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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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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Nations race to Devalue their Currencies to Boost Exports and Destroy Retirement Savings

Posted by PITHOCRATES - February 3rd, 2013

Week in Review

If you ever traveled to a foreign country you know what you had to do before buying foreign goods.  You had to exchange your currency first.  That’s why they have currency exchanges at border crossings and airports.  So people can convert their currency to the local currency.  So they can buy stuff.  And when traveling people liked to go to areas that have a weaker currency.  Because a stronger currency can get more of a weaker currency in exchange.  Allowing your own currency to buy a lot more in that foreign country.  And it’s the same for buying exported goods from another country.

The weaker a country’s currency the more of it people can get in exchange for their currency.  Allowing importers to buy a lot more of those exported goods.  Which helps the export economy of that nation with a weak currency.  In fact having a weak currency is such an easy way to boost your exports that countries purposely make their currencies weaker.  As they race each other to see who can devalue their currency more.  And gain the biggest trade advantage (see Dollar Thrives in Age of Competitive Devaluations by A. Gary Shilling posted 1/28/2013 on Bloomberg).

In periods of prolonged economic pain — notably the 2007-2009 global recession and the ensuing subpar recovery — international cooperation gives way to an every-nation-for-itself attitude. This manifests itself in protectionist measures, specifically competitive devaluations that are seen as a way to spur exports and to retard imports.

Trouble is, if all nations devalue their currencies at the same time, foreign trade is disrupted and economic growth is depressed…

Decreasing the value of a currency is much easier than supporting it. When a country wants to depress its own currency, it can create and sell unlimited quantities. In contrast, if it wants to support its own money, it needs to sell the limited quantities of other currencies it holds, or borrow from other central banks…

Easy central-bank policy, especially quantitative easing, may not be intended to depress a currency, though it has that effect by hyping the supply of liquidity. Also, low interest rates discourage foreign investors from buying those currencies. [Japanese] Prime Minister Shinzo Abe has accused the U.S. and the euro area of using low rates to weaken their currencies.

“Central banks around the world are printing money, supporting their economies and increasing exports,” Abe said recently. “America is the prime example. If it goes on like this, the yen will inevitably strengthen. It’s vital to resist this.”

So a cheap and devalued currency really helps an export economy.  But there is a downside to that.  In some of these touristy areas with a really weak currency it is not uncommon for some people to offer to sell you things for American dollars.  Or British pounds.  Or Eurozone euros.  Why?  Because their currency is so week it loses its purchasing power at an alarming rate.  So fast that they don’t want to hold onto any of it.  Preferring to hold onto a stronger foreign currency.  Because it holds its value better than their own currency.

When a nation prints money it puts more of them into circulation.  Which makes each one worth less.  And when you devalue your currency it takes more of it to buy the things it once did.  So prices rise.  This is the flipside to inflation.  Higher prices.  And what does a devalued currency and rising prices do to a retiree?  It lowers their quality of life.  Because the money they’ve saved for retirement becomes worth less just as prices are rising.  Causing their retirement savings to run out much sooner than they planned.  They may live 15 years after retirement while their savings may only last for 5 or 6 of those years.

Printing money to devalue a currency to expand exports hurts those who have lived most responsibly.  Those who have saved for their retirement.  Making them ever more dependent on meager state pensions.  Or welfare.  And when that’s not enough to cover their expenses they have no choice but to go without.  We see this in health care.  Where those soaring costs have an inflationary component.  With the government squeezing doctors on Medicare reimbursements doctors are refusing some life-saving treatment for seniors.  Because the government won’t reimburse the doctors and hospitals for these treatments.  Or doctors will simply not take any new Medicare patients.  As they are unable to provide medical services for free.  And with their savings gone seniors will have no choice but to go without medical care.

The United States, Britain, Europe, Japan—they are all struggling to provide for their seniors.  As China will, too.  And a big part of their problem is their inflationary monetary policies.  Coupled with an aging population.  The Keynesians in these nations have long discouraged their people from saving.  For Keynesians see private savings as leaks in the economy.  They prefer people to spend their money instead of saving it.  Trusting in state pensions and state-provided health care to provide for these people in their retirement.  Which is why the United States, Britain, Europe and Japan are struggling to provide for their seniors in retirement.  A direct consequence of printing too much money.  And not letting people take care of their own retirement and health care.

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The U.S. and Japan assailed Argentina’s Mercantilist Trade Policies at the World Trade Organization

Posted by PITHOCRATES - August 26th, 2012

Week in Review

International trade can be a funny thing.  For mercantilist ways of the past are hard to give up.  Especially the misguided belief that a trade deficit is a bad thing.  Some nations are better at some things than other nations.  And have a comparative advantage.  And it would be foolish to try and produce something another nation can produce better.  It would be better for nations to do the things they are best at.  And import the things that others are better at.  Just as David Ricardo proved with his law of comparative advantage.  Still everyone still wants to export more than they import.  Still believing that their mercantilist policies are superior to the capitalistic policies that are characteristic of advanced economies.  While mercantilist policies can rarely advance beyond emerging economies.  Case in point Argentina (see Argentina says to file WTO complaint against U.S by Tom Miles and Hugh Bronstein posted 8/21/2012 on Reuters).

The United States and Japan assailed Argentina’s import rules as protectionist at the World Trade Organization on Tuesday, putting more pressure on the country to revamp policies that many trading partners say violate global norms.

The two complaints mirrored litigation brought by the European Union in May and triggered a swift reaction from Argentina’s center-left government, which vowed to challenge U.S. rules on lemon and beef imports.

Argentina is seen by many fellow Group of 20 nations as a chronic rule-breaker since it staged the world’s biggest sovereign debt default in 2002. It remains locked out of global credit markets and relies on export revenue for hard currency.

They have inflated their currency so much that it is nearly worthless.  They can get little of foreign currency in exchange for it.  So they depend on the foreign currency buying their exports for their money needs.  For they can’t destroy foreign currency with their inflationary policies.  Only the wealth and savings of those in Argentina who don’t have access to these foreign currencies.

In the old days the mercantilist empires brought gold and silver into their countries.  They had their colonies ship raw material back to the mother country.  The mother country manufactured them into a higher valued good.  Then exported it for gold and silver.   Today we don’t use gold and silver anymore.  So Argentina just substituted foreign currency into the formula.  While keeping the rest of it in place.

Argentina began requiring prior state approval for nearly all purchases abroad in February. Imports have since fallen compared with last year’s levels, boosting the prized trade surplus but causing some shortages of goods and parts and sharply reducing capital goods imports.

EU and U.S. officials say Argentina has effectively restricted all imports since the new system came into place…

On Monday, Argentina hit the EU with a separate WTO complaint, alleging discriminatory treatment by Spain against Argentine shipments of biodiesel.

“This measure, like others taken by the European Union and other developed countries for decades, effectively aims to keep our industries from rising along the value chain, limiting the role of developing countries to the provision of raw materials,” the Foreign Ministry said in a statement…

Latin America’s No. 3 economy relies heavily on a robust trade surplus, which is used to help fatten central bank foreign reserves tapped to pay government debt. The government has also moved to curb imports to protect local jobs, while imposing capital and currency controls to keep dollars in the country.

“Import growth has halted, which we should have done long before,” Foreign Trade Secretary Beatriz Paglieri was quoted as saying on the presidential website last weekend…

Argentina has also been criticized for a policy of “trade balancing,” which forces an importer to guarantee an equal value of exports. That has spawned offbeat deals whereby a car producer, for example, must ship a large amount of rice out of the country in return for a consignment of vehicle components.

Mercantilist to the core.  Which will forever trap them into being an emerging economy.  For they’ve been doing this for decades.  And they’re still an emerging economy.  Juan Peron rose to power with the same mercantilist arguments.  He was a Justicialist.  Today’s president is a Justicialist.  President Cristina Fernandez.  And little has changed since World War II.  Argentina is still an emerging economy.  Thanks to their mercantilist policies.  If they’d only give capitalism a chance their economy would explode with economic activity.  At least, based on history.  For the most advanced economies today are NOT based on the current Argentine model.  They’re based on the free trade of capitalism.  And David Ricardo’s comparative advantage.

In countries with free trade people enjoy higher standards of living.  Their governments give them this good life by doing as little for them as possible.  Letting the free market shower them with wealth and happiness.  Which brings us back to the funny part about international trade.  The countries that try to do the most for their people by restricting free trade give their people a lower standard of living.  Except, of course, for the few in power.  Or for those connected to power.

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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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World War I, Gold Standard, German Reparations, Hyperinflation, Credit-Anstalt, Keynesian Policies and the Great Depression

Posted by PITHOCRATES - March 13th, 2012

History 101

Nations abandoned the Gold Standard to Borrow and Print Money freely to pay for World War I 

Banks loan to each other.  They participate in a banking system that moves capital from those who have it to those who need it.  It’s a good system.  And a system that works.  Providing businesses and entrepreneurs with the capital to expand their businesses.  And create jobs.  As long as all the banks in the system go about their business responsibly.  And their governments go about their business responsibly.  Sadly, neither always does.

World War I changed the world in so many ways for the worse.  It killed a generation of Europeans.  Bankrupted nations.  Redrew the borders in Europe as the victors divvied up the spoils of war.  Setting the stage for future political unrest.  Gave us Keynesian economics.  Saw the beginning of the decline of the gold standard.  A deterioration of international trade.  A rise of protectionism and nationalism.  Punishing German reparations.  To pay for a war that they didn’t necessarily start.  Nor did they necessarily lose.  Which created a lot of anger in Germany.  And provided the seed for the Great Depression.

A set of entangling treaties brought nations eagerly into World War I.  There was great patriotic fervor.  And a belief that this war would be Napoleonic.  Some glorious battles.  With the victors negotiating a favorable peace.  Sadly, no one learned the lessons of the Crimean War (1853-1856).  Which killed approximately 600,000 (about 35% of those in uniform).  Or the American Civil War (1861-1865).  Which killed approximately 600,000 (about 20% of those in uniform).  The first modern wars.  Where the technology was ahead of the Napoleonic tactics of the day.  Modern rifled weapons made accurate killing weapons.  And the telegraph and the railroads allowed the combatants to rush ever more men into the fire of those accurate killing weapons.  These are the lessons they didn’t learn.  Which was a pity.  Because the weapons were much more lethal in World War I (1914-1918).  And far more advanced than the tactics of the day.  Which were still largely Napoleonic.  Mass men on the field of battle.  Fire and advance.  And close with the bayonet.  Which they did in World War I.  And these soldiers advanced into the withering fire of the new machine gun.  While artillery rounds fell around them.  Making big holes and throwing shredded shrapnel through flesh and bone.  WWI killed approximately 10,000,000 (about 15% of those in uniform).  And wounded another 20 million.  To do that kind of damage costs a lot of money.  Big money.  For bullets, shells, rifles, artillery, machine guns, warships, planes, etc., don’t grow on trees.  Which is why all nations (except the U.S.) went off of the gold standard to pay for this war.  To shake off any constraints to their ability to raise the money to wage war.  To let them borrow and print as much as they wanted.  Despite the effect that would have on their currency.  Or on foreign exchange rates.

As Countries abandoned the Gold Standard they depreciated their Currencies and wiped out People’s Life Savings

Well, the war had all but bankrupted the combatants.  They had huge debts and inflated currencies.  Large trade deficits.  And surpluses.  A great imbalance of trade.  And it was in this environment that they restored some measure of a gold standard.  Which wasn’t quite standard.  As the different nations adopted different exchange rates.  But they moved to get their financial houses back in order.  And the first order of business was to address those large debts.  And the ‘victors’ decided to squeeze Germany to pay some of that debt off.  Hence those punishing reparations.  Which the victors wanted in gold.  Or foreign currency.  Which made it difficult for Germany to return to the gold standard.  As the victors had taken most of her gold.  And so began the hyperinflation.  As the Germans printed Marks to trade for foreign currency.  Of course we know what happened next.  They devalued the Mark so much that it took wheelbarrows full of them to buy their groceries.  And to exchange for foreign currency.

Elsewhere, in the new Europe that emerged from WWI, there was a growth in regional banking.  Savvy bankers who were pretty good at risk evaluation.  Who were close to the borrowers.  And informed.  Allowing them to write good loans.  Meanwhile, the old institutions were carrying on as if it was still 1914.  Not quite as savvy.  And making bad loans.  The ones the more savvy bankers refused to write.  Weak banking regulation helped facilitate these bad lending practices.  Leaving a lot of banks with weak balance sheets.  Add in the hyperinflation.  Heavy debts.  Higher taxes (to reduce those debts).  Trade imbalances.  And you get a bad economy.  Where businesses were struggling to service their debt.  With many defaulting.  As a smaller bank failed a bigger bank would absorb it.  Bad loans and all.  Including an Austrian bank.  A pretty big one at that.  The largest in Austria.  Credit-Anstalt.  Which was ‘too big to fail’.  But failed anyway.  And when it did the collapse was heard around the world. 

As banks failed the money supply contracted.  Causing a liquidity crisis.  And deflation (less money chasing the same amount of goods).  Currency appreciation (further hurting a country’s balance of trade).  And low prices.  Which made it harder for borrowers to service their debt with the lower revenue they earned on those lower prices.  So there were more loan defaults.  Bank runs.  And bank failures.  Spreading the contagion to Amsterdam.  To Warsaw.  Germany.  Latvia.  Turkey.  Egypt.  Britain.  Even the U.S.  Soon countries abandoned the gold standard.  So they could print money to save the banks.  Lower interest rates.  Depreciate their currencies.  And wipe out large swathes of wealth denominated in that now depreciated currency.  What we call Keynesian policies.  People’s life savings became a fraction of what they were.  Making for a longer working life.  And a more Spartan retirement. 

Abandoning the Gold Standard didn’t fix the U.S. Economy in 1971

Meanwhile in the U.S. the government was destroying the U.S. economy.  Trying to protect domestic prices they passed the Smoot-Hawley Tariff.  Raising the price for businesses and consumers alike.  And kicking off a trade war.  Both of which greatly reduced U.S. exports.  New labor legislation keeping wages above market prices while all other prices were falling.  And higher taxes to pay for New Deal social programs.  Wiping out business profits and causing massive unemployment.  Then came the fall in farm prices due to increased farm productivity.  Thanks to farmers mechanizing their farms and greatly increasing their harvests.  Thus lowering prices.  Making it hard to service the bank loans they got to pay for that mechanization.  Thus leading to bank failures in the farming regions.  That spread to the cities.  Causing a liquidity crisis.  And deflation.

Then came Credit-Anstalt.  And all the woe that followed.  Which caused a speculative run in Britain.  Which made the British decide to leave the gold standard.  To stem the flow of gold out of their country.  Which destroyed whatever confidence was still remaining in their banking system.  People thought that the U.S. would be next.  But the Americans defended the dollar.  And instead raised interest rates (by reducing the money supply).  To keep the dollar valuable.  And to protect the exchange rate.  Making it less attractive to exchange cash for gold.  And to restore confidence in the banking system.  Of course, this didn’t help the liquidity crisis.  Which Keynesians blame for the length and the severity of the Great Depression.

Of course, it wasn’t the gold standard that caused the fall of Credit-Anstalt.  It was poor lending practices.  A weak banking regulation that allowed those poor lending practices.  And a lot of bad government policy throughout Europe.  Especially those punishing German reparations.  And the gold standard didn’t cause the economic collapse in the United States.  For it worked well the previous decade.  Providing all the capital required to produce the Roaring Twenties that modernized the world.  It was government and their intrusive policies into the free market that caused the economic collapse.  And abandoning the gold standard wouldn’t have changed that.  Or made the economy better.  And we know this because leaving the gold standard didn’t solve all of the countries woes in 1971.  Because the government was still implementing bad Keynesian policies.

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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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