Maybe I should be singing Barry McGuire’s Eve Of Destruction, instead of Hall and Oates. What with the articles warning about hyperinflation, the demons of deflation, the race to devalue one’s currency, and now the fall of the dollar as the world’s reserve currency, we all might believe we have dropped into that proverbial pit called hell.On the other hand, the main component so many of these articles tend to share is a basic ignorance of currency, money (yes, there is a difference), credit, and debt. Let’s start with money. If I were to ask you what you think money is, what would you tell me? I’ve got a five dollar bill in my pocket and some change. No, that’s currency. I have in my wallet, jars, dishes, and strong boxes, several different currencies. I have Mexican pesos, Euros, French Francs, German Marks, British pounds, and a host of other currencies I have brought back from my travels to various countries. Currency it what countries issue as a representation of money. I know, it sounds confusing. Simply put, money is a medium of exchange. It has worth according to at least those who will use it as an exchange for goods and services. Money is that third party in a barter economy. You want something I have but you don’t have something I want. Hence we need a third party who has what I want and wants what you have. Problem solved. Money is that thing we will take in exchange for what we have.
Big deal, you say. Yes, it is a big deal. You have goods and services to sell but live in a different country with a different currency. To you, your currency is the same as money. I have goods and services to sell as well and my currency is of a different currency than yours. Yes, we both have money in our respective countries but now we have a problem. You can’t spend your currency in my country and I can’t do the same. How do I know the value or worth of your currency and you the same knowledge of mine? We need a medium of exchange that arbitrates the differences between currencies. We use to call it a gold standard, but after 1971 no one settles their national currency accounts in gold. You see, gold is a precious metal, that is, among the metals we find in the earth, it has a rare occurrence. Silver is a little more plentiful and can be used to the same effect as gold. In fact, gold, silver, and platinum have acted are mediums of exchange over the centuries. Their collective drawback when used as money is that they are heavy, a little bulky, and quantities of the same material are not always of the same purity. So what happened in 1971? America went off the gold standard and all crude oil contracts were quoted in US dollar amounts. The American dollar became the reserve currency. That seemed to be easy enough as a solution to not enough world gold (the assumption that those who mined and produced gold were at a distinct advantage over those who did not) to make currency account settlements equitable. America was the world’s largest economy by far and thus, since everyone held dollars why not let the dollar be the de facto gold standard by way of a reserve currency. Of course one can grasp the idea immediately, what if we cheated and printed more currency? Ah, the perfect introduction to current accounts settlement comes from the segment of the film “NetWork” when Arthur Jensen is speaking to Howard Beale in the boardroom of CCA. “The Arabs have taken billions of dollars out of this country and now they must put it back, (meaning the buying of CCA and other American companies) It is the ebb and flow of world business.”
In the perfect world countries would trade with each other according to their percentage of the total world’s economy. This would create equilibrium and so the flows of currencies would, relative to a reserve currency or gold standard, occur somewhat evenly, no great disruptions in the system. But like owning the only gold mine, every time you dig more out and spend it you create more inflation, prices rise relative to the quantities of goods and services. Since Great Britain owned South Africa and the other gold producing regions in that area of Africa, it could essentially buy its empire with the gold it produced. But don’t take my world for it, go back to Spain’s empire, all purchased with gold. Why bother building up industry when you can buy all you need, except for the peons, whose needs are great and whose resources are poor. So we use a reserve currency, the American Dollar. Of course we now have the problem that China and Japan and Germany have the second, third, and fourth largest economies in the world and world trade needs something better than the dollar. The dollar is losing its reserve status. That means that we will go through a devaluation due to the fact that other currencies are being used in the place of the dollar. It is the law of supply and demand. More and more countries will not wish to hold reserves of our dollars or what be the second best substitute, US Treasuries. What does this mean to the world? If apples are used as the reserve currency and now pears and peaches are being substituted for apples, then we may have too many apples in barrels standing around. Now in order to use apples we may have to use double the number of apples to buy goods and services from the people who use to be satisfied with the original amount. We are losing that third party standing in the world of currency. That makes the dollar weaker in the long run.
This brings us to foreign exchange trading. When there is no real standard to a currency, then its value, its worth is subject to interpretation. What makes a dollar worth a dollar? Our Federal Government says that each printed dollar can be used to settle accounts that individuals and corporations have with the federal government. If I owe the IRS $100 in taxes, it will accept a one hundred dollar bill or one hundred one dollar bills or any valid combination of denominations. On the other hand, how do I know that your apple is worth one dollar? How do you know its value shouldn’t be two dollars? This is the problem with fiat currency, the value is what the issuing government says its worth but that appraisal is limited to what the government will buy, and if the government is not buying apples then it’s anybody’s guess what an apple is worth. Kind of scary, isn’t it? This brings us to the idea of credit. Credit is a promise, nothing more. Credit is not money (or more properly, currency) in the bank. Credit says that if you borrow currency from the bank or you parents or your friend, that you are good for it, you can and will repay that amount back and with interest (the cost of renting currency). In the same way, fiat currency is very much like credit. The issuing government promises that it is worth what it says it is worth and the rest of us take the government’s word until we can’t. Hyperinflation is when we no longer believe that a fiat currency is worth what the issuing government says it is worth. Sometimes credit is an easy promise, such as when te old credit union rules allowed you to borrow against your savings for a very small interest rate. The credit union knew you were good for it because you had the currency in the savings account to make it good. Essentially, credit is the Wimpy transaction, a hamburger for today for a dollar next thursday. Credit is a possible claim on future earnings. That is, if you decided to borrow against your future earnings you would have the opportunity to do so. If no one is willing to give you credit then you cannot possibly borrow against future earnings. That borrowing is what we call debt.
Debt can be rightly considered an inflationary device. Why? Because it shits demand forward to the present and puts pressure on supply, thereby increasing price. But this also means that future demand is pushed further into the future and if supply then increases too much the price will contract. This is the deflationary part of debt. The cost of debt is the inflated prices and the cost or renting the amount of currency used to increase demand. Now let us tie this into reserve currency. The value of a reserve currency is a promise of its worth by many different parties. But being that it is not exactly fixed to a standard (barrels of crude oil fix the standard but that is as long as supply remains relative to consumption. If supply increases, then the dollar is worth less, deflated relative to the supply of oil, and it supply is reduced than the dollar is worth more, or inflated), the dollar is subject to a good many other forces in the world economy. And one must sum up all the various economies in the world and see the relative interaction to understand what is happening in the world. So now China wants it Yuan to be at least one of the worlds reserve currencies. This would be similar to having a gold and a silver standard for currencies. You see, the problem of not having a reserve currency or of having two or three is that it increases the cost of foreign exchange transactions. And one of the main costs in foreign exchange is the conversion manipulation by these huge banking entities. When you can’t trust your bank to settle an honest account then the world does, indeed, have problems. Price fixing by large bank FX traders is a real problem and adds unnecessary cost to transactions. The individual world banks may be too big to fail but the individual big bankers aren’t too big to hang.