Since January 2002 the US dollar has fallen by 25.6% against the Euro (see chart) and 13.2% against the yen (see chart).
Most experts are of the view that the sharp fall in the dollar is the result of the fact that American imports of goods by far exceed exports of goods. In March the trade gap stood at $43.5 billion, not far from the record deficit of $44.9 billion in December last year (see chart). As a percentage of GDP the annualised trade deficit stood at 4.7% in Q1 against 4.5% in the previous quarter (see chart). But is it true that the state of the trade account is what determines the exchange rate of the US dollar?
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Every participant in a market economy is a seller and a buyer of goods and services. In his capacity as a seller of goods he in fact exports those goods to other individuals. While in his capacity as a buyer of goods he in fact imports these goods from other individuals. In other words, every participant in a market economy is both an exporter and an importer. For instance, a baker that produces 10 loaves of bread and consumes 2 loaves can now sell ie. export 8 saved loaves of bread to a shoemaker for a pair of shoes. The pair of shoes that the baker secures for the 8 loaves of bread is his import. Observe that he paid for the import with his export i.e., 8 loaves of bread is payment for the pair of shoes.
The introduction of money does not alter the essence of what we have said i.e., that individuals pay for their imports by means of exports. Thus a producer exchanges the goods he produces for money and then employs money to secure ie. to import, goods from other producers.
In similarity to prices of goods the supply and demand for money determines the price of money, or its purchasing power. For a given supply of money an increase in the production of goods implies that producers would demand more money since more goods must now be exchanged for money. As a result of this the exchange value or the purchasing power of money will increase. Every dollar will now command more goods. If the supply of money increases for a given stock of real goods the purchasing power of money falls since now there are fewer goods per dollar. In short, the prices of goods at any point in time are the manifestation of a given state of supply and demand for money.
Would the calculation of the balance of payments alter our conclusion that the purchasing power of money is determined by the supply and demand for money? For the balance of payments to influence the purchasing power of money one needs to show that it can alter the supply and demand for money. Can the balance of payments, which is the difference between the monetary value of what was sold versus the monetary value of what was bought, alter the supply of money? Obviously not, since the supply of money is determined by central bank monetary policies. Likewise, the balance of trade cannot determine the given stock of goods. The balance of payments only records the value of given goods bought and sold by an individual or a group of individuals.
We can thus conclude that the balances of payments within a country do not cause the purchasing power of money in that country.
Now, if a given basket of goods is exchanged in the US for $1 and the same basket of goods is exchanged for 2 Euros in Europe then the rate of exchange between the US dollar and the Euro will be set as $1 for 2 Euro. If money supply increases in Europe and as a result 3 Euros are now exchanged for the same basket of goods, the rate of exchange between the US$ and the Euro will be set as $1 for 3 Euro. Any deviation of the exchange rate from the level dictated by the purchasing power of currencies will set corrective forces in motion.
To put it simply, if in the US the price of 1kg of potatoes is $1 and in Europe 2 Euros, then according to the purchasing power framework the currency rate of exchange should be $1 for 2 Euros. Now suppose that the rate of exchange was set in the market at $1 for 3 Euro. In other words, the dollar is now overvalued. It will pay to sell potatoes for Dollars then exchange dollars for Euros and then buy with Euros potatoes — thus making a clear arbitrage gain.
For example, individuals will sell 1kg of potatoes for $1 dollar, exchange the $1 for 3 Euros, and then exchange 3 Euros for 1.5 kg of potatoes, gaining 0.5 kg of potatoes. The fact that holders of Dollars will increase their demand for Euros in order to profit from the arbitrage will make Euros more expensive in terms of Dollars and this in turn will push the exchange rate in the direction of $1 to 2 Euros.
According to Rothbard:
"Thus, the exchange rate between any two monies will tend to be at the purchasing power parity. Any deviation from the parity will tend to eliminate itself and re-establish the parity rate.
"In similarity to balances of payments within a country, the balance of payments between countries does not cause the respective purchasing power of money and hence does not cause the currencies rate of exchange. Within a country when a baker imports shoes from a shoemaker he pays with the bread he produced. Things will not be different if American baker has exchanged his produce with a Japanese shoemaker. Note that the respective import and export of goods doesn't alter the overall stock of goods. Hence for a given stock of money no change in the purchasing power of money emerges."
Let us assume that the rate of exchange between the US$ and the Yen is 1:1 i.e.$1 for 1Yen, and it is also in line with the respective purchasing power parity of the US and Japan. Let us further assume that money is created out of "thin air" in the US. American importers employ the new money to buy Yen. In the process the exchange rate of Yen against the dollar appreciates to $2:1Yen.
With Yen Americans now buy Japanese goods. The trade balance of the US with Japan moves into deficit. Observe that what we have here is an exchange of nothing for something. Americans sell unbacked by production money for goods. Japanese would have difficulty to secure real goods from Americans for the dollars they have received since these dollars are unbacked by production. This will be manifested by an increase in prices in the US. In short, by means of empty dollars Americans have diverted real Japanese savings to themselves.
Consequently, what we have here is a fall in US money purchasing power, a fall in the US$ rate of exchange against the Yen and US trade deficit with Japan.
So while the trade balance doesn't cause the currency rate of exchange, it does however, provide an indication of the extent of monetary abuses of the central bank. In short, it provides an indication regarding the diversion of foreigners’ real savings to the country that is engaged in reckless monetary policy. Since the US$ is the most acceptable medium of exchange the US central bank’s monetary policy is an important means in the diversion of foreigners’ real savings. Can this diversion continue without consequences?
Now, within the framework of a fixed exchange rate excessive monetary pumping by a country's central bank will lead to a run on the currency of the country and put a halt to loose monetary policy. However, in the framework of a floating exchange rate system the adjustments in rates of exchange are smooth and it takes a long time before the crisis point emerges. Moreover, if all central banks are coordinating their monetary policies, as is the case at present, the crisis can be averted for a long period of time. Only if central banks stop coordinating their policies can a currency plunge and an economic crisis emerge — on account of one central bank pushing its monetary pumping more aggressively. It remains to be seen whether the US central bank has decided to go its own way and accelerate its monetary pumping relative to other central banks.
An important factor that currently forces the US$ down is the emerging perception that policy makers want the dollar to weaken. According to this way of thinking a weaker dollar will boost exports, which in turn will revive the entire economy.
However, currency depreciation cannot create more real goods and thus grow the economy. On the contrary, a fall in the exchange value of the dollar on account of a loose monetary policy can only weaken and not strengthen the economy.
As a rough guide looking at changes in the supply of money relative to its demand can do much to explain movements in the purchasing power of moneys and the exchange rate. A comparison of money supply growth versus the rate of growth of a country's economic activity gives the "excess money supply rate of growth". (An increase in economic activity implies more goods are produced and hence a greater demand for money). The relative excess money supply rate of growth provides an important clue for the likely direction of a currency's rate of exchange. Thus, if over time the excess money supply rate of growth in the US exceeds the excess money supply rate of growth in Europe the US$ will depreciate against the Euro. The converse will happen if over time the excess money growth will fall in the US versus Europe.
In this regard, the excess money growth of the EMU in relation to US, or the excess money growth differential between the EMU and the US, after falling to -4.3% year-on-year in September 2001 jumped to 5.5% in March this year (see chart). In short, Europeans print money at a faster pace now than Americans. Given the fact that the effect from changes in money supply operates with a lag this means that the strong rebound in the excess money growth differential between the EMU and the US raises the likelihood that in the months ahead the US$ should strengthen against the Euro.
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After falling to 0% in February 2001, the excess money growth differential between Japan and the US climbed to 27.6% by April last year. From then onward the excess money growth has been on a decline falling to 7.8% by March this year (see chart). On account of the lags we suggest that the effect from the acceleration in the differential between February 2001 and April 2002 is likely to assert itself in the months ahead. In short, the US$ is still likely to strengthen against the Yen before the effect of the falling differential between April 2002 and present asserts itself.
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Contrary to popular thinking, it is the purchasing power parity, and not the state of the trade account, that sets the exchange rate between any two monies. The latest fall in the US$ is not so much a crisis of the US currency in response to the trade deficit as it is a crisis of the present floating exchange rate system, which permits unchecked loose monetary policies by central banks. These unchecked policies create the conditions for severe distortions.
In the floating exchange rate framework by means of monetary policies coordination, central banks can create the illusion of currency stability. But this approach can undermine real economies over a prolonged period of time.
The longer the current floating exchange rate regime is allowed to function, the more damage is inflicted on wealth producers. The only way out of this mess is to seal off all loopholes to monetary pumping.
