superior to mine.

Now don’t get me wrong.  I like Canada.  I just don’t like hypocrisy.  He made good money over here.  And with a much more favorable exchange rate back then, that translated into big dollars on the other side of the border.  Back when the American dollar was strong and the Canadian dollar was weak, he did very well.  Those strong American dollars exchanged into a whole lot more Canadian dollars.  Which allowed him to buy a whole lot more stuff than his fellow Canadians.  In fact, a lot of Americans vacationed in Canada back then.  Because the American dollar bought more in Canada than it did in America.

Have Cheap Cash, Will Travel – In Canada

So what’s the point talking about this cheap bastard?  Exchange rates.  And whenever there’s a currency war on the horizon, I can’t help but think about this cheap bastard.  See how he, a Canadian working in America, lived very well with a cheap Canadian dollar.  We paid him in strong U.S. dollars.  He then could use those strong U.S. dollars to buy gas and other ‘less taxed’ items on the U.S. side of the border.  (If he brought in and exchanged weak Canadian dollars for strong U.S. dollars, that same amount of gas would cost him more.)  And when he took those strong U.S. dollars across the border back into Canada, he exchanged them and got so many weak Canadian dollars in return that he alone stimulated the local economy.

Of course, he wasn’t the only one bringing strong American dollars into Canada.  When those strong dollars were exchanged for weak ones, the Canadian tourism industry boomed.  People could vacation in Canada for a week for what a weekend in America would cost.  Canadians traveling into America, on the other hand, paid more for less.  A weekend in America would cost what a week in Canada would cost.

In the above example, you can see how the nation with the weaker currency has more economic activity than the nation with the stronger currency.  Now, to understand international trade and foreign exchange rates, make the following substitutions in the above example:

  • Canada -> America
  • America -> China/Germany/Brazil/other U.S. trading partner

Alone Against the World.  And Alan Greenspan

Well, America is devaluing their currency.  They’re printing money to buy back treasury debt.  Supposedly to stimulate the economy by injecting more liquidity. But our problem is not a liquidity problem.  It’s a lack of consumer spending because of high unemployment.  And a fear of being unemployed soon.  So this will do little to solve our problems.  But it will make our exports cheaper.  And our trading partners’ imports more expensive.  In other words, we’re trying to fix our broken economy by flooding our trading partners’ economies with cheap American goods.  Which is pissing them off big time (see Reuters’ Analysis: German tempers fray as U.S. policy gulf widens by Stephen Brown and Andreas Rinke posted 11/10/2010).

Finance Minister Wolfgang Schaeuble, 68, said last week that the U.S. Federal Reserve decision to buy $600 billion of government bonds undermined U.S. credibility and was “clueless.” There was no point, he said, in pumping money into the markets.

China and Brazil were among those echoing his comments but U.S. officials were particularly stung by Schaeuble and German Economy Minister Rainer Bruederle saying the Fed move amounted to “indirect manipulation” of the dollar to boost exports; this at a time when Washington is criticizing China for exactly the same kind of strategy.

“It’s not acceptable for the Americans to criticize China for currency manipulation then slyly help the dollar by printing at the Federal Reserve,” Schaeuble told Der Spiegel magazine.

And speaking of Brazil, President Luiz Inacio Lula da Silva said warned America not to rely on exports alone (see Brazil’s Lula Says World Headed For ‘Bankruptcy’ Unless Rich Nations Act posted 11/11/2010 on the Dow Jones Newswires).

“If they don’t consume, and they just bet on exports, the world will go into bankruptcy,” he told reporters as leaders at the Group of 20 industrial and developing nations headed into a two-day summit in the South Korean capital.

Even Alan Greenspan, former Federal Reserve Chairman, is expressing concern over the impact of American policy on foreign exchange rates (see Greenspan warns over weaker dollar by Alan Beattie in Seoul posted 11/10/2010 in the Financial Times).  In that same article, Mervyn King, governor of the Bank of England, warned that this currency manipulation could trigger a trade war that would make the next 12 months worse than the previous 12 months.

We’re All Cheap Bastards Now

When it comes down to it, I guess we’re all cheap bastards.  We all want some unfair advantage in life.  Like my one-time Canadian coworker.  And I can understand how our trading partners feel.  I’ve worked with and been lectured for years about how my country should change.  All the while he prospered quite handsomely from the way things were.  Of course, I can take some solace in the dollar’s slide.  It’s trading pretty much at parity with the Canadian dollar now.  It’s gotten so bad that I’ve heard my old friend has since found work on his side of the border.  Good for him.  Now he can truly embrace all those taxes that he spoke so highly about while he was avoiding them for all those years.

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