If one were going to try and predict the future currency exchange rates, and notice that I am putting the question in terms of exchange rates, not relative strength within a particular country or monetary union. one would need to consider a great many factors. First of all, the Dollar is still the preferred world currency for contract settlements. As much as the Chinese want to become the world’s reserve currency, that cannot happen if they still want to cheat and peg their currency to the Dollar. One country cannot have its cake and eat it too. Being the reserve currency places undue stress on a currency. It gives it a force, a boost in value and strength that would not come through the normal exchange processes. We are talking the difference between currency and money. Confused? All economic transactions are really extensions of the barter process. You and I have something to sell, perhaps we can do a deal. But only if you have what I want and I have what you want. Otherwise we are at an impasse. We may need other parties to barter with us so that we each can sell what we have and but what we want. Money is called a medium of exchange for a reason. It facilitates the barter system. I am willing to work as an engineer designing bridges. You are a construction company owner. You pay me in the currency of the realm for my services. The butcher doesn’t need my services, he needs my currency. The steel company doesn’t need the constructions services, it need currency. And so it goes, transaction after transaction. Money is that third part to a two party agreement when the two parties can’t agree on exchange. One no longer needs to seek out one or more other participants in the bartering to make deals possible. Money does that for you, and currency is what we exchange as money. Now the problem comes when each of us has our own currency and we wish to trade. This idea of exchanging currency is the same as bartering. Money is still the medium of transactions, but we must decide how we can value each currency. Back when we had a gold and silver standard that was quite easy. How much gold does your country have in the vault versus how much gold does my country have in the vault? If you print too many pieces of your currency then I may insist on payment in gold according to what my currency is worth. Simple enough, just divide that amount of currency you have into the amount of gold you have and out pops the relative value.
The world has been off the precious metal standard for some forty four years now and look at the problems we have with reserve currencies and currency pegs. Last year America’s current account with the EMU was $264 Billion, a deficit, meaning we bought more of their stuff than they bought of ours. What do they do with all those extra Dollars in their account? Well, we are the world’s reserve currency and thus The EMU needs dollars to settle their current accounts with other non EMU countries. But when they have more than they need and the rest can’t be used to settle any other accounts, then the value of our Dollar drops. We either have to buy less or or sell more goods and services to the EMU. If the value of our currency goes down because we are running a deficit in our current accounts (note the plural) then our goods and services become less expensive and more attractive to other buyers. Thus we sell more sell more goods and services and our current accounts may see surpluses. But there is a joker in the deck of cards. Credit is that joker because credit spends just like money. Notice I said just like money since credit does operate as a medium of exchange just as money does. This is something that almost all economists fail to fully comprehend. No, they say, credit isn’t money. Do you have a credit card? Can you go and buy stuff with your credit card? If you can, then you are spending credit from your credit card. Did you even notice that there is a limit to the credit you have? You can spend all the credit in your account and you might be able to ask for more and get it. Go ahead, Mr Economist with all your Phds and explain how credit isn’t money.
But even more fun is that we can denominate credit in terms of currency. If I wish to purchase a house in Budapest I could ask for a mortgage where the repayment terms are in Euros or Swiss Francs. The bank, who may wish to sell my loan, perhaps bundle it in with a number of others and then sell slices of that total debt as shares of a security may find it far more attractive to potential customers than if the repayments were in Forints (the Hungarian currency whose value may fluctuate more widely that Euros or Swiss francs). But then there is the other considerations. If a country such as Greece decides to default on some 360 euros worth of loans/bonds, what does that do to the currency in the EMU? Think about this for a minute. If many of the largest banks in the EMU are over leveraged to the point where their holdings of Greek debt causes them to become insolvent, than what does that do the the euro? Understand, gold is an asset that pledges the value of a currency. But if government bonds which were pledged as assets for the value of the EURO as a currency are now worthless, then what does that do to the value of the euro? That bond you marked on your books as an asset now becomes a loss, a liability. And if all the individual EMU countries central banks are holding such assets/losses, and if the ECB is holding such assets/losses, can we say that the euro is a strong currency? We are talking about relative worth.
If our federal government has borrowed so much currency (not money) in terms of debt (debt is credit that has been spent but not repaid) and cannot possibly be repaid, then what is the worth of our currency? Remember, currency is a promise to pay some specified value for some specified good or service. It all gets down to that, doesn’t it? Why Economics 101 can’t teach this straight principle I don’t know. Do you see where this is going? Currency, like debt, is a promise of value, a promise to pay some prescribed value. You take out a loan you promise to repay some prescribed value to the creditor. Inflation may alter that value. That is, an inflated value of the “money” known as currency. When inflation is high a country’s currency is valued less. Why? Because it takes more of it to buy something of known value. When deflation occurs, as it is in Europe because the asset values have been greatly inflated as has been the credit/debt exchange, then re see deflation in asset values. That is, the price of various assets drop and one can buy more of them with the existing currency. Why does this sound like algebra equations? Over supply reduces demand which reduces price. But if your currency is based on asset values, then even though asset prices may diminish and your currency buys more, this is a relative value. Your currency on the world exchange may buy considerably less because your assets that back the currency are considerably reduced in world prices. Oh, no one really considers that problem. Why? Because when there is no universal standard such a precious metals, then we have to use something.
Consider for a moment that you wish to build a house. To do so you need a standard of measurement. You need to know what a foot and an inch are. A wooden yardstick may not be accurate down to the micron but it is accurate enough to build a house with universal measurements. A yard stick that varies in length, like one made of very stretchy rubble is of little value since the measurements will not be standard but vary greatly. Your house will look like something that Jack built. This is the problem with world currencies, Our financial house is the one that Jack built and we are having trouble living in. The corners aren’t square, the walls lean every which way, the roof leaks, the floor is uneven, the problems are numerous. So the real question as to how far the euro will far against the dollar is really a matter of he who defaults last. Europe will default before the US and thus we will be the last currency standing. This will greatly over value our currency before we, too, plunge into the economic abyss. China will fall possible before Europe and has a greater chance of civil war breaking out towards the end of this year, but ti will happen. Japan will fail either this year or next because there is so very little holding their economy up. It is the domino effect, once one goes the rest cascade until no one is left standing.