International Currencies Made EZ #5

by | Dec 15, 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 Five. This report is dated but do not let the dates and numbers get in the way. The fundamentals remain the same.

Definition of Currency

In this lesson we dive deeper into money and currencies — how they are created, how inflation occurs, and how the value of money is determined by foreign exchange markets.

Money makes it possible for us to buy and sell without bartering. Money gives us a “medium of exchange,” which allows our complex economic system to function.

Money acts as a way to put tangible, universal value on commodities and services. It helps us compare the value of one thing with another. This gives us a “unit of value,” which allows us to make decisions about purchases and investments.

Money also functions as a way to store wealth — to preserve purchasing power for spending at a later date.

Money must be real to carry out these functions. We learned in earlier lessons that only money created by real production can be real money, but there are other qualities money must also have if it is to work properly. Money must have six specific qualities:

* Specific Money Quality #1: Money must be acceptable by both parties in a transaction. To be absolutely universal in value, money must be acceptable to everyone.

* Specific Money Quality #2: Money must be portable. One must be able to take money where it is needed. This is what has made paper and plastic money so much more popular than gold. Paper currencies, checkbooks and credit cards are so much easier to carry than lumps of gold and silver (though as we will see, the price we pay is high for giving up the discipline that comes from the rarity of precious metals).

* Specific Money Quality #3: Money must be rare and require effort (real production or work) to attain. If you look at all of the qualities of money, you can easily see why gold makes such good money. This precious metal has all of the qualities required of money. Yet if you compare gravel to gold, you will see that gravel also has most of these qualities, except rarity. Gravel is as common as dirt and if gravel were used as money instead of gold, the temptation to just pick it up on the road, rather then work for it, would be too great. Money must offer an incentive to work and apply discipline. Rarity creates this incentive.

We will see in this and later lessons how important this quality of rarity is when we see how governments reduce the rarity of money and how this action destroys money's value.

* Specific Money Quality #4: Money must be divisible and uniform in quality. In other words, people must be able to know that each unit of the money is real, not forged or altered.

* Specific Money Quality #5: Money must have some intrinsic value, or be useful in itself or be backed by some intrinsic value.

* Specific Money Quality #6: Money must be naturally durable. There have been many times when goods or commodities such as chocolate, coffee, cigarettes or silk stockings, etc. have been used as money. The conditions were such that the commodity was so desirable and so rare that these two qualities were enough to make them a form of money. Yet they fail to last as a money because they are too fragile and once consumed cannot be used as money again. Real money must be naturally durable and able to be used again and again.

Metals such as bronze, gold and silver fit many of these categories. Some of the early goldsmiths, who took gold on account, offered scrips or tickets stating how much gold was being warehoused. Eventually people realized that these scrips in themselves had value, since they represented claims on a specific amount of gold. As a result, the scrips began to be exchanged as money. They were certainly easier to carry than the metal itself, and since they were backed by gold, why would they not be as good as gold?

Goldsmiths soon realized that it was possible to issue more scrips than could actually be converted into gold — if not everyone came at the same time wanting to convert their money into the precious metal standing behind it. Thus were born the first bankers, who in essence created money by issuing more of it than was backed by gold. Such money is called Commodity Money.

Important point to remember: The creation of commodity money is perhaps the most important step in the evolution of money for modern society. Fiat money if disciplined is essential for expansion. However the uncontrolled expansion of commodity money by governments to the point where the money is forced to become fiat money has been the prime ingredient in the destruction of currency after currency since this idea began.

Originally bankers were able to create paper money from their scrip because of their reputation. The bankers were the keepers of gold and the lenders of money. They were known to be prudent, honest and very disciplined. Their businesses, their reputations and the economic lives of the community were in the hands of the bankers' judgement. Hence the reputation of the steely eyed, tough minded banker who lent money only to those who would be most likely to pay the loan back.

Once governments discovered that it was possible to create money without backing, they quickly caught onto the idea. No government in history has wanted to be left out of a scheme that creates money from thin air, so in short order most governments in the world took over the process themselves, issuing scrip not wholly backed by gold. Thus was born “commodity money”, which consists of paper money convertible to the precious metal designated. The money may be backed 100% by gold, or 50%, or 25% — or less than 1%.

“Fiat money” is coin or currency that is not convertible to precious metal. Issued by governments, it has value only because it provides all the necessities of money as described above — and because it is declared to be money by government decree. In fact, Webster's defines the word fiat as “A decree, order, or sanction.” It comes from the Latin, “Let it be done.”

Pure fiat money (currency or bank deposits with no tie to precious metal or any commodity with inherent value) can be valuable only when it is scarce. If a government issues too much fiat money, the value falls and inflation results. Thus, the value of fiat money ultimately depends on the confidence people have in the government issuing the money.

Almost all currencies in the world today are fiat money not backed by silver or gold. A U.S. citizen cannot walk into a bank and exchange a dollar for gold. A dollar is valuable only because everyone believes (has confidence) that it will be accepted as legal tender by everyone else.

Important Point To Remember: As the confidence in the U.S. dollar erodes, the value of the dollar will fall. As the dollar is still the reserve currency of the world, other currencies that are backed by the dollar will lose confidence as well. Until confidence in the dollar is restored or until a new reserve system is created, there will be global currency turmoil.”

Until Next message, good investing!