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.

www.PITHOCRATES.com

Share

Tags: , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,

FT125: “Welfare states fail because economic systems based on slavery don’t create enough stuff.” -Old Pithy

Posted by PITHOCRATES - July 6th, 2012

Fundamental Truth

In the Barter System the Only Way to Get Something you Wanted was to create Something of Value Yourself

What’s more important?  Money?  Or stuff?  Stuff, of course.  Because people work to earn money to buy stuff.  They don’t work just for the money.  Because you can’t eat money.  You can’t drink money.  You can’t smoke money.  You can drive money.  You can’t watch or listen to money.  You can’t live in money.  You can’t surf the Internet with money.  No.  The only thing money is good for is buying stuff.  It’s the stuff we buy that makes our lives more enjoyable.  Having money helps.  But it is only a means to an end.  That end being stuff.  And someone has to make that stuff.  For if no one does then all the money in the world is worthless.

Early economies were barter economies.  People traded stuff.  Stuff they created, dug up, grew, manufactured, etc.  Instead of working to earn money to buy stuff they created stuff and traded it for other stuff.  So the only way to get something you wanted was to create something of value yourself.  Money didn’t change this.  Money just made trading with other people more efficient.  By being a temporary storage of wealth.  Because the barter system had a serious flaw.  High search costs. 

It took time to bring two people together to trade their stuff.  If a toolmaker wanted a pottery vase he had to find a potter who wanted a tool the toolmaker made.  This could take awhile.  Hence the high search costs.  Because while these people were seeking each other out they couldn’t make anything else of value.  With money, though, you could accept money in trade.  And then go and trade that money for what you wanted.  This greatly reduced search costs.  Because all you had to do was find the things you wanted.  And trade your temporary storage of wealth (i.e., money) for them.  Allowing them to spend more time creating value.  And less time searching.

The North won the American Civil War because the North practiced Free Market Capitalism while the South Didn’t

Advances in agriculture allowed larger and larger food surpluses.  Which, in turn, allowed more and more people to do something other than farm.  This unleashed human capital.  Allowed people to think about other things.  Create new things.  And improve existing things.  This created a middle class of artisans.  Craftspeople.  The people that created goods and services and brought them to the market place.  Creating the complex economy.  These people became entrepreneurs.  They efficiently used resources and sold things in the market place the people were demanding.  Not out of the goodness of their hearts.  But because they were pursuing profits.

This is free market capitalism.  The economic system that ushered in the modern world.  Free people thinking freely.  Creating.  Bringing their bold new ideas into reality.  Giving us the steam engine.  The railroad.  Machine tools.  Electric power.  The assembly line.  Free market capitalism brought us these things and improved our standard of living.  Because they were free to enter the market place.  And make profits.  Providing a powerful incentive to make the world a better place for everyone else.  Because when they took risks and worked hard to make the world a better place they could get rich in the process.

This is why the North won the American Civil War.  Because the North practiced free market capitalism.  While the South did not.  Their economy was a slave economy.  Instead of an expanding middle class working and contributing to the economy they had an expanding slave population.  That didn’t contribute to the economy.  They worked in the fields.  With all the proceeds from their labors going to a few plantation owners.  Slaves in general didn’t tinker or bring new things to market to enrich their masters.  For they had no incentive to do so.  They did have an incentive to do as they were told and work the fields.  To avoid punishment.  And they had no wages to spend in the market.  So there was less demand for manufactured goods in the South (in some states of the Deep South slaves made up to a third to half of the population).  So there was less manufacturing in the South.  Far less.  This is why the North exploded in manufacturing.  Entrepreneurs could bring things to market.  And the manufacturing workers earned wages they could use to buy those things.  As well as mass-produce the implements of war.  Unlike they could in the South.  Because of the economic superiority of the North it was just a matter of time before the South was overwhelmed.  And lost. 

When the Roman Empire turned into a Welfare State they had to Force People to Make Stuff Against their Will

Governments can print money.  They can tax people.  They can borrow money.  But the one thing they can’t do is create stuff.  If they could create stuff (i.e., economic activity) simply by printing money then the South would have matched the North in economic output.  But they did not.  Which is why they ultimately lost the war.  Because they could print Confederate dollars.  But that didn’t make muskets, bullets, canon, shoes, food, ships, steam locomotives or railroad track.  Creative people had to make these things first before the Confederate government could procure them.  Which is why the government didn’t procure them.  Because no one made them.

This is why governments just can’t print money and give it to the people.  They could.  But it would be pointless.  Let’s say they gave everyone $100,000 a year.  So no one would ever have to work again.  A lot of people would vote for the politician that promised that.  Of course if no one works who will create all the stuff to buy with that $100,000?  Having money is one thing.  But if there is nothing to buy with it then that money is worthless.

This is why the welfare state will ultimately fail.  As more people collect welfare benefits instead of creating stuff there will be less stuff to buy.  When supply shrinks while demand increases prices rise.  Higher prices that everyone has to pay.  People who create.  And people who don’t.  So they will raise taxes on those who work to pay for the benefits for those who don’t.  So those who don’t work can afford the higher prices, too.  Higher taxes are a great disincentive to create.  Or to become an entrepreneur.  Some may just choose the easier path.  Stop creating.  And start collecting that government money, too.  Further reducing supply and increasing demand.  Raising prices further.  Reducing overall economic activity.  And reducing the standard of living.

This happened in the Roman Empire as they kept raising taxes and debasing their coin to pay for their excessive government spending.  It got so bad that people quit their jobs because they couldn’t make any money.  Creating great shortages of goods.  And food.  So the Romans passed laws forbidding people from leaving their jobs.  Even tied people and their descendants to the land they farmed.  Which grew into European feudalism.  And Russian serfdom.  Economic systems little better than the slavery of the Deep South.  Which stunted innovation.  Lowered the standard of living.  And led to the fall of the Western Roman Empire.  But it was the only way the Romans could get the stuff they needed.  By forcing people to make it against their will.  Which is what they had to do when the Roman Empire turned into a welfare state.  And the creators quit creating.

www.PITHOCRATES.com

Share

Tags: , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,