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Monday, September 14, 2009

Exchange Rates, Strength of the Dollar

An earlier discussion lamented the weakness of the dollar against the Euro. Specifically how much the dollar had declined since January of this year, although it was pointed out that it appeared to be that weak and more mid last year (2008).

The protagonists in the discussion were practical people, but were focused on the wrong evidence to support their argument. Comparing one currency against another is useful only if one of the currencies can be considered stable. In the case(s) of the Euro and the dollar, neither can be considered stable currencies for the purpose of evaluation of public policy during the period in question.

Both currencies are being heavily managed by their respective states. The ECB and the Fed (and Treasury) are both busy trying to manage their economies through artificial injection of capital, interest rates and other monetary policy tools. As such, neither can be evaluated simply by comparing one to another. Neither can we evaluate the effectiveness of the policies, one against the other, without also considering the differences in policy making.

In one case, the EU and the ECB, policy has been relatively stable, with adjustments mainly in interest rates and not much in terms of new debt and additional money supply. Further, the business public (private sector and investors) was kept fairly well informed of the discussions and future of their currency. In the other case, the U.S., the Fed had been increasing the money supply (measured by M1 and M2) "on the sly" for over 15 years. The Fed even decided it was no longer important to track and publish M2 (which contains, among other things, the business to business money markets - so-called commercial notes). During this period, the US money supplied more than tripled, while the actual growth of the economy was roughly around 4% annual or an aggregate growth of around 45%). Does anyone see a problem here?

Anyway, because of the differences in the supply of money, the comparison to dollars to Euros is difficult. It becomes much more difficult when the velocity of money changes, as it did late last year and worsened significantly this year. Now, we, the US, have not only a greatly expanding supply of money - printing it as fast as we can spend it - but also a slowing turnover of those dollars as the economy slows.

In such times it is useful to compare the value of a currency against a standard of some sort. Unfortunately, comparing against the Euro is not useful, except in very specific transactions (e.g. the price of a mass in Germany).

We are no longer adhering to a gold standard. There is a "basket of currencies" approach that the IMF administers, but it is not very useful either, as the two heaviest weighted currencies in the basket are the dollar and the Euro.

The way to evaluate any currency at the end of the day is with what the currency can buy. Every country has an interest in maintaining prices of common goods to affordable levels, and free markets will adjust prices including valuing or devaluing their own currency such that particular common goods are priced according to some common standard of value.

Believe it or not, economists have determined a common good (product) that is universal enough (can be found in almost all countries) and popular enough (enough transactions occur each day by enough diverse people) to be a meaningful measure. This good has been tracked now for over forty years in over one hundred different countries, so economists have historical data.

The currency index is here.

According to this index, the Euro is currently overvalued, relative to the dollar, by 35%. This is a level not seen since the introduction of the Euro. It indicates a lack of confidence in the dollar. One can reasonably make the case that the dollar needs to be reduced in terms of global confidence and its use as a global currency - not on the weakness of US policies but on the relative increase in strength of other global economies.

I am unable to attribute the weakness of the dollar specifically to our profligate ways, our increasing debt burden, our anti-business policies, or the current and pending actions of the Fed and Congress. I could also attribute some of the weakness to a long overdue adjustment based on the growth of other economies relative to the US economy. All I can reasonably conclude is that our policies aren't helping, and that our currency will reach a new equilibrium when there is some stability in what it is being measured against (besides burgers).

For now, we have seen that the price of a mass has been adjusted such that to us, the price of beer is approximately the same as in prior years - isn't the free market (where it survives) a wonderful thing?

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