Folks,
If you were able to read up on what money is (and is not), here is more on
Currency Devaluation and Economic Growth, something much in the news. First I
have the URL and then there is the article in case you cannot access the
website.
John
http://www.mises.org/fullstory.asp?control=1345
Currency Devaluation and Economic Growth
By Frank Shostak
[Posted October 3, 2003]
A September 21 announcement by the G-7 finance ministers endorsed less
intervention in the foreign exchange market, and triggered a large sell-off
of the US dollar. On the day of the announcement, in relation to the end of
August, the US currency fell by 4.8% against the Euro and 4.1% against the
Yen.
Many economists have suggested that the weakening in the US dollar could
actually be good for the economy—since a weaker dollar will boost
manufacturing production, which in turn will lift employment and all this
will set in motion economic growth. It follows then that the US dollar
devaluation is exactly what is needed to keep the US economy going.
The popular way of thinking
According to popular thinking the key to economic growth is demand for goods
and services. It is held that increases in demand for goods and services
gives rise to economic growth by triggering the production of goods and
services. Increases or decreases in demand for goods and services are behind
rises and declines in the economy's production of goods. Hence in order to
keep the economy going economic policies must pay close attention to overall
demand.
Now, part of the demand for domestic products emanates from overseas. The
accommodation of this demand is labeled exports. Likewise, local residents
exercise demand for goods and services produced overseas, which is labeled
imports. Note that while an increase in exports gives rise to overall demand
for domestic output, an increase in imports weakens demand. Hence exports,
according to this way of thinking, are a factor that contributes to economic
growth while imports are a factor that detracts from the growth of the
economy.
Because overseas demand for a country's goods and services is an important
ingredient in setting the pace of economic growth, it makes sense to make
locally produced goods and services attractive to foreigners. One of the
ways to make domestically produced goods more in demand by foreigners is by
making the prices of these goods more attractive.
For instance, the price of an identical bag of potatoes in the US is $10 and
10 Euros in Europe. Also, the exchange rate between the US dollar and the
Euro is 1:1 i.e. one–to–one. At the exchange rate of 1 Euro to $1 a European
can get for his 10 Euro one American bag of potatoes.
One of the ways of boosting their competitiveness is for Americans to
depreciate the US dollar against the Euro. Let us assume that in response to
a Fed announcement that it will drastically loosen its monetary stance, the
rate of exchange falls to 0.5 Euro per $1. Consequently, this will mean that
$10 is now worth 5 Euro, which in turn implies that an American bag of
potatoes in Europe is offered for 5 Euro. Consequently, a European can now
purchase for 10 Euro two American bags of potatoes instead of one before the
depreciation of the US dollar. In other words, the purchasing power of
Europeans with respect to American potatoes has doubled.
If we were to apply the potatoes example to all goods and services, one can
reach the conclusion that as a result of currency depreciation, all other
things being equal, the overall demand for domestically produced goods is
likely to increase. This in turn will give rise to a better balance of
payments and in turn to stronger economic growth. Observe that to lift
foreigners' demand, Americans are now effectively offering two bags of
potatoes for one European bag of potatoes. This also means that the price of
the European bag of potatoes in the US is now twice what it was before the
depreciation of the US dollar. This most likely will lower American's demand
for European potatoes. What we have here, as far as the US is concerned, is
more exports and fewer imports, which according to mainstream thinking is
great news for economic growth.
Equally, at the original exchange rate of 1:1 a reduction in the domestic
price of US potatoes from $10 to $5 would also enable a European to exchange
his 10 Euro for two bags of potatoes. In short, changes in the exchange rate
or changes in prices in respective countries will determine so-called
international competitiveness, which is also labeled as the real exchange
rate. This can be summarized as:
Real exchange rate = (domestic prices/foreign prices)*exchange rate
The exchange rate is the number of foreign currency per unit of local
currency.
According to this expression, a fall in the real exchange rate implies
growing competitiveness and a rise means falling international
competitiveness. Hence, following this expression, currency depreciation (a
fall in the number of foreign currency exchanged per local currency) will
lead to a fall in the real exchange rate and thus to an increase in
international competitiveness.
A fall in foreign prices, however, will lift the real exchange rate and
therefore reduce competitiveness. In this way of thinking, it is quite clear
that currency depreciation—all other things being equal—is beneficial for
economic growth.
For instance, in their research study of the Mexican economy, Dornbusch and
Werner have concluded that: "If the currency is not devalued, growth will
not keep pace with the growth of the labor force; the divisions in Mexican
society will widen; and national stability will be threatened."[1]
Furthermore, according to Dornbusch and Werner, "…recent major devaluations
in Finland, Sweden, Italy, Spain and the United Kingdom did not lead to
inflation—in fact, it has come down, as have interest rates. Devaluation was
a boon to these countries."[2]
It seems that the message conveyed by the real exchange rate equation tends
to confirm the experience in the US. Thus since 1999 US competitiveness viz.
Japan has been steadily falling. The real exchange rate, which stood at 138
in November 1999 jumped to 176 in August 2003. The fall in competitiveness
during this period was associated with a sluggish economy. In short, the
data seems to support the view that a rising real exchange rate may be an
important contributing factor to currently subdued economic growth.
Moreover, our statistical analysis indicates that the lagged growth momentum
of the real exchange rate displays good visual inverse correlation with the
growth momentum of industrial production. An increase in the growth momentum
of the real exchange rate (deterioration in US competitiveness) is followed
by a fall in the growth momentum of industrial production. A fall in the
growth momentum of the real exchange rate (improvement in US
competitiveness) is followed by an increase in the growth momentum of
industrial production.
It seems, therefore, that it makes a lot of sense to depreciate the US
dollar in order to revive the economy.
Why boost in exports due to currency depreciation cannot grow the economy
When a central bank announces a loosening in its monetary stance, this leads
to a quick response by the participants in the foreign exchange market
through selling the domestic currency in favor of other currencies, thereby
leading to domestic currency depreciation. In response to this, various
producers now find it more attractive to boost their exports. In order to
fund the increase in production, producers approach commercial banks, which
on account of a rise in central bank monetary pumping are happy to expand
their credit at lower interest rates.
By means of new credit producers can now secure resources required to expand
their production of goods in order to accommodate growing overseas demand.
In other words, by means of newly created credit producers divert real
resources from other activities. As long as domestic prices remain intact,
exporters will record an increase in profits.
However, the so-called improved competitiveness on account of currency
depreciation means that the citizens of a country are now getting less real
imports for a given amount of real exports. In short, while the country is
getting rich in terms of foreign currency, it is getting poor in terms of
real wealth, i.e., in terms of the goods and services required for
maintaining peoples' life and well-beings. As time goes by however, the
effects of loose monetary policy filters through a broad spectrum of prices
of goods and services and ultimately undermine exporters profits. In short,
a rise in prices puts to an end the illusory attempt to create economic
prosperity out of thin air. According to Ludwig von Mises,
The much talked about advantages which devaluation secures in foreign
trade and tourism, are entirely due to the fact that the adjustment of
domestic prices and wage rates to the state of affairs created by
devaluation requires some time. As long as this adjustment process is not
yet completed, exporting is encouraged and importing is discouraged.
However, this merely means that in this interval the citizens of the
devaluating country are getting less for what they are selling abroad and
paying more for what they are buying abroad; concomitantly they must
restrict their consumption. This effect may appear as a boon in the opinion
of those for whom the balance of trade is the yardstick of a nation's
welfare. In plain language it is to be described in this way: The British
citizen must export more British goods in order to buy that quantity of tea
which he received before the devaluation for a smaller quantity of exported
British goods.
Contrast the policy of currency depreciation with a conservative policy
where money is not expanding. Under these conditions, when the pool of real
wealth is expanding, the purchasing power of money will follow suit. This,
all other things being equal, will lead to currency appreciation. With the
expansion in the production of goods and services and falling prices and
thus production costs, local producers can improve their competitiveness and
profitability in overseas markets while the currency is actually
appreciating. Within the framework of loose monetary policy exporters'
temporary gains are at the expense of other activities in the economy,
within the framework of a tight monetary stance gains are not at any one's
expense but just the manifestation of real wealth generation.
Can currency depreciation take place in a free market?
The entire issue of the alleged benefits of currency depreciation is only of
relevance in a hampered market where paper money is enforced by the
government through its central bank. In a free-market economy, there cannot
be such a thing as currency depreciation, which supposedly can grow the
economy.
Within the free market, there cannot be currency depreciation as such. Since
in a true free-market economy money is gold, there cannot be an independent
entity such as a "dollar." Prior to 1933, the name "dollar" was used to
refer to a unit of gold that had a weight of 23.22 grains. Since there are
480 grains in one ounce, this means that the name dollar also stood for
0.048 ounce of gold. This in turn, means that one ounce of gold referred to
$20.67. Now, $20.67 is not the price of one ounce of gold in terms of
dollars as popular thinking has it, for there is no such entity as a dollar.
Dollar was just a name for 0.048 ounce of gold. On this Rothbard wrote, "No
one prints dollars on the purely free market because there are, in fact, no
dollars; there are only commodities, such as wheat, cars, and gold.[3]
Likewise, the names of other currencies stood for a fixed amount of gold.
The habit of regarding these names as a separate entity from gold emerged
with the enforcement of the paper standard. Over time, as paper money
assumed a life of its own, it became acceptable to set the price of gold in
terms of dollars, francs, pounds, etc. The absurdity of all this reached new
heights with the introduction of the floating-currency system.
In a free market, currencies do not float against each other. They are
exchanged in accordance with a fixed definition. If the British pound stands
for 0.25 of an ounce of gold and the dollar stands for 0.05 ounce of gold,
then one British pound will be exchanged for five dollars. This exchange
stems from the fact that 0.25 of an ounce is five times larger than 0.05 of
an ounce, and this is what the exchange of 5-to-1 means.
In other words, the exchange rate between the two is fixed at their
proportionate gold weight, i.e., one British pound = five US dollars. The
absurdity of a floating currency system is no different from the idea of
having a fluctuating market price for dollars in terms of cents. How many
cents equal one dollar is not something that is subject to fluctuations. It
is fixed forever by definition. [4]
The present floating exchange rate system is a byproduct of the previously
discredited Bretton Woods system of fixed currency rates of exchange, which
was in operation between 1944 to 1971. Within the Bretton Woods system the
US dollar served as the international reserve currency upon which all other
currencies could pyramid their money and credit. The dollar in turn was
linked to gold at $35 per ounce. Despite this supposed link to gold, only
foreign governments and central banks could redeem their dollars for gold.
A major catalyst behind the collapse of the Bretton Woods system was the
loose monetary policies of the US central bank which pushed the price of
gold in the gold market above the official $35 per ounce. The price, which
stood at $35/oz in January 1970 jumped to $43/oz by August 1971 – an
increase of almost 23%. The growing margin between the market price of gold
and the official $35 per ounce (see chart) created enormous profit
opportunity, which some European central banks decided to exercise by
demanding the US central bank redeem dollars for gold.
Since Americans didn't have enough gold to back up all the printed dollars,
they had to announce effective bankruptcy and cut off any link between
dollar and gold as of August 1971. In order to save the bankrupt system
policymakers have adopted the prescription of Milton Friedman to allow a
freely floating standard.
While in the framework of the Bretton Woods system the dollar had some link
to the gold and all the other currencies were based on the dollar, all that
has now gone. In the floating framework there are no more limitations on
money printing. According to Murray Rothbard:
One virtue of fixed rates, especially under gold, but even to some extent
under paper, is that they keep a check on national inflation by central
banks. The virtue of fluctuating rates—that they prevent sudden monetary
crises due to arbitrarily valued currencies—is a mixed blessing, because at
least those crises provided a much-needed restraint on domestic inflation.
Through policies of coordination, central banks maintain synchronized
monetary pumping so as to keep the fluctuations in the rate of exchanges as
stable as possible. Obviously, in the process such policies set in motion, a
persistent process of impoverishment through consumption is not backed up by
production of real wealth.
Furthermore, within this framework, if a country tries to take advantage and
depreciate its currency by means of a relatively looser monetary stance this
runs the risk that other countries will do the same. Consequently, the
emergence of competitive devaluations is the surest way of destroying the
market economy and plunging the world into a period of crisis.
On this Mises wrote, "A general acceptance of the principles of the
flexible standard must therefore result in a race between the nations to
outbid one another. At the end of this competition is the complete
destruction of all nations' monetary systems."
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Frank Shostak is an adjunct scholar of the Mises Institute and a frequent
contributor to Mises.org. Send him MAIL and see his outstanding Mises.org
Daily Articles Archive. Special thanks to Michael Ryan for his comments.
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[1] Dornbusch R. and Werner A. 1994. "Mexico, stabilization. Reform and no
growth," Brookings Papers on Economic Activity, Vol 1, pp, 253–315.
[2] Ibid.
[3] Murray N. Rothbard. "The Case for a Genuine Gold Dollar," in Llewellyn
H. Rockwell, Jr., The Gold Standard: An Austrian Perspective (Lexington,
Mass: D.C. Heath, 1985), pp. 1–17.
[4] Ibid.
Friday, October 3, 2003
More on Money
Monday, September 29, 2003
Money
Folks,
Danny DeVito has a funny line in the David Mamet movie "Heist" in which his
character says to Gene Hackman "Of course you want money, everyone wants money,
that's why they call it money."
What is odd in popular economics is they have a hard time defining money,
probably for the same reason they have a hard time defining "free trade;"
probably because they are never really talking about "money." Something else.
The current USA President has thrown down the gauntlet to the Chinese over
"money," and the Chinese management of their money. If you want to learn about
money, get some definitions straight and think clearly about it, here is a
good starting place:
http://www.mises.org/fullstory.asp?control=1333
The Origin of Money and its Value
by Robert P. Murphy
[Posted September 29, 2003]
The importance of the Austrian school of economics is nowhere better
demonstrated than in the area of monetary theory. It is in this realm that
the simplifying assumptions of mainstream economic theory wreak the most
havoc. In contrast, the commonsensical, "verbal logic" of the Austrians is
entirely adequate to understand the nature of money and its valuation by
human actors.
Menger on the Origin of Money
The Austrian school has offered the most comprehensive explanation of the
historical origin of money. Everyone recognizes the benefits of a
universally accepted medium of exchange. But how could such a money come
into existence? After all, self-interested individuals would be very
reluctant to surrender real goods and services in exchange for intrinsically
worthless pieces of paper or even relatively useless metal discs. It's true,
once everyone else accepts money in exchange, then any individual is also
willing to do so. But how could human beings reach such a position in the
first place?
One possible explanation is that a powerful ruler realized, either on his
own or through wise counselors, that instituting money would benefit his
people. So he then ordered everyone to accept some particular thing as
money.
There are several problems with this theory. First, as Menger pointed out,
we have no historical record of such an important event, even though money
was used in all ancient civilizations. Second, there's the unlikelihood that
someone could have invented the idea of money without ever experiencing it.
And third, even if we did stipulate that a ruler could have discovered the
idea of money while living in a state of barter, it would not be sufficient
for him to simply designate the money good. He would also have to specify
the precise exchange ratios between the newly defined money and all other
goods. Otherwise, the people under his rule could evade his order to use the
newfangled "money" by charging ridiculously high prices in terms of that
good.
Menger's theory avoids all of these difficulties. According to Menger, money
emerged spontaneously through the self-interested actions of individuals. No
single person sat back and conceived of a universal medium of exchange, and
no government compulsion was necessary to effect the transition from a
condition of barter to a money economy.
In order to understand how this could have occurred, Menger pointed out that
even in a state of barter, goods would have different degrees of
saleableness or saleability. (Closely related terms would be marketability
or liquidity.) The more saleable a good, the more easily its owner could
exchange it for other goods at an "economic price." For example, someone
selling wheat is in a much stronger position than someone selling
astronomical instruments. The former commodity is more saleable than the
latter.
Notice that Menger is not claiming that the owner of a telescope will be
unable to sell it. If the seller sets his asking price (in terms of other
goods) low enough, someone will buy it. The point is that the seller of a
telescope will only be able to receive its true "economic price" if he
devotes a long time to searching for buyers. The seller of wheat, in
contrast, would not have to look very hard to find the best deal that he is
likely to get for his wares.
Already we have left the world of standard microeconomics. In typical
models, we can determine the equilibrium relative prices for various real
goods. For example, we might find that one telescope trades against 1,000
units of wheat. But Menger's insight is that this fact does not really mean
that someone going to market with a telescope can instantly walk away with
1,000 units of wheat.
Moreover, it is simply not the case that the owner of a telescope is in the
same position as the owner of 1,000 units of wheat when each enters the
market. Because the telescope is much less saleable, its owner will be at a
disadvantage when trying to acquire his desired goods from other sellers.
Because of this, owners of relatively less saleable goods will exchange
their products not only for those goods that they directly wish to consume,
but also for goods that they do not directly value, so long as the goods
received are more saleable than the goods given up. In short, astute traders
will begin to engage in indirect exchange. For example, the owner of a
telescope who desires fish does not need to wait until he finds a fisherman
who wants to look at the stars. Instead, the owner of the telescope can sell
it to any person who wants to stargaze, so long as the goods offered for it
would be more likely to tempt fishermen than the telescope.
Over time, Menger argued, the most saleable goods were desired by more and
more traders because of this advantage. But as more people accepted these
goods in exchange, the more saleable they became. Eventually, certain goods
outstripped all others in this respect, and became universally accepted in
exchange by the sellers of all other goods. At this point, money had emerged
on the market.
The Contribution of Mises
Even though Menger had provided a satisfactory account for the origin of
money, this process explanation alone was not a true economic theory of
money. (After all, to explain the exchange value of cows, economists don't
provide a story of the origin of cows.) It took Ludwig von Mises, in his
1912 The Theory of Money and Credit, to provide a coherent explanation of
the pricing of money units in terms of standard subjectivist value theory.
In contrast to Mises's approach, which as we shall see was
characteristically based on the individual and his subjective valuations,
most economists at that time clung to two separate theories. On the one
hand, relative prices were explained using the tools of marginal utility
analysis. But then, in order to explain the nominal money prices of goods,
economists resorted to some version of the quantity theory, relying on
aggregate variables and in particular, the equation MV = PQ.
Economists were certainly aware of this awkward position. But many felt that
a marginal utility explanation of money demand would simply be a circular
argument: We need to explain why money has a certain exchange value on the
market. It won't do (so these economists thought) to merely explain this by
saying people have a marginal utility for money because of its purchasing
power. After all, that's what we're trying to explain in the first place—why
can people buy things with money?
Mises eluded this apparent circularity by his regression theorem. In the
first place, yes, people trade away real goods for units of money, because
they have a higher marginal utility for the money units than for the other
commodities given away. It's also true that the economist cannot stop there;
he must explain why people have a marginal utility for money. (This is not
the case for other goods. The economist explains the exchange value for a
Picasso by saying that the buyer derives utility from the painting, and at
that point the explanation stops.)
People value units of money because of their expected purchasing power;
money will allow people to receive real goods and services in the future,
and hence people are willing to give up real goods and services now in order
to attain cash balances. Thus the expected future purchasing power of money
explains its current purchasing power.
But haven't we just run into the same problem of an alleged circularity?
Aren't we merely explaining the purchasing power of money by reference to
the purchasing power of money?
No, Mises pointed out, because of the time element. People today expect
money to have a certain purchasing power tomorrow, because of their memory
of its purchasing power yesterday. We then push the problem back one step.
People yesterday anticipated today's purchasing power, because they
remembered that money could be exchanged for other goods and services two
days ago. And so on.
So far, Mises's explanation still seems dubious; it appears to involve an
infinite regress. But this is not the case, because of Menger's explanation
of the origin of money. We can trace the purchasing power of money back
through time, until we reach the point at which people first emerged from a
state of barter. And at that point, the purchasing power of the money
commodity can be explained in just the same way that the exchange value of
any commodity is explained. People valued gold for its own sake before it
became a money, and thus a satisfactory theory of the current market value
of gold must trace back its development until the point when gold was not a
medium of exchange. *
The two great Austrian theorists Carl Menger and Ludwig von Mises provided
explanations for both the historical origin of money and its market price.
Their explanations were characteristically Austrian in that they respected
the principles of methodological individualism and subjectivism. Their
theories represented not only a substantial improvement over their rivals,
but to this day form the foundation for the economist who wishes to
successfully analyze money.
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Robert Murphy has been a summer fellow at the Mises Institute and now
teaches economics at Hillsdale College. robert_p_murphy@yahoo.com. See the
Study Guide on money. See the Murphy Archive.