Thursday, 29 October 2009

Understanding why the dollar will devalue

John Mangun
Outside the Box
Business Mirror

JUDGING from the e-mails I receive, the more I try to explain, the more it seems that I confuse. But that is not entirely my fault. Money is a very complicated subject.

We tend to think of things in terms of value. The value or price that we place on a chicken is actually determined by the amount of effort, of work that we have to do to acquire it. A butcher might “pay” a doctor two chickens to be healed. That same butcher might only pay one chicken to the carpenter who helps build the butcher’s house.

Currency, money, was simply a kind of IOU representing the value of labor or goods. The butcher gives the doctor two IUOs each good for one chicken in exchange for the medical care.

Currency was originally printed by the banks as an IOU for the gold or silver that was deposited in the bank. Instead of carrying around a bag full of gold, a person could exchange bank notes for goods and the person who took the notes knew that a certain and fixed amount for the precious metal was stored at the bank.

Then governments started printing the money with fixed gold-exchange rates. In the early 20th century, one ounce of gold was exchanged for $20.

The fixed rate between gold and “money” was a good system for international trade. Imbalances in trade were theoretically solved automatically by a standard gold-exchange rate. A country with a trade deficit would have reduced gold reserves because its currency could be exchanged for physical gold, and the gold would flow out as they paid for imported goods. Most important, the money supply, based on the amount of stored gold, would be reduced. This would, in turn, reduce imports because there was not enough currency to spend to import.

But after World War I, the global economy was in such bad condition that countries like Great Britain changed their gold-/currency-exchange rate in order to create the illusion of wealth. Take this loose example. If in 1996 I held $100, I could also say that I was worth P2,600. Now if I still have that same $100, I can say that I am much richer today, worth P4,700. That is sort of what governments did.

Governments revalued their currency based on their gold reserves and, magically, they had more paper money which they called their wealth.

Back to the butcher. When he originally wrote that IOU good for one chicken, each chicken weighed 1.5 kilos. So the doctor thought he would be getting three kilos of chicken in return for his medical services. But when the doctor comes to make his claim with the butcher’s IOU, suddenly the chickens are much smaller. His two chickens now weigh a total of two kilos. So the next time the butcher wants to exchange chickens for medical care, the doctor wants three IOUs. The butcher has reduced the value of his IOU, his “currency”; the doctor has increased his “price.”

That is the simple example of currency devaluation and the resulting inflation.

Now to the US dollar. There is no gold standard anymore. Governments can print any amount of paper currency they want to. The US has doubled the amount of dollars in circulation between 2008 and 2009. The purpose was to stimulate economic activity and increased activity would create wealth.

That strategy has failed miserably.

The case for dollar devaluation is this. Increases in money supply without increasing wealth cause all sorts of domestic price inflation.

Assume that you are a foreign government or financial institution and you are owed $200 billion by the US government. When you loaned out that money, your $200 billion could buy an entire company like Coca-Cola. The price of Coca-Cola stock is up 35 percent in one year. But the value of the company based on profits is down about 3 percent. That is price inflation: price increasing faster than value. The dollar value of your loan in terms of what you can buy is now reduced.

More serious, though, is the risk of future substantial dollar depreciation. The US government is printing more dollars that are “worth” less. Why would the US government devalue the dollar? To more easily pay off its $20-trillion public debt in exactly the same way our butcher paid off his debt with smaller chickens.

Imagine this extreme example. Obama prints a lot of dollars and sends every American $1 million. Everyone is a millionaire. The person who works at McDonald’s is not going to work for $10 an hour anymore since he has a million in his pocket. So to get him to work, McDonald’s starts paying its employees $50,000 per hour. But then the Big Mac has to cost $10,000. That is hyperinflation, and it is a possibility if the amount of money in circulation grows too fast and too large. It happened in Germany in the 1920s, Hungary in the ’30s and Zimbabwe four years ago.

Hyperinflation is unlikely. But foreign dollar-denominated debt holders have lost 15 percent this year. If you are a Japanese bank, you sold yen, bought dollars and loaned the dollars to the US government. Now, when they pay you back the dollars and you bring the money back to Japan, you have lost money on the deal. Now, do you see why no one wants dollars?

As long as the US pursues its current monetary policy of printing money to fuel nonexistent growth, and there is no indication that policy will change soon, the dollar will continue to depreciate and depreciate.

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