Think your lek can kick my colón? Get riyal.

Strong dollar, weak dollar, what does it mean?

I haven't seen this many Indochinese dong since Sunee Plaza. Hi-oh!

It means the price of the dollar, as quoted in foreign currencies. (It doesn’t make a lot of sense to quote the dollar in terms of domestic currency. It’s always going to be worth $1.) There are 182 national currencies in circulation across the planet, but for this post we don’t need to concern ourselves with sparsely traded ones like the Botswanan pula or the Kyrgyz som (no offense to our readers in Gaborone or Bishkek. Control Your Cash is huge in Bishkek.)

Most of the world’s large cross-currency financial transactions are undertaken in just a handful of currencies: among them the euro, the pound sterling, the Japanese yen, the Canadian dollar, the Australian dollar, the New Zealand dollar… and the U.S. dollar. In the world financial markets, the U.S. dollar’s value is expressed relative to the prices of these other currencies. And around the world, that can be vital. One Control Your Cash author had the perspective of growing up in Canada, where the value of the Canadian dollar (quoted in U.S. cents) is at least as prominent a financial indicator as the Dow is in the U.S. Given that the U.S. dollar has historically been the most widely held stable (and most stable widely held) currency in the world, it makes sense that it’d be the one that other countries would choose to quote their currency in terms of. In many parts of the world not referred to above, three particular (foreign) currencies carry equal importance when measuring their relative strengths. In South Africa, for instance, the U.S. dollar, pound, and euro are quoted in terms of each other, making for 3 daily rate quotes (6 if you count each quoted in terms of South Africa’s own rand.)

We do this – quoting euros in dollars, or dollars in pounds, or pounds in euros – because there’s no pure, objective measure of wealth: no commodity whose value always stays the same with respect to everything else. There can’t be, as the economy is dynamic and accelerating. Millennia ago, it might have made sense to count, say, a suckling pig as a unit of currency. My hog is worth 4 of your sucklings. My horse is worth 20. My cow, maybe 8. Oh, wait, it’s a bull? Fine, you can have it for 3. When consumer electronics and decorative tiles and golf clubs don’t yet exist and therefore can’t be quoted in terms of suckling pigs, no problem. But the moment an economy advances even a little, you need something uniform and readily transferable to conduct business in. Even cigarettes work better than piglets, but that implies that your economy has already advanced to the point where cigarettes can be manufactured. Gold works to some extent, as we discussed here, but there are myriad reasons – mostly nationalism and conspicuity – why each nation insists on printing its own money.

If everything has a value – and if anything should, money should – it stands to reason that currencies can be traded for each other. And what makes a currency worth buying? Well, considering money isn’t edible, what makes it valuable is its potential for growth. It’s an investment, like anything else people trade in the financial markets.

If I buy ExxonMobil stock, I’m betting that the stock will increase in value – or in other words, that each dollar I’m buying the stock with will one day be worth less stock.

Yes! Breakthrough.

But currencies are different. If I buy pounds, doesn’t that mean I’m betting that my dollars will one day be worth fewer pounds?

Yes.

Does that make me a traitor to my country?

No, it makes you an investor. Indeed, currency transactions differ from most transactions in that when you deal in currency, you’re exchanging two abstract quantities whose only practical purpose – whose primary purpose – is ultimately to buy other things with. But if the currency you do business in (and if you’re American, that’s largely going to be U.S. dollars) is in danger of losing value relative to other currencies, there’s no point in waiting for it to happen while watching your dollars get weaker.

A “weak” dollar only means weak relative to other currencies. A currency can also lose value relative to itself over time (and almost always will), but that’s a different phenomenon – inflation, which can occur without respect to what’s happening in the rest of the world.

There are plenty of reasons why currencies fluctuate in value, a big one being interest rates. Let’s use the U.S. dollar and the pound as examples. The United Kingdom’s central bank*, the Bank of England, recently set its bank rate (the rate at which commercial and investment banks can borrow money from it) at ½%.  Every few months the Federal Reserve sets the American equivalent, the federal funds rate. Instead of a number, it’s a range, which is currently 0–¼%. (The more a bank borrows, the lower the rate it pays.) The effective federal funds rate, which is a weighted average of the money borrowed by banks, is .11%.

The U.K. rate is unequivocally higher, and not by a little. Which means that ever since those rates were set, the pound has promised higher returns than the dollar. Which makes the pound more desirable than the dollar, which is why the pound is worth more dollars now than it was a few months ago.

(The Bank of Japan’s rate is .1%. The European Central Bank’s is ¼%**, as is the Bank of Canada’s.) We’re not recommending currency investing, nor discouraging it. We’re just trying to explain how it works, which is better than you understanding it retroactively.

In the last 10 months, the pound has gained 20% on the dollar. Does that mean the entire American economy is weak relative to the Brits’? No. If your U.S.-based business buys a lot of British materials (labor, capital, whatever), it’s gotten more expensive to operate, because your business is taking in money in dollars and paying it out in pounds. If your U.S.-based business exports a lot to the U.K., then life is magical. You might not have noticed a thing regarding the price of what your company sells, or what it costs to make it, but from the perspective of a British consumer, your products got cheaper (in pounds.) Which is a big advantage over any British competitors of yours.

There are other criteria that determine currencies’ relative strengths, of course. A country with a lot of debt relative to its size (e.g. Venezuela) might have a crazy person in charge (which it does.) That crazy person (Hugo Chavez) can keep printing currency to settle the country’s debts, making the currency worthless and vaporizing the wealth of all the Venezuelans who earn and save money in that currency. But a country with a vibrant economy, little debt, and lots of imports relative to its size (e.g. Singapore) will usually have a stable currency. Singapore has to buy goods from other countries in order to survive, which means Singapore has a vested interest in keeping its currency worth something. It doesn’t have a lot of financial obligations, so there’s no incentive to weaken its currency by inflation.

Where do we fit on this scale? The United States has a tremendously vibrant economy, at least relative to the rest of the world, regardless of what’s been happening the last 18 months. The U.S. also has a lot of debt. However, we import a lot in absolute terms (although in relative terms, it’s nothing compared to Singapore. Plus we export a lot, too.) And while our chief executive isn’t crazy, it’s not a stretch to call him an opportunist who’d think nothing of ordering the Federal Reserve to help accomplish certain political goals that might not be economically sound.

Where to find currency rates? Yahoo! Finance is our favorite all-purpose financial site: it’s clean, comprehensive and easy to navigate. Scroll down to “Currency Investing” on the left column and have at it.

*You do a blog post, and then you realize halfway through that you might introduce an unfamiliar term. A country’s central bank – most every country of decent size has one – isn’t a bank in the sense that it has branches you walk into and make deposits in. A central bank exists to lend a country’s government its currency. The central bank actually creates the money the government borrows, which is why the dollar bills in your pocket carry the phrase “Federal Reserve Note”.

**You can choose between decimals and vulgar fractions on your own blog. We’re using both.

**This post is featured at Compounding Life**

#79 in the periodic table, #1 in our hearts

Makes it harder for people to bum change off you, too.

Every news story that contains a dollar figure is a product of its time, because inflation taints everything. That’s a recurring theme in the book version of Control Your Cash, soon to be released by a major publisher if certain contingencies break the right way.

Inflation, in one paragraph: with rare exceptions, the value of money always decreases. Slowly, but consistently. Right now a dollar is worth about 2% less than it was a year ago. That 2% is fairly consistent throughout the last century. It’d take a few more paragraphs to explain why. Better yet, a future post.

When the dollar amounts get big enough, and a federal government that lost its financial moorings a long time ago starts throwing out 12- and 13- and even 14-digit numbers, you can lose perspective. It’s hard to conceive of a million of anything, let alone a billion or a trillion. Especially when those numbers get bigger every year, thanks in part to inflation.

In the late 1940s, the U.S. dollar replaced the pound sterling as the world’s reserve currency – the default that international transactions are measured in when using another currency would be impractical or confusing. Americans today still benefit from that. Just by virtue of living here, we don’t have to worry about our currency becoming gradually worthless – and our life savings evaporating.

The dollar became the reserve currency largely due to the size of the American economy and the dollar’s relative stability. (It then self-perpetuated: the more stable the dollar, the more firmly entrenched it became as the reserve currency.) But that doesn’t mean it’ll be this way forever. Just this past week, China and several Middle Eastern countries proposed inventing a new currency to supplant the weakening dollar as the denomination in which oil and other commodities should be traded. This new currency would be nothing formal and tradable, just an amalgamation of existing world currencies that aren’t the dollar. That people are taking this seriously shows the dollar is assailable.

The U.S. dollar has enjoyed a 60-year-and-counting (however tenuously) reign as a powerful medium of exchange. As impressive as that is, gold has served as a store of value for about 100 times longer.

When the government creates too much currency, that currency weakens. Inflates. Becomes less valuable. It’s not hard for this to happen: the government just needs to fire up the presses. When a government owes a lot of money, like the United States’ does, this is an easy way of giving its creditors less than what they really deserve. But, by punishing its creditors, the government also punishes anyone else who does business in dollars. Which would be all Americans.

Gold can’t be injected into the economy as quickly as dollars can. To increase the gold output, you need to find a particularly rich vein, start extracting, put thousands of hours of manpower on the task, refine, purify, separate the dross, and bring it to market. Which is exactly what the world’s gold manufacturers try to do anyway, every day they operate. It’s not easy. That’s why gold, and not cobalt nor nickel, is the historical commodity people have used for money.

Gold isn’t an objective measure of wealth, but it’s as close as we can get in the practical world. Because extra gold is so hard to introduce to the market, gold’s value won’t fluctuate as much as something issued by the Federal Reserve, the Bank of England, or the EU. That’s why financial newscasts, publications and websites prominently display the price of gold. When the price of gold goes “up” (you’ll understand the quotation marks in a minute), that’s supposed to represent something noteworthy about both gold’s scarcity and the general state of the economy.

But gold is pretty scarce no matter what. Here’s a semi-rhetorical question: why do we quote gold prices in terms of dollars, a currency continuously weakened by inflation?

Right now, gold is trading at $1049/ounce, “down” $14.90 from yesterday. The Control Your Cash book recommends again and again that in order to greater appreciate how money works, you should examine every financial transaction you engage in from the other party’s perspective. Commodity prices are no exception. Instead of quoting the price of an ounce of gold in dollars, why not say that a dollar is currently trading at 29.65 milligrams of gold (up .41 milligrams from yesterday)?

We propose our own new unit of currency: the gold milligram, symbol Aumg (prounounced “OMG”).

Here are some current exchange rates:

euro 44.18 Aumg
pound sterling 48.15
yen .33
Swiss franc 29.14
Mexican peso 2.26
renminbi 4.34

With no more than two digits before the decimal point, these numbers are easy to visualize. And because of inflation, the numbers will almost all decrease as time passes, reminding the people who use these currencies of their ever-weakening power.

Here are some more for you:

2005 U.S. dollar 73.32
1998 U.S. dollar 109.46
1968 U.S. dollar 883.49

Puts a modest 2% inflation rate into perspective, doesn’t it?

Why should we assume the dollar (or any other state-issued currency) is the objective and constant measure, and gold is the commodity with the wildly variable price? Shouldn’t it be the other way around?

The short answer to the first question is conditioning. Decades ago the United States switched its currency from one defined in terms of gold to one “backed by the full faith and credit of the United States government”, a remnant from the reliquary of charmingly naïve and obsolete buzzphrases.

It’s natural for Americans to phrase their economic thinking in terms of “dollars”. Natural, and convenient, but damaging and incomplete. When a dollar is only as weak or as strong as the Federal Reserve arbitrarily chooses to make it, then the Federal Reserve has the ability to dictate the terms of (and to a large extent, even the size of) the nation’s economy. It’s hard to find a better example of too much power concentrated in the hands of too few. You know, the issue we fought the Brits over.

By one method, the United States money supply increased 6% from 2006 to 2007. That includes not only all the currency in circulation, but all the money held in checking accounts. If a 6% increase sounds modest, consider that the world gold output increased by 1.5% last year. Which triply overstates things, because 2/3 of the gold mined last year was used for industry, jewelry, etc. The 6% figure for the increase in greenbacks is conservative, too. It doesn’t include money in savings accounts, money market accounts, nor certificates of deposit.

In 2006 the Federal Reserve stopped calculating the increase in the broadest possible definition of money; the definition that includes huge institutional certificates of deposit held by banks. (These are CDs worth several hundred times more than the thousand-dollar ones you might be holding. But because they don’t trade among individuals, the government has an excuse for removing them from the equation.) The Fed argued that the costs to collect the data outweighed any benefits, which is why it would no longer estimate how much money is really circulating through the economy.

Yes, a branch of the 21st century American government willfully stopped crunching numbers. Can you think of any scenario in which a branch of the government would do that, if it had nothing to hide? The ironic thing is that the Fed isn’t even hiding what it’s hiding: paraphrasing, they said “Citizen, this information doesn’t concern you, and you wouldn’t know what to do with it anyway. Nothing to see here.”

If the Fed released those numbers, we’d know how many trillions of dollars they’re diluting the economy with. We’d know how few Aumg it’ll take to buy a dollar next year. We’d know how badly inflation is eroding the nest eggs we’ve each spent a lifetime building.

Some estimate that the money supply is really increasing by around 16% annually. Which is more than 30 times faster than the supply of commodity gold is increasing. So which is more stable – the dollar or the Aumg?

The point of this exercise is not to argue that the next time you buy a coffee, you should offer to pay with 40 milligrams of gold. Rather, the point is to put things in perspective when, for instance, Sen. Harry Reid says health care reform will cost 59,301,000,000,000 Aumg. Or 59,301 metric tons of gold. Or 38% of all the gold ever mined.

Putting the “Lies” in “Centralized”

When the republic crumbles, it’ll start here

Answering this question for the first and last time:

Q: Why do you only post once a week?

A: Technology has not compressed the length of time it takes to research, prepare, write and edit a worthwhile post. There are web “columnists” who write a column-length piece every day – and it shows. If you want 40 posts a day, go visit Glenn Reynolds and read about what fascinating brand of mayo he had on his turkey sandwich this afternoon. We’ll be waiting here with timely, worthwhile advice and education.

This week’s post is about a macroeconomic topic, but one that affects you at a personal level. Control Your Cash doesn’t typically review books, but Ron Paul is the exception to a lot of things. The Texas congressman/frequent presidential candidate just released his latest, End the Fed. It’s 207 pages that, although written in a clear and concise language, offer some of the most challenging concepts you’ll ever read.

(If you’re not familiar with Dr. Paul, read the news once in a while. Here’s his two-paragraph bio. A Republican, the 73-year old physician represents suburban Houston. He is perhaps the strictest interpreter of the Constitution ever elected to office, refusing to vote for any bill that will increase government spending or reduce freedom. He’s so unflappable that he refused to take a congressional pension, and forbade his kids from applying for federally guaranteed student loans.

Being principled has little to do with compatriotism, though. Here’s a superlative for you: in the history of the House of Representatives, of all the times a congressman has been alone on one side of a vote, 80% of the time that congressman has been Ron Paul. Even though he’s not an economist by profession, Dr. Paul has a far greater grasp on the financial problems plaguing our society than any of his 434 cohorts do.)

His new book starts with a wonderfully pithy title, and doesn’t stop. End the Fed is an argument for the abolition of the Federal Reserve, the mysterious entity that governs much of American economic behavior and at times appears accountable to no one.

The Fed is responsible for distributing the hundreds of billions of dollars in bailout money authorized by both the current and previous Congresses. It’s also responsible for printing money, which is why the bills in your pocket bear the phrase “Federal Reserve Note”. And in 95 years of existence, the Fed has taken great steps to keep its activities largely secret.

The Fed chairman is Ben Bernanke, who was appointed to a 4-year term by George W. Bush in 2006 and re-appointed by Barack Obama last month. When asked why the Fed wouldn’t disclose who’s receiving bailout money, Bernanke was more than a little evasive:

“It is counterproductive and would destroy the value of the program.”

Dr. Paul then called for (and being a congressman, is drafting) a law (HR1207) mandating the Fed be audited. To which Bernanke responded,

“My concern about the legislation is that if the (General Accounting Office) is auditing not only the operational aspects of the programs and the details of the programs but making judgments about our policy decisions would effectively be a takeover of policy by the Congress and a repudiation of the Federal Reserve would be highly destructive to the stability of the financial system, the dollar and our national economic situation.”

In other words, “I like not having to answer to anyone. The absolute power I wield is pretty nice, too.”

Unfortunately, if there’s no pressure to be candid and transparent, most elected (and appointed) officials won’t. Which is why Dr. Paul wants to start by forcing an audit of the Fed. Then, once the reasons for its almost pathological secrecy are exposed, Paul figures voters will clamor to abolish the Fed.

Most of us have at least a hazy notion that the Fed is responsible for controlling interest rates, which is true. Every fortnight the Fed sets its “discount rate” (currently 0–¼%). Banks across the country then use this as a benchmark, setting their own interest rates a few basis points above the Fed rate in order to turn a profit.

Economics students hear interest rates referred to as the “price of money”, which makes sense if you think about it. If your bank pays you 1% to stash your savings in an account, it’s paying you – the price of money – to help it pool assets to make loans (which are of course, its stock-in-trade) with. If you’re Floyd Mayweather, you pay 16% to a lender (in his case, JP Morgan Chase) for the privilege of borrowing the money to buy an obscenely overpriced car. (Before the IRS lien, the civil case and the repo, that is. Floyd dreams about getting financed at 16% today.)

Paul argues that the Fed shouldn’t be in the business of setting interest rates any more than some other government arm should be setting the price of furniture or shoes. But his greater worry is the Fed’s unchecked ability to print money.

In 8 short months, the Obama administration has doubled the nation’s already stratospheric debt ceiling. With our federal government borrowing tons of money from China, Japan, the United Kingdom, and plenty of other countries, we’re in grave danger of having to pay a national bill we can’t afford (that’s a bill with your name on it.)

So if the Chinese government owns $600 billion in U.S. government bonds (which our government issued to raise funds for everything from welfare payments to car manufacturer bailouts), and demands $600 billion that we as a nation don’t have, then what?

Well, one solution is to fire up the presses and print at least part of that $600 billion.

But won’t that make each dollar less valuable?

Yes.

 

And won’t that make existing dollars less valuable?

Yes. No one cares whether the dollar bill in your wallet has “2009” or “1978” written on it.

 

Wait. I get paid in dollars.

Now you’re getting it.

So your financial position weakens, even if you’ve spent your life saving, investing and living within your means. By inflating the currency, a profligate government agency is dictating the value of your life’s accomplishments.

The worst part about inflation is that even though it hits everyone, it punishes poor and middle-class people the hardest.

Why?

Because the richer you are, the less of your wealth is held in cash.

Let’s say you make $40,000 a year, carry no consumer debt, and have $10,000 cooling in a savings account. This is fairly impressive: most people who make $40,000 a year don’t have anywhere near a quarter of it stashed away.

Now let’s say you’re Alice Walton, whose fortune increased about $1.4 billion in the past year (that’s the increase, not the total. She’s worth about $18 billion.)

Do you think Alice Walton has a savings account, or even a CD, with $350 million in it?

She doesn’t. She has real estate, she has Wal-Mart stock, she has foreign currency reserves, she has collectible fine art.

A weak, inflated currency hurts all of us. But for the rich and the ultra-rich, who have already made their money and can invest it in hard assets that are difficult to devalue, it’s not so painful. For the people who aspire to be rich, and are looking to move from holding cash to buying hard assets, it’s like running in quicksand. With 45-pound weights around your waist. And a fat woman strapped to your shoulders.

Dr. Paul argues that the potential for American prosperity would be a lot greater if we had a currency based on gold, as opposed to one based on thin air and whimsy. And we did, up until the 1930s. When each unit of our currency represents a certain amount of gold, there’s almost no potential for inflation or debasement.

Gold is scarce, easily divisible, universally recognized, hard to counterfeit, and compact. Because mining gold requires enormous amounts of labor and capital, the price of gold isn’t going to fall dramatically: it’s not like the world aggregation of gold will somehow double in the next year. Gold isn’t a perfect store of value – nothing is – but comes closer than does a purely subjective piece of paper that can be produced in virtually unlimited quantities and is worth whatever the Fed says it is this week. Paul argues that having a currency that’s transferable to gold makes it harder for a federal government to make financial commitments it has neither the desire nor the capacity to honor. As to how convincing his argument is, read the book and understand we burned a weekly post on it for a reason.

Fair or not, lately Republicans have been assailed as everything from reactionary Bible-thumping zealots to thieving robber barons to flaming racists. With his quiet, private faith, noble occupation, and reasoned approach to constitutional questions, Paul is the very antithesis of every stereotype. By virtue of being principled and not beholden to any special interest, the seemingly incorruptible Paul is that rare politician who transcends the political spectrum. Just ask long-haired folkie Arlo Guthrie, who remarks on the back cover of End the Fed that “rarely has a single book not only challenged, but decisively changed my mind.”

The Federal Reserve is technically a private corporation, and not part of the federal government. Also, college athletes are amateurs who are on campus to get an education, and not to enrich their schools’ athletic programs as indentured servants.

As a political appointee, the Fed chairman has interests to please and his own position to preserve. And God knows there are few things as hard to dismantle as a government agency. Still, if you devote an evening or two to reading End the Fed and the arguments therein, you might be a little more inclined to expect the same fiscal responsibility from your government that you should be expecting from yourself.