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Sunday, September 5, 2010

The U.S. Dollar's Value (A Primer)

The other day I had a discussion with a person who seems to believe that the U.S. Dollar could never go to zero or near it.  After discussing things with him, I realized that a lot of people need a better education on how our money appreciates/depreciates and its role as the reserve currency.  I think it is appropriate to discuss what it means to be a reserve currency first.  A reserve currency is one that is used to purchase products from around the world like oil, gold and other commodities.  These commodities/goods are purchased in the reserve currency worldwide, therefore governments around the world have to hold the reserve currency to purchase their imports of oil and such.  The U.S. Dollar has the privilege of being such a currency, as it was the most stable currency in the world to date.  This means that if Japan wants to import oil, they need to first purchase U.S. dollars and then make their purchase of oil in dollars.  This establishes a strong demand for U.S. Dollars as everyone needs to have them to get what they need.  The reserve status also gives the U.S. the ability to purchase things cheaper than other countries as they don't have to pay the spread or transaction cost to convert the money.  For larger nations the transaction cost is cheaper, for others it is higher.  This also lets the U.S. borrow money at at a better rates as their will always be demand for the U.S. currency (due to its reserve status).

Now that we have established demand for U.S. currency, lets discuss how do other countries get it.  Most currencies are traded by banks on the foreign exchange market or Forex market.  Central banks purchase the countries reserves on the forex market where there is an established spread in the cost of the currency desired.  It is only in the past few decades that the Forex market was opened up to retail investors who can purchase on leverage along side the banks.  Currencies are sold in pairs.  An example of currency pairs are USD/JPY (U.S. Dollar/Japan Yen), EUR/USD (Euro/U.S. Dollar) or USD/CAD (U.S. Dollar/Canadian Loonie).  Here are some examples of currency pairs, the in order from left to right the pairs are EUR/USD, USD/JPY and AUD/USD.

The significance of the first currency in the pair  (take the EUR/USD) is that if you were to buy the pair, you'd be going long the Euro and short the dollar.  Inversely, if you sold the currency pair, you'd be going short the Euro and long the dollar.  You can see the spread in EUR/USD is 3 pips (price per point), you buy 3 pips higher than the sell price (that is the spread or the price you pay for the transaction).

Given the demand for the USD and the means by which to obtain it, you can see how demand for dollars keeps the USD relatively stable against other major currencies.  You can see how the reserve status gives the USD that stability as it forces demand for our currency.  Another main ingredient to our dollar is faith.  The USD was backed by gold up until the 1970's when President Nixon took us off the gold standard to make us a fiat currency (backed by the full faith in the U.S. government).  The reason we were taken off the gold standard was due to inflation in commodities and the spending on the Vietnam war, which was not counteracted by spending cuts in other areas and a worsening trade deficit caused a situation where the USD was worth less than the gold it was backed by (you can draw parallels to today).  Foreign holders of USD demanded redemption of their dollar for gold. President Nixon was concerned this would deplete the US supply of gold, so he took us off the standard over a period of a few years.
Courtesy of Wikipedia
From the picture above you can see how the USD devaluated considerable in milligrams of gold.  Since then we have driven up our nations debts funding wars, housing, economic recoveries and such.  Money supply has expanded (printing of dollars, whether it by by credit expansion or creating new money), interest rates are at all time lows, and productivity (GDP) is low (among other things).  Some think this is a phenomena that has recently occurred, but it has been occurring since the mid 70's late 80's, we've just put it into hyperdrive.  Here is a current chart of the USD valued against the Japenese Yen.

Either we are moving sideways with currencies or we are devaluating against them.  The Euro has its own problems as the European block has multiple crisis' that make it devaluate along with the USD.  Since the Euro reached its high in 2008, the USD has been appreciating against it (reflective of the crisis with European fiat currencies).
Recently countries have noticed where the US fiscal policy has been going and have asked for a new reserve currency.  China, Russia, India and some middle eastern countries (to name a few) have insisted on using a basket of currencies.  The IMF is proposing using SDR's to use as a reserve currency.  This did not get very far, but some countries have begun selling their exports to non-US interests in their currency or the Euro.  This is being done due to a lack of faith in our currency, as a stable currency.  China has begun diversifying their foreign reserve holdings into the Japanese Yen and the Euro.  These are disturbing trends for the USD, as these assets start to trade in other fiat currencies, the USD's demand will start to diminish causing it to devaluate further.  If these countries and/or the IMF succeed in changing the reserve currency, this could send the USD into a free fall.  Even though this is not the case today, the USD has depreciated considerably over time.  Using normal CPI numbers (kept artificially low) a $20 item purchased in 1950 would cost $180.92 today (a 804.6% increase).  A $20 dollar item purchased in 1970 would cost %112.38 (a 461.9% increase).  So you can see, that not only is it possible to go to zero or near zero, we have been devaluating in terms of purchasing power for quite some time.  Only recently are we seeing large swings in the currency prices.

Having said all that, the contrary argument is that it is not in the best interests of other countries currently to allow the USD to fail.  China holds upwards of a trillion in US debt holdings and about 1.6 trillion in U.S. reserves.  We need to watch them closely to see how the dollar will react as China has recently been diversifying their reserves and selling small amounts of U.S. reserves.  China also converted long term U.S. debt to short term debt as they did not want the exposure.  China movings in and out of assets slowly (like the way they are increasing gold holdings) as to not effect the price too much, so small sells of U.S. assets is what you have to watch for.  China recently warned against a monetary system denominated by the dollar and possible depreciation.  [ Read more ... ]

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