International Currencies Made EZ #3

by | Dec 13, 2004 | Archives

Few economic events can have as much impact on your life as the falling U.S. dollar. I am learning this right now while on a trip to London. If one converts what things cost here in dollars…well its just better not to.

While I am away, the Gary Scott messages each day contain a review from the course International currencies Made EZ. This information can help you understand why and how currency parities move. Here is a section from Chapter Three. This report is dated but do not let the dates and numbers get in the way. The fundamentals remain the same.

Fundamentals-What Is a Currency?

Last lesson we learned that the elements that sustain life must be either produced or purchased. Things in this world are produced by work, prudent planning and sustained effort. We saw that in modern society, great wealth is produced by specializing work, and this specialization means that we must trade. Currency is the lubricant of trade.

How are things purchased? They are traded by exchanging something of value for something else of value. Thus there is no difference, essentially, between the “production of” and the “purchase of” the elements that sustain life. Production of the elements of life requires work, planning and sustained effort. Purchasing these same elements requires having a medium of exchange that other people think is valuable — and this medium of exchange can only be obtained by working, planning, etc. In other words, real money is stored work or stored energy.

Things of value are acquired by exchanging something else of value for them. This may be some form of commodity-an ox, a pelt, an ear of corn or a coin of gold. All of these are currencies, in so much that they are recognizable units of value that can be exchanged for other items of value. And each, ultimately, represents work. Currency, then, and money in general, can come from no other source than work. Currency represents work. It represents human effort and planning.

This definition of currency is just as true in our complex world as it was in ancient times. Fluctuations in currency prices may temporarily sway exchange rates, but prices will always ultimately be determined by the true underlying value, which is always dependent on work. In our modern and complex world, understanding this and keeping firmly fixed on this concept (using it as the basis for investment decision) gives a person a guide for establishing short and long term financial plans.

The way to keep our minds fixed on the reality of money is to understand that the underlying, fundamental truths of currency are based on very specific and simple economic rules.

Money is a form of exchange and as such is nothing more than a social agreement. This agreement (as with all social pacts that work for the long run) is ultimately tied to some part of natural law. In the case of money, the ultimate bottom line is the fact that something cannot be consumed unless it is first produced. This simple, commonsense law that is the fundamental of all money is so totally obvious it hardly seems worth stating. Yet ignorance of this fact has led governments (and will continue to lead then) to destroy currency after currency.

More History – Early Banking

The merchants of Italy are acknowledged to have been the world's first bankers, in the sense that the term is known today. By the 13th century, Italian merchants helped finance governments and businesses, supplying loans, bills of exchange, “branch offices” for ease of international payments, and depositories for storage of documents, coins and bullion.

Apparently many of these activities were transacted on a bench, or “banca” — the origin of word “bank.”

The Medici Bank, centered in Florence during the days of Michaelangelo, established over ten branches and a network of agents throughout Europe. They were involved in the development of business throughout the Mediterranean area, and the information passed between them gave the Medici Bank a strong information network.

It's fascinating, and perhaps prophetic of the underlying theme of this entire report, that a loan to a government brought the house of Medici down. Defaults by King Edward IV led to overextension and the ultimate collapse of the far-flung banking empire.

During the 15th and 16th centuries, banks were instrumental in the development of international trade. Without bills of exchange and direct loans to businesses, the money supply would not have expanded as it did, and international trade would have been much slowed.

The dominance of Italian banking diminished when more organized financial markets developed in Holland and England during the late 16th and early 17th centuries. The Bank of Sweden, directly funding the Swedish government, was the first real central bank. The Bank of England, in contrast, was a private company, with stockholders and management comprised of merchants from many of the most successful companies of the day.

The Sun Never Set on the British Empire

For our purposes, the story of modern currency begins in the early 1700s. Sir Isaac Newton, the English scientific genius of the late 1600s and early 1700s, inventor of calculus and founder of the Laws of Motion, was made Master of the British mint in later life, mostly to honor his contributions to mankind. The job began as a sinecure, but it rapidly became clear that he loved it, and he devoted his last years to establishing the British pound as the world's key currency.

In 1717, Newton, as Master of the Mint, declared that the English guinea (27 shillings) would henceforth be worth 129.4 grams of gold. Furthermore, he announced that the guinea would be fully redeemable in gold. All a person had to do was bring in a guinea, and he could leave with the appropriate weight in pure gold. The pound was on a gold standard.

Soon the world began trading in guineas. Only twice during the period from 1717 to 1931 did England suspend the convertibility of its currency. Each time was during a war. The first was to fight Napoleon, the second to fight the Kaiser. Each war produced paper money and inflation, as wars often do.

After Waterloo, when Napoleon was defeated for the last time, British currency became the world's unofficial standard. It was tied to gold and could be redeemed at will. The British government was stable, the Royal Navy sailed the world, and trade blossomed worldwide like flowering plants wherever the pound fell on fertile ground. England was the central country for the industrial revolution, and its manufactured goods spread around the world. Every time there was the smallest question about the value of the pound, interest rates were raised sharply. That often depressed the domestic economy (as will be explained in detail later), but the high interest rates drew in foreign exchange, and the pound retained value.

The British government even issued perpetual bonds, called “consols.” These bonds were handed from father to son, and so strong was British money that consols actually increased in value over time.

British capital spread everywhere, financing American railroads, mining gold in South Africa and Argentina. As the central storage currency for the world's great monarchies, British capital drilled for oil near Baghdad and Dallas and owned the Moscow Power and Light Company.

During this time the French franc was also strong. It was tied to silver, and also offered complete convertibility. But Great Britain was the strongest country, and for a long period was the world's banker.

Europe Crushed

World War I was a blow to all this. The world's three strongest countries (Great Britain, France and Germany) were sent into turmoil. Germany was shattered. The mark inflated to a trillion times its former value, and Germany became the largest debtor nation of the era. France lost much of its reserves to finance victory, and to compound matters it lost the lion's share of its foreign investment to the Russian Revolution.

Russian aristocracy had long had a love affair with French ways. Cultured Russians spoke French, dressed in French styles, and built French-style mansions. This was swept away by the revolution. Many wealthy Russian families escaped to Paris, but they took little of their former wealth with them.

Great Britain was also crushed financially by war costs. British companies and investments worldwide had to be sold to make artillery shells and other items unproductive in an sane world. Soon the pound, which had ruled and stabilized the world for centuries, was no longer worth a pound. Through the 1920s, the British tried to hold the pound at $4.86. The government raised interest rates, trying to attract foreign investment.

It didn't work. The effects on the domestic economy were too painful. Growth slowed, then stopped altogether. Unemployment rose. The great depression of 1929 was especially untimely, which put too much pressure on the British stock market and banks. In 1931 the English government abolished the pound's convertibility and let it float.

Important Point to Remember: History does repeat itself. The U.S. is in the same position today. The dollar is falling but the Federal Reserve Bank hesitates to raise interest rates to strengthen the dollar because it fears that high borrowing costs will harm business and the domestic economy.

Only the United States emerged from World War I as an economic winner. U.S. business and finance swiftly replaced Britain's as the world's strongest. The United States was the only major country able to keep its currency pegged to gold in the years immediately after the war, and the dollar soon became the world's key currency.

During the depression, which means throughout the 1930s and early 1940s, the world broke into economic blocs, with each bloc trying to gain advantage by depreciating its currency to increase exports and put its workers back on the job at the expense of its neighbors. This practice is called “beggar-thy-neighbor,” and it made the world's economy a disaster.

Important Point to Remember. Understanding the concept of “beggar- thy-neighbor” is important for getting a full picture of international currency fluctuation. Let's look at this concept below.

Beggar-thy-neighbor is a concept in which the government of one country tries to gain political advantage at the expense of a government of another country.

Let's use what would seem a very extreme example (had it not just taken place in reality) to illustrate this concept. Suppose that the Mexican government, either by design or incompetence, causes the value of the peso to fall by 50% on the international market. This means that instead of taking three pesos to buy a dollar, it now takes six.

It also means that the same tequilla, which before sold for $10 in Boston, will now sell for 50% less in Boston — or $5. The tequilla will still sell for 30 pesos in Mexico City, and the workers at the distillery will still be paid 1,000 pesos a month, but the price of the tequilla will fall in the United States. This immediately makes the tequilla more attractive to U.S. drinkers, who will purchase it in greater amounts. And, of course, this means that U.S. wine buyers will purchase less tequilla and other spirits made in the United States, because it will be more expensive compared to the suddenly cheap (but still high quality) Mexican drink. Nothing has changed except the value of the peso.

This concept is so vital to the understanding of international trade (which in turn is vital to understanding the importance of international currency fluctuation) that I've made a chart to help explain it more clearly.

                     Before 50% depreciation of Mexican peso: 

U.S. Dollar Peso

$1.00 3 pesos

Price of bottle in U.S. Price of bottle in Mexico City

$10.00 30 pesos

After 50% depreciation of Mexican peso:

U.S. Dollar Peso

$1.00 6 pesos

Price of bottle in U.S. Price of bottle in Mexico City

$ 5.00 30 pesos

Note that the bottle of tequilla still sells for 30 pesos in Mexico, and the Mexican workers still will be paid 1,000 pesos a month. But the tequilla will sell for half as much in the U.S. — and as a result will be much more attractive to U.S. buyers. The quality of the tequilla and American drinks are unchanged, but because the price of the tequilla is now less, its sales will be stimulated outside the country and the tequilla economy will be strengthened. More tequilla will be sold, more workers can be hired (increasing employment), and greater tax revenues will be generated for the Mexican government.

Politically, beggar-thy-neighbor has one overwhelming object: to increase employment within a country. Democratic elections are almost always affected by employment. Political parties want to be elected; hence, they do whatever they can to increase employment.

This is a manipulation that makes a country appear richer in the short term, but actually makes it poorer. We will explain why this concept backfires in the next lesson.

This is the essence of beggar-thy-neighbor. Throughout the 30s and early 40s it created an international battleground of competing currencies.

A government that inflates its own currency can gain enormous short term trade advantage windfalls at the expense of other nations. For centuries, the arbiter has been gold, but when no large central currency is pegged to gold, (as is the case now) all currencies in the world fluctuate freely and trade becomes uncertain and disorderly.

The Second World War and Bretton Woods

Like World War I, the Second World War brought devastating changes to the world's economic system. England was deep in debt, as were France and Italy. The economies of Germany and Japan were all but destroyed. The United States and the Soviet Union emerged as the two superpowers. The U.S. economy, revved up to fever pitch during the war, momentarily went on hold, then sprung forward as strong as ever with an intense effort toward internal growth and rearmament.

Likewise, the U.S. momentarily withdrew from international economic involvement, flirting with isolationism (understandable after such intense, sudden world involvement). But the U.S. quickly became fully re-engaged in world financial and military affairs.

Meanwhile, Russia walled itself in and withdrew from all economic relations with the capitalistic West, leaving the U.S. dominant over a weakened Europe. The economic stage of the postwar years was set. What emerged from WWII was a global system comprised of two distinct sectors: a large communistic bloc that existed primarily from internal trade and a highly-regulated economy, and a large capitalistic block made up of weak countries under the dominance of a single economic giant (the U.S).

There was, however, one great difference from the time immediately after WWI. After WWI, Germany and its allies were forced to make reparations. These payments, along with the expenses of rebuilding, were too much for the economies of the defeated countries. To pay its debts, Germany simply started printing marks. A disastrous inflation resulted. By the time the mark stabilized, it was worth only one-trillionth its former value. For a time during the inflationary period, a loaf of bread cost 50 million marks.

This hyperinflation wiped out the life savings of millions of people and resulted in chaos. In fact, the social unrest gave Hitler his stairway to power. He was elected to office on the platform of returning the mark's stability and putting Germans back to work. Once in office, Hitler borrowed money ferociously from central banks around the world, using the funds to build roads and munitions plants.

One interesting story from this period of German history illustrates how even a wealthy family can be wiped out by hyperinflation. With no source of steady income, one aristocratic German family began selling pieces of its art collection to pay bills. The pieces of art were collector's items and were readily salable. However, every time a piece was sold, art dealers took several weeks to make payment. By the time payment was received, the amount had been made inconsequential by inflation. The mark was inflating so rapidly that even a two-week delay made payment worthless. The family had to sell more pieces, then more pieces. Each time, the amount of money they received in payment had been wiped out by decreasing value of the mark and wasn't even enough to cover basic elements of life such as food and clothing.

These historical results of the period immediately following WWI caused great concern to the Allies (the U.S., Great Britain, France, Australia, and Canada in particular). After WWII these countries made the effort to consciously organize their economic systems.

In 1944, delegates from countries around the world met in Bretton Woods, New Hampshire to work out a new, stable order to govern exchange rates and international trade. The agreement was made barely a month after D-Day. Germany had not yet officially surrendered, but the end was near. The Allies were anxious to avoid the economic turmoils that followed WWI, and the agreements made at Bretton Woods stabilized the world economy during the years of rebuilding.

The Bretton Woods Agreement was one of the most unique and influential financial arrangements ever made. Over the years since its inception, economists have thoroughly studied its ramifications and underlying significance. The Agreement stands as the beginning of what can be called modern economics. The world was a shattered wreck at the time, emotionally and economically. As a result of the agreement, several years later the world was experiencing an unprecedented period of growth and international cooperation.

Representatives from 44 countries were present, from Australia to Chile and Cuba to Yugoslavia. Representatives were sent from Russia, but the country never signed the ensuing agreement. Of course, the two main participants were the central powers of the victorious allies: the U.S., led by Secretary of the Treasury, Henry Morgenthau and his brilliant assistant Harry Dexter White, and Great Britain, led by John Maynard Keynes.

The U.S. and Great Britain had quite different goals at the beginning of the conference. As the world's economic superpower, with over half the world's manufacturing production and over two-thirds of the world's gold supply, the U.S. wanted above all to secure free and open markets for trade. This is not surprising, considering that the U.S. was the only country to end the war with full industrial plant capacity intact. In addition, the U.S. wanted elimination of all discriminatory trade and exchange controls, and an international payments system based on completely convertible currencies.

Great Britain, on the other hand, had been ravaged by the war. The country was enormously in debt, and with plant capacity low, it was afraid the United States would dominate world trade. Therefore, Great Britain went into the conference afraid of a massive developing trade surplus. (For example, Great Britain was afraid that they would be forced to purchase and import goods manufactured in the U.S.) Great Britain's overriding goals were to gain full employment for its citizens, debt relief, and even financial help with reconstruction. Relief of debt was such a high priority that, in fact, Great Britain did not ratify the Bretton Woods Agreement until 1946, when the U.S. granted a loan of $3.75 billion to pay outstanding loans. In addition, Canada loaned Great Britain $1.25 billion.

Somehow, these two seemingly conflicting goals were reconciled into a single agreement. The quarter century that followed was a golden age of currency stability and worldwide economic growth. Inflation was almost nonexistent. Trade flourished. National income in the G7 nations rose more rapidly than in any period before or after. The “Bretton Woods Era” came to an unofficial end on August 15, 1971, when President Nixon suspended the official convertibility of the dollar into gold. But during its reign, the Bretton Woods Agreement brought a new era to world economy.

An understanding of the ideas behind the Bretton Woods Agreement, and why the Agreement eventually collapsed, is fundamental to the study of modern day currency fluctuation. The designers of the Bretton Woods system wanted to establish international economic arrangements that would combine the classical gold standard (which would stabilize currency rate fluctuation) with the ability of individual nations to adjust their own internal affairs (employment, inflation, depletion of monetary reserves) by maintaining some ability to float rates.

They wanted to avoid the beggar-thy-neighbor practices so common between wars, without having the fixed-to-gold regime become so rigid that individual nations would be hurt as their own internal business cycles of inflation and recession unfolded.

Above all, the designers of the system wanted a plan that would maintain world peace. They wanted a monetary system that would encourage international capital flow and investment and provide a stable platform for each country's internal stability.

We will learn in Lesson Four how this agreement reduced inflation by placing all currencies on a dollar standard and the dollar on the gold standard. But then strange, uncontrollable things began to happen. As American businesses bought and financed overseas industrial plants and equipment, and as massive relief aid poured from the U.S. to all parts of the world, more dollars went out than came in. This was the case throughout the 1960s. Foreign countries gradually rebuilt and became strong enough to finance and build their own auto plants. They no longer needed dollars to buy oil from Texas. Ultimately, Americans even began sending dollars out to buy Volkswagons and Toyotas, and an “overhang” of dollars abroad began to develop.

The dollar was used as a reserve currency by most governments, especially in Europe, and by the middle '60s there were more dollars outside of the U.S. than within. These dollars were called “Eurodollars.” This term “Eurodollars” refers to any dollar outside the U.S. whether in Europe, Asia, South America, etc.

Many experts feel that the increase of dollars outside the U.S. was a natural result of the structure of the Bretton Woods Agreement. Since the U.S. was, essentially, the world's banker, and the dollar was the currency most in demand worldwide, all countries needed to have a store (or reserves) of dollars to meet international obligations. When a country (such as Germany or Italy, as example) had a deficit, they needed to buy or borrow dollars. But the U.S. could finance deficits by simply printing dollars. This, in fact, happened to a greater and greater extent, especially as the U.S. sought to finance the Vietnam War (which we'll discuss in Lesson Four as well).

When the number of Eurodollars became large compared with U.S. gold reserves, the world's central bankers began to get nervous about their ability to cash in dollars and receive gold. As with any bank, the great fear was that all depositors would arrive at the same time wanting their money. Confidence in the dollar eroded. In March of 1967, a run on the dollar forced the U.S. to suspend the convertibility of the dollar into gold for all except central banks.

The dollar began inflating around the world, and since all currencies were pegged to the dollar, they, too, began feeling the pressure of inflation. France had to devalue the franc in 1969. Germany devalued the mark the same year, and Canada released its dollar from the gold peg and began floating in 1970. In May of 1971, the German and Dutch currencies floated. The German Central Bank, the Bundesbank, stopped taking in dollars and exchanging them for marks. The dam burst on August 15, 1971, when President Richard Nixon announced that the U.S. was “temporarily” suspending the convertibility of dollars in gold.

Nixon's announcement had numerous causes. There were too many Eurodollars, with their inevitable claim on U.S. gold. Inflationary pressure was too great and had to be released. And, too, unemployment in the U.S. was becoming a political issue. Nixon faced an election in the following year, and political expediency demanded a stronger U.S. job market. That meant he had to send dollars out into the economy. Without dollars, industrial growth (and employment) would stagnate. But Nixon couldn't send out dollars if each had to be backed by gold.

So the dollar was freed from gold, and the world's key currency no longer had the backing of a precious metal. The G7 (the leading industrial countries — United States, Great Britain, Canada, France, Germany, Italy, Japan) met in Washington to try for another Bretton Woods. They tried to devalue the dollar and peg it to gold at a lower price, and to peg currencies to new fixed rates. This didn't work. Inflation shifted into higher gear. The Reuters Commodity Index of food, minerals, etc., rose 65% from the end of 1971 to early in 1973 alone.

By the end of 1973 every major currency floated, meaning that on any given day it was worth — in terms of any other world currency — only what someone would pay for it. The world had entered a new era, one which exists to this day. In effect, the world economy started from scratch after the WWII with the Bretton Woods Agreement in 1944. It then started from scratch again in 1971 when convertibility was removed.

From 1971 to the present; complex, varied forces drove the currency markets. Currency values rise and fall daily. The forces that cause these rises and falls are discussed in the next lesson. The case study shows how investors made fortunes on the first devaluation wave that started in 1971 and lasted for ten years. In Lesson Four, we will review how and why we are in the second devaluation wave and how to make fortunes in this economic cycle too.”

Until next message, Good Investing!