International Currencies Made EZ #6

by | Dec 16, 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 Six. This report is dated but do not let the dates and numbers get in the way. The fundamentals remain the same.


There are different types of inflation. Open inflation means simply that prices are rising on consumer goods and services. Price changes are measured in the U.S. by the Consumer Price Index and the Wholesale Price Index, both compiled by the Bureau of Labor Statistics for the U.S. Department of Labor. These, along with wage levels, are measures used to indicate the purchasing power of the dollar.

Suppressed inflation means that a situation exists in which prices would rise — if government regulations did not establish artificial limits on prices, wages, etc.

Perhaps the most classic example of suppressed inflation occured during the years 1968-1971. There was a tremendous pent-up price demand for gold. During that time, gold was pegged at $35 an ounce to the U.S. dollar. Inflation was accelerating. The United States was churning dollar bills off the printing presses, disregarding the tie to gold. When President Nixon finally announced, what the economic world had known for quite some time, that the dollar would be freed from its peg to gold, the price of gold shot upward, reaching a high of $860 an ounce within five or six years.

In this sense, prices are like steam. They can be contained for short periods, but as they expand exponentially, they must break free.

Important Point to Remember: Don't be fooled by suppressed or artificial prices.

Today the dollar, which has vast inherent weaknesses, is being supported from time to time by organized international buying. In other words, its price is being artificially held. Governments around the world (the U.S. included) find that occasionally they need to buy dollars to keep the price from free-falling. These buying binges accomplish two things: they temporarily keep the dollar afloat (until the next crisis), and they mask the extent of the dollar's weakness to investors who ignore fundamentals and do not look beneath the surface.

Open inflation has different forms. The following academic terms describe some of the forms inflation can take.

Gross Inflation: This occurs when rising prices are encouraging an increase in output and are bringing about fuller utilization of the work force and production capacities. People always want to take advantage of rising prices by making more articles that can be sold at higher, more profitable prices. Therefore, rising prices tend to bring factories to fuller capacity, because the factory owners see increased profit potential from selling their goods.

Gross inflation occurs when prices are inflating at a high enough rate over a long enough period of time. These figures vary, depending on the economic climate. There are many variables to consider. For instance, if prices were rising, say, 10% a year, production capacities would surely rev up to take advantage of future higher prices.

But inflation at that rate means that prices will double approximately every 7 years. (Use the rule of 72 to determine how long it takes a figure to double. Divide the interest rate into 72 — the answer gives you the number of years it will take for the principal, or in this case, prices, to double.) With prices doubling every 7 years, it's hard for wages to keep pace. People with fixed incomes will find their purchasing power cut in half every 7 years. Eventually, products and services will become too expensive for people to purchase, and consumer sales will fall. As a result, companies will tend to produce less, workers will be laid off, and the economy will stall. This scenario has been played out countless times around the world. Inflation rates of 10%, 15%, 20% or more have eventually stalled an economy.

Pure Inflation: This occurs when prices rise after the work force and production capacities are increased to the fullest extent. This, clearly, is not in the best interest of the country. Pure inflation comes after gross inflation. As discussed in the previous example, ongoing price increases eventually are the undoing of an economy, destroying the economic and social fabric of a country.

Creeping Inflation: This occurs when prices rise gradually, over long periods of time. This is the type of inflation seen in the U.S. today. Creeping inflation (2%-3%) per year is tolerated as a means of keeping productivity and employment levels high. People see that prices are rising steadily, so they are encouraged to increase production of goods to sell them at more profitable prices. This encourages factories to move toward higher levels of output, increasing employment. Creeping inflation, however, does not encourage such rapid industrial output that commercial loans increase dramatically, (remember how the Fed and banks can make money out of thin air through loans) with the inevitable sharp rise in prices (because there is too large a supply of money). Wages keep up with prices more easily, and individuals on fixed incomes can more easily adjust on a yearly basis to increasing prices of goods and services.

Hyperinflation: This occurs when prices rise uncontrollably, threatening to destroy a currency by decreasing its value and making it worthless. Germany, Brazil, Mexico, among countless other countries through history, have experienced hyperinflation and the resulting social chaos.

Between WWI and WWII, the German mark inflated so rapidly that workers had to leave work at the moment they were paid so they could cash their checks and purchase food. If they waited even until the end of their workday, prices would have inflated so much in those few hours that their checks would have been worthless. The resulting social unrest laid the foundation for Hitler's socialistic Nazi Party to work its way into power.

Stagflation. This is a period of simultaneous economic inflation and business recession. A classic example of stagflation gripped the U.S. from approximately 1979-1981. OPEC had strengthened, reducing shipments of oil and increasing prices. Nonetheless, the United States continued importing oil in high quantities. In 1978, the U.S. imported 8 million barrels of oil a year. In 1979, that figure fell to 7.9 billion per year, then 6.4 billion in 1980 and 5.4 billion in 1981. But the cost of oil skyrocketed, and the total cost of imported oil doubled from 1978- 1980 ($44.7 billion in 1978, $82.9 billion in 1980).

Understanding stagflation is important because many of the same factors were in play in mid 1995. Only history will tell if these factors lead again to stagflation, but we will examine this possibility after the case study later in this lesson.

War and Inflation

Major wars almost always result in inflation. Governments either simply print money or borrow heavily to meet increased expenditures. Yet, even if governments try to maintain a prudent fiscal policy during wartime, inflation is inevitably built into the economic climate of starting and waging a war.

Why? Because as a country goes to war, the work force shifts from production of consumer articles to production of wartime articles (guns, bullets, etc.) Civilian goods decrease in output, yet government expenditure for the war effort tends to increase total wages paid, especially if a high level of unemployment existed prior to the war. Thus, the output of consumer articles is reduced, but total consumer income is increased. In addition, war materials are essentially totally non- productive products. Since most war materials are destructive, the war products that are created (and paid for) cannot be offered back into the community where the money was earned to create them.

Inflation is simply too much money and too few products. In an inflationary state, people are willing to offer more money for less product or service. Thus, if a third of a population is paid to produce products (such as guns and bullets) that are not used in the economy then all the money they earn will be competing for the fewer civil products that are still available.

In effect, there is suddenly more money available to buy fewer goods, which is the classic definition of inflation. Governments often establish wartime price levels and rationing, but these can have only limited effect. Inevitably, the prices of goods rise.

Inflationary spirals often result from the increasing prices of consumer goods. This, in turn, generates pressure for wage increases to offset the price increases. An ongoing spiral results, with prices rising and rising.

During the Vietnam War years, the U.S. government played all ends against the middle. It printed money and borrowed heavily to pay for war materials and operations. At the same time, it printed money and borrowed heavily to finance and underwrite the world's largest-ever increase in government-sponsored domestic growth. Roads and schools were built, public welfare funding shot up, and businesses were subsidized. If you think there was a lot of debate about the U.S.'s involvement in Vietnam, think how hot things would have gotten if the American people hadn't been receiving all that government funding during President Lyndon Johnson's “Great Society” efforts.

The U.S. government kept a lot of the people happy, but it also started the process toward federal bankruptcy with its “Guns and Butter” policies during this period.”

Until next message, good investing!