For the love of money is the root of all evil1
All money is a matter of belief 2
Money makes the world go round3
As the above quotes indicate, money has been around for a long time, and some would argue since the beginning of time. Money is so common that everyone has experience with it and likely interacts with it on a daily basis. This familiarity does not, however, mean that money is universally understood. Therefore, we will begin by providing the following definition of money as described by the International Monetary Fund.
- (1)
Store of Value, which means people can save it and use it later
- (2)
Unit of Account, that is, it provides a common base for prices
- (3)
Medium of Exchange, something that enables people to buy and sell from one another
While crypto currencies do not necessarily meet all of the definitional requirements at the moment, they do represent a natural evolution of money. Additionally, many of the most appealing aspects of crypto currencies attempt to address many of the issues that have plagued money throughout history. From the perspective of these challenges, we will start by providing a brief history of money.
Barter
While one of the earliest forms of money is often considered barter, it actually falls short of the International Monetary Fund’s definitional requirements for money. In a pre-currency society it is certainly easy to see how barter naturally evolves, with the baker looking to trade his bread for butchered meat as envisioned by Adam Smith in The Wealth of Nations. Of course, the limitations also become obvious as the baker has to first find a butcher interested in trading for bread before even determining the ratio of the two goods. These two parties also need to find farmers with wheat and ranchers with cattle that are interested in providing the baker and butcher with their inputs. While there are aspects of a medium of exchange, the requirements that bread (or meat) is a store of value and unit of account are not accomplished in this example.
These types of exchanges eventually gave way to a more standardized approach that facilitated a greater variety of transactions. Within each community, there were generally some agricultural products that were widely demanded by a large portion of that population, such as grain that could be ground or planted. In these instances, merchants of all kinds would be more willing to accept the broadly desired commodity if there was a general ability to exchange that product for something else. In our example above, while the butcher may not want bread, he would accept grain from the baker that could then be used to exchange for livestock from a farmer. The farmer in turn would be incented to accept grain as payment if it could be used to acquire tools from the blacksmith. These are broad examples of the development of commodity money, with salt, tea, and seeds widely accepted forms of “commodity money.”
There are a few key points to take away from our example; firstly, grain has the potential to evolve into a unit of account and a medium of exchange, although its store of value is only as long as the grain does not spoil. An additional observation is that the success of grain as a currency is based on the broad-based belief in its convertibility into other goods and services. If that belief were suspended by enough of the community’s population, the appeal of accepting grain would be hampered and only those that naturally needed it would continue to partake in this form of barter. This situation would then convert grain into just another bartered product that is limited by many of the issues described above. One last issue concerns the store of value, where a grain’s shelf life is limited, but can also be broadly replenished on a year-to-year basis. In fact, a bumper crop may flood the market with grain that would lead to devaluation of that currency. As we shall see a little later in this discussion, this is akin to drastically increasing the supply of money, which in practical terms leads to inflation as there is a greater supply of currency available in the economy. For purposes of this chapter, we refer to currency as a medium of exchange, most closely associated with fiat currency issued by a central bank that generally has no intrinsic value. Money can be anything that fits the definition provided above.
Moving Beyond Barter
The Illustrious History of Shell Money
Functioning money in a format that we are more familiar with began to emerge at least several thousand years ago, with estimates in the 1000–2000 BC era. However, unlike paper currency or even metal-based coins, the earliest forms of global currency took the form of shells, more specifically cowry shells. It is understandable why someone may want to accumulate these shells as they are still aesthetically desirable as jewelry or for display. As a currency, these shells were appealing in that they were durable, relatively lightweight, and fairly unique looking, which guarded against counterfeiting.
Shells were therefore more appealing than cattle and grain in that they could be divided much more easily, didn’t spoil, and were much more easily transportable. While cowry shells are most plentifully found around the warm waters of the Indian and Pacific Oceans, their role as currency is most closely tied with the Chinese adoption of the “currency.” At the time, China had a vast empire and needed a way of facilitating transactions across a wide geographic region. In addition to the physical aspects of the shells discussed above, acquiring cowry in China was difficult given its distance from the harvesting fields. This gave Chinese emperors the ability to more easily control the supply of cowry in circulation and, by extension, the ability to control inflation.
While cowry shells are the most often cited form of shell money, they were by no means alone in their role within commerce. American Indians are often cited as using wampum, which is a string of small cylindrical beads made from quahog shells, as a medium of exchange. These examples also point to the durability of various clam and oyster shells that functioned much as cowry was used. Wampum was often strung together, which increased its appeal, although drilling, the process of cutting a hole in these hard shells, was a labor-intensive process for Indian tribes. In a way, this process naturally controlled the supply of marketable wampum in that while the shells were plentiful, converting them to tender limited the number of shells in circulation.
The arrival of Europeans and more importantly European tools permanently altered this relationship, however. The shells proved no match for metal tools, which allowed Europeans to produce tens of millions of wampum beads by the mid-seventeenth century. This effectively flooded the market with wampum beads, devaluing its worth and ultimately leading to the collapse of its usefulness as a currency. Nonetheless, shell money maintains a place in history as one of the longest lasting forms of currency, with examples of cowry shells being used as currency as recently as 1950s in various African markets.
From Shells to Coins and Paper
The next stage for the evolution of money was the introduction of coinage. Metal had been used as a medium of exchange almost as long as barter and shells, but the first minting of coins is thought to have occurred in the sixth or fifth century BC. The Lydians, an Iron Age empire that existed in parts of modern-day Turkey, are often cited as the first culture to introduce standardized metal coins. These early coins were likely created for ornamental purposes or as souvenirs, but were soon used as money. Further adoption and refinement saw standardized coins emerge in many cultures, including Greek, Persian, Indian, and Chinese societies.
Early coinage was made from electrum, a naturally occurring mixture of gold and silver. Other metals were subsequently utilized to make coins, including gold, silver, copper, and bronze. The use of these precious and semi-precious metals was by itself a store of value. Most cultures minted multiple sizes of all these metals, thereby allowing the facilitation of trade for all types of goods, big and small. The availability of precious metals also had an impact on the type of coins that were introduced. It was thought that some of the earliest pure gold coins were minted by the Persians as they held much of the world’s gold at that time. In contrast, other cultures, such as the Greeks, did not have easy access to gold and chose to store their limited gold instead of converting it into coinage. Silver was therefore also widely used in coinage, particularly as gold became scarcer.
Gold and other precious metal coins ultimately gave way to paper money. That is not to say that gold has fallen out of favor, as we still have official gold coins being produced, such as the American eagle, Canadian Maple Leaf, and South African Krugerrand. While coins fulfilled all of the definitions of money, they could still be cumbersome, particularly for large transactions. In addition to the logistics of carrying around large sums of metal coins, such practice also opened the bearer to theft.
Evidence suggests that paper money had its origins in China, as the invention of paper naturally gave way to the development of paper money. Dispersed and growing trade routes made transportation of large quantities of coinage increasingly challenging. Additionally, the limitations of coinage were evident either when there was not enough metal to produce currency needed to support growth or when inflation required the transportation of more coinage. The earliest forms of paper money were private transactions, where traders deposited their coins at their companies, which issued a promissory note based on this collateral. Governments eventually saw the benefits of issuing paper money, with broad introductions around the eighth century AD. Governments eventually established themselves as the only entity that could issue paper money, with the concept of the ministry of finance becoming formalized 500–600 years after paper money was first introduced.
The development of paper money was not without hiccups, however, as the temptation of unlimited printing of money eventually led to rampant inflation in China. Paper money was actually eliminated for several hundred years following an especially deep financial crisis. This entire life cycle of paper money in China occurred before the Europeans even considered issuing their own paper currency, even though Marco Polo reported on its use in the late thirteenth century.
Development in Europe followed a similar path, as banks held gold and silver for its customers providing a receipt promising the repayment of the collateral on demand. These notes then became demand notes for the bearer, making them an ideal vehicle in facilitating business transactions. The first official European note is credited with the Swedish, with the private Bank of Stockholm issuing notes backed by copper and silver holdings in collaboration with the Swedish government. Similar to the Chinese experience above, too many such notes were printed, which declined in value when the bank was not able to meet the demand of its depositors who wanted the return of their silver and copper. The bank eventually collapsed, was taken over by the government, while its founder was imprisoned within ten years of its founding. Sweden also banned the issuance of new banknotes until the eighteenth century.
Despite these setbacks, paper money continued to flourish although initially it was banks that were the primary issuers of paper money. The growth of international trade in the thirteenth and fourteenth century in Europe evolved with the issuance of notes that represented holdings of gold or silver at a depository. Initially these notes only entitled the depositor to the precious metals, but evolved to provide the bearer with the right to the collateral. Merchants then started to request multiple notes for their larger deposits as the concept of multiple denominations emerged.
Banks themselves started to issue banknotes that were backed by gold or other collateral that they held, which often resulted in floating more notes than were physically backed by collateral in their vaults. This was possible as banks did not expect all note holders to demand collateral at the same time, very similar to the modern banking system. Of course, as illustrated above, the temptation of issuing too many notes is ever present. In those instances, bank solvency becomes a problem for banknote holders, as was the case of the Bank of Stockholm. In the Swedish example, the Riksbank, or Swedish central bank, was established in the aftermath of this early crisis. Given that the monarchy was involved in the establishment of the Bank of Stockholm, which initially provided the venture with credibility, the Riksbank was established outside of the government, with the primary task of maintaining price stability. These principles became the foundation of modern central banks, and the Riksbank is considered the first and oldest central bank.
While Sweden is credited with the first banknote and the first running modern bank, out of caution, the Riksbank did not issue new bank notes for over 100 years after its establishment. During that time, other countries stepped in to fill this void and advance modern financial theories. England played a pivotal role in this sequence of events, but it was from a position of necessity that its financial innovations were first introduced. The English military was ravaged after a long war with France that required significant resources to rebuild. With credit tight, the Bank of England was established in 1694 to raise 1.2 million pounds in order to rebuild the navy.
Over the course of several hundred years, standardized banknotes issued by the Bank of England were first introduced. Counterfeiting also became rampant as private banks and the Bank of England both continued to print notes, causing some confusion as to which notes were real and which were fake. While the sentence for counterfeiters was death, fake notes continued to cause problems, leading to the Bank Charter Act that granted note printing monopoly powers to the Bank of England. The US printed its first government note in 1862 declaring it legal tender, meaning that they must be accepted to settle debts. These advancements in finance and the payment system have been largely replicated around the world.
As we will review the development and role of central banks a little later in this book, we will jump to some of the more important developments with regard to currency which paved the way for crypto currencies. Crypto has been a natural extension of the digitization of money, which began with the advent of the charge card. By way of background, a charge card is characterized mainly by the requirement that the balance be repaid in full by at the end of each month. Earlier versions of electronic charge cards were introduced by the likes of Diners Club, Carte Blanche, and American Express. Credit cards are distinct from charge cards in that they are essentially forms of revolving credit, with less than full payment due each month, with outstanding balances subject to interest charges. Earlier versions of credit cards were pioneered by large merchants, which evolved to general use credit cards in the 1960s.
While charge and credit cards began making consumers comfortable with the digital payment system, users were still accessing their money through traditional bank channels. They either needed to get cash to pay these bills or wrote a check in order to facilitate the payment. The ATM further advanced how we access money by tying our bank accounts to a card that contained our identifying information. The first ATMs started in Europe in the late 1960s but quickly spread around the developed world. The development of interbank networks further advanced easily accessing our money, while also making access to money outside our domestic markets possible. There are an estimated 3 million ATMs globally.
By combining the concept of credit/charge cards with the accessibility of our own money we evolved to the debit card. According to the Kansas City Fed the first debit card was introduced in 1972. Other historians assign the first debit card usage later in the 1970s as an alternative to using checks with merchants, which was a cumbersome process of communications between a bank and a merchant. Nonetheless, debit cards have been around for a while, although their use did not really begin to accelerate until the 1990s. While slow to start, debit card usage has taken off, particularly after the financial crisis, as credit became tighter and consumers more conscious of their financial position. At present, when measured by the number of transactions, debit cards are used more frequently than any other non-cash payment method, including checks and credit cards. Further evolution of the payments system all have an electronic component, and include the development of peer-to-peer payments systems such as PayPal, Venmo, and Square, although each of these examples ultimately ties back to a more traditional payment vehicle.
As e-payments grow, they are expected to ultimately exceed cash transactions. In many ways, this has already occurred, with cash payments used for only 1/3 of transactions, with checks and electronic methods accounting for the balance. Governments also appear to be taking sides, actively trying to reduce the amount of cash in circulation. For instance, the European Central Bank stopped printing €500 notes, although existing large denomination notes remain legal tender. In far more dramatic fashion, India demonetized its largest bills, the 500 and 1000 rupee note. Converted into US dollars (USD), these notes would be comparable to removing the legal tender associated with $10 and $20 bills in an essentially overnight announcement. This caused hardships for Indian citizens, especially the elderly and the poor, as currency became scarce and many of these groups did not have access to electronic forms money. This movement is also gaining steam, with certain factions encouraging the US and UK to eliminate the $100 and £50 bills.
Payments type switch from cash to electric. (Federal Reserve Bank of San Francisco)
While cash is money, as discussed above, money is much more than cash. What cash does provide are some unique and powerful characteristics within the payment system that other payment forms cannot replicate. Mainly, cash is universally accepted, is instantly cleared, and cannot be electronically hacked. It is, however, subject to government intervention, as was recently experienced by Indian citizens. As a national currency, money can also be devalued by monetary and fiscal policies. Large transactions involving cash can also prove impractical, subjecting the parties to theft and/or increased scrutiny when large sums of cash make their way into the banking system. Lastly, cash is also anonymous, which provides solace in an increasingly connected and transparent global society. Crypto currencies have emerged as an alternative that potentially addresses the desire for anonymity in the payment system, while also providing many of the conveniences offered by electronic methods. As will be discussed in later chapters, crypto currencies have also been designed to protect from debasement created by government policies. Before we get there, however, we will look at a little more history and provide some of the more (in)famous failings of money.
The Role of Gold in Money
Gold has always played a pivotal role in the development of money from the start of currency transactions. It is one of the longest lasting forms of money if one considers that the earliest coins obtained most of their value based on the amount of gold they contained. National wealth was often measured by the amount of gold a country held, which had a direct relationship in European interest in exploring and often conquering the new world, often to gain access to its gold reserves. The discovery of gold in the Western US during the 1800s gave the US massive gold reserves, which provided the lever for US economic gains which contributed to much of the nation’s modern successes.
The almost mythical position that gold has obtained occurred despite the metal’s limited productive use. Initially, its use as a form of money was based on its non-corrosive nature, malleability, and aesthetics, which all made it a prime candidate as an early form for money. This could not be said of other metals, such as copper or iron, which corroded and therefore did not provide a store of value. Gold is also relatively rare, which gave it a leg up on silver in maintaining its value, but not so rare that it would impact economic development. It is worth mentioning again that money is only as valuable as the worth that society puts on any given currency. Therefore as long as gold maintained its value, it became increasingly valuable in the payment system.
Gold consequently played an important role in the development and acceptance of paper money. Earlier incarnations of paper money were simply deposit slips from institutions that held harder to transport versions of metal money. As governments became the predominant and then sole issuers of paper money, they initially maintained the tradition of having gold and/or silver reserves to back their currencies. It was not uncommon to have bimetallic currencies, although declining scarcity of silver ultimately created currency devaluation and market volatility for countries that maintained large silver reserves and relatively small gold holdings.
During the 1800s, most developed countries had moved toward using some sort of gold reserves to back their currency. England was once again at the forefront of currency innovation as it established the gold standard in 1821, formally tying its official currency to gold stocks. Slowly over the next 50 years, other countries followed suit, with France, Germany, and the US each backing their currency against gold reserves. This broad acceptance of the gold standard provided the platform for nations to cooperate on monetary policies. The period between 1871 and 1914 is often considered the height of influence for the gold standard, a time that was characterized by strong gains in global trade, limited inflation, and broad cooperation among central banks to maintain external balances at the cost of internal balances.
The basic concepts of the gold standard is one where an economy is adjusted based on price of goods, flow of specie, which was often gold coins or bars. As a simple example, assume that Country A is running a trade deficit with Country B. This would obligate Country A to transfer gold reserves to Country B in the amount of the imbalance. Shrinking gold reserves at A would cause its currency stock to decrease, while the amount of B’s currency would increase. This would cause the price of goods at Country A to deflate, which would stimulate more exports, presumably to Country B. In turn, Country B would experience inflation as it has more currency in circulation. Given the weaker economy in Country A, and higher prices of Country B’s goods, the trade imbalance would reverse. This ultimately creates a reversal of the gold outflows, changes the amount of currency in circulation, and brings the imbalance back into equilibrium.
Our example is a fairly simple example of the gold standard, but one that we can use to highlight key aspects of the system. Firstly, decisions around monetary policy are fairly limited, as the amount of gold ultimately dictates the amount of currency in circulation. Interest rates are important in that they should be used to help facilitate the ultimate movement of gold to bring external balances back to neutral. Imbalances can also lead to investment from gold-rich countries that improves productivity in weaker economies. While prices fluctuate, exchange rates do not unless the amount of gold in the global system changes. Since monetary actions are limited by gold holdings, governments are somewhat helpless when facing internal economic hardships. Inflation is generally held in check, but so is overall global growth, both limited by the finite stores of gold reserves.
It is no coincidence that this period of the gold standard ended in 1914, which coincided with the start of World War I (WWI). Trade imbalances had been growing for a while as serial deficit countries ultimately cheated on their obligations to encourage external rebalancing in an attempt to hold on to their gold reserves. A degree of distrust also limited greater amounts of investments from reserve-rich countries for trading partners that ran deficits. The economic hardships of WWI caused nations to suspend the gold standard, as many were forced to print money in order to finance war efforts.
Following WWI, many countries tried to reestablish their gold reserves, which were challenged by the much larger monetary base that the depleted gold reserves needed to back. There were several instances of hyperinflation across Europe, with Germany a notable case in that its economic disarray sowed the seeds for World War II (WWII). Other countries were forced to depreciate their currency relative to pre-war levels as the currency in circulation was not anchored by gold reserves. Most attempts to reestablish a gold standard failed, which led to a gold exchange standard. Under this plan, participating nations agreed to accept the USD and Great British pound (GDP) as a standard to settle international transactions as they became the first reserve currencies. This system required coordination between the Federal Reserve Bank and the Bank of England, which assured other participants of the expandability of the USD and GBP into gold. The system proved fragile as countries, nonetheless, attempted to hoard gold rather than hold the reserve currencies.
The Great Depression effectively ended the gold exchange standard, with some scholars blaming the system on exacerbating the depth of the depression. In the US the collapse of many banks during the depression created an environment ripe for gold hoarding. To address this problem, the US government passed several major laws that effectively made it illegal to hold gold. The first was the requirement that banks exchange all of their gold reserves into Federal Reserve notes. This was followed by the requirement that all residents exchange their gold holdings into Federal Reserve notes. These series of actions made it impossible to convert holdings into gold as it was illegal to hold any gold. The US government ultimately created the Fort Knox depository to hold its ballooning stock of physical gold.
Reviving a gold standard took yet another step backward with the outbreak of WWII. It wasn’t until near the end of WWII that the allied powers started to consider how to rebuild the global financial system. In one of the most important agreements in modern finance, 44 nations agreed to again use gold as a standard for monetary policy, except this time it would be via the US dollar. The US emerged after WWII as the most powerful country in the world, without most of the reconstruction challenges that most countries faced. The US also held between 65% and 75% of the world’s gold stores, providing the US dollar with a clear advantage over other currencies in international trade. Therefore, following a three-week meeting at Bretton Woods, New Hampshire, the Bretton Woods Monetary Management System was established. Under this system, countries would agree to maintain fixed exchange rates closely tied to the US dollar. If exchange rates moved outside a 1% band to the USD, central banks would intervene, either buying or selling their local currencies to reestablish the relationship. Both the International Monetary Fund and the World Bank were established as part of Bretton Woods to assist in maintaining the system.
In exchange, the US. would guarantee the convertibility of the USD into gold at a rate of $35 per ounce. Gold exchanges were established in the US and in London to allay convertibility concerns. The result was that the USD replaced the gold standard in settling international imbalances. This new system was seen as a way to remove some of the rigidity of a pure gold-based system, while also avoiding some of the exchange rate volatility that emerged during the intra-war period of the gold exchange system. The main goals of Bretton Wood were to foster stable exchange rates, eliminate competitive devaluations, and drive global growth. By all accounts the Bretton Wood agreement was short-lived, as it took over a decade to implement and cracks in the system began to form almost immediately.
The US, which had run trade surpluses against most of the world during the post-WWII reconstruction phase, started to run deficits in the 1950s. Dollar claims against gold reserves exceeded their actual supply by the 1960s. The Vietnam War, fiscal deficits, and rampant inflation in the US during the 1960s into the early 1970s essentially doomed Bretton Woods. While Presidents Kennedy and Johnson attempted to preserve the system, in 1971 President Nixon announced that the gold window was closed and that the US would no longer convert dollars into gold in what became known as the Nixon Shock. Other agreements between the world’s largest economies attempted to reestablish a stable exchange rate following the Nixon Shock, but were generally unsuccessful as floating exchange rates emerged. While the USD was no longer the world’s official exchange currency, its position as the world’s reserve currency was already well established by 1971, a role it maintains to this day.
As currencies were no longer backed by gold after 1971, all currency became fiat money on that fateful day. The main attribute of fiat is that it is money that is deemed legal tender, but has no value other than that promise. Recall that gold or any other physical backing for money essentially limits the amount of money that can be produced. This is not the case with fiat, where a government can essentially print as much money as it sees fit. Printing too much money risks depreciating its value via inflation, where your purchasing power decreases. Printing excessive amounts of money may potentially result in hyperinflation, where the value of money can depreciate hourly in the most acute instances. Some of the most extreme examples of hyperinflation include the post-WWI German mark, post-WWI Hungarian pengo, and most recently the Zimbabwe dollar. In these examples, inflation often exceeded 10,000% per year, with examples of Germans using the mark for kindling wood given its inability to fulfill its role as a store of value. Despite these extreme examples, overall global inflation has fallen since the financial crisis despite large increases in the supply of fiat currencies by the world’s largest economies.
Determining the Value of Money
The value of a country’s money is now best defined via its exchange rate versus another country’s currency. The US dollar remains the world’s reserve currency and it is therefore the main pair member for almost all currencies, a position that emerged as part of Bretton Woods. For instance, it is common for two non-USD currencies to be first paired against the USD in order to facilitate a non-USD cross-currency transaction. In terms of how those values are determined, currencies currently freely float, are fixed to another currency, or use a hybrid of a free and fixed model, often called a managed or dirty float.
Most of the world’s largest economies allow their currencies to freely float, with China’s managed float being a notable exception. Under a freely floating currency regime, valuation is determined by currency supply and demand factors, which causes exchange rates to constantly fluctuate. A global foreign exchange market is estimated to trade $5.3 trillion in currencies daily and essentially functions 24 hours per day on practically every weekday. The benefit of having a deep and frequently trading market is that valuations reflect all current information and price change can generally avoid large market shocks in all but extreme circumstances.
The price of a currency in the foreign exchange (FX) markets is determined by the underlying demand created by international trade along with the speculative aspects created by traders looking to profit from price fluctuations. Export of goods and services creates the most obvious source of demand, as a supplier will generally wish to be paid in their local currency. In simplistic terms, the importer would need to acquire the foreign currency by selling their local currency in order to make payment for those goods and services. This creates demand for an exporter’s currency, driving its value higher, while adding supply (selling) of the other currency, driving its value lower. However, bilateral trade may create demand on both sides and if there is an equal exchange of goods, the balance of trade is neutral and there will be no need for any change in FX rates from a trade perspective.
In the real word, balanced trade is a rare occurrence, with countries running trade deficits or surpluses, sometimes in sizable quantities for extended periods of time. Under a classic gold standard, changes in money supply would be dictated by the changes in gold reserves as a result of deficit and surplus balances. The changes in money supply in turn would expand or contract the respective economies, creating periods of greater wealth in one nation over another. The better performing economy would be able to consume more, while the citizens of the deficit nation would find their consumption curtailed. A good’s prices and demand would ultimately be impacted, as the net importers return to balance through a combination of cheaper exports and less imports. Throughout this period, exchange rates would be unchanged as they are fixed to the value of gold.
Floating currencies provide a similar adjustment mechanism, although the exchange rate itself alters the supply and demand equation. In our simplistic example provided above, the country that is a net importer runs a trade deficit, while the export-driven country has a trade surplus. Focusing on the deficit country, the value of its money declines as there is less demand relative to the surplus country (as implied by their individual trade situation). The decline in currency value ultimately makes its goods cheaper to the outside world, which eventually brings the trade imbalance back into balance. The opposite is true for the surplus country as its stronger currency now makes its goods more expensive and therefore less desirable. It would see its exports subsequently fall, contributing to make the move neutral. Ultimately, rising or falling exports impact the wealth of a nation’s citizens, which has clear political ramifications that makes our simple example purely theoretical and not particularly useful for determining the value of money in the real world.
US trade balances (in billions). (US Census Bureau)
The world’s willingness to hold US dollars is tied to its status as the predominant reserve currency, with the USD being used to price most of the world’s commodities. The economic strength and rule of law of the US makes holding US assets appealing, which cannot be said for all countries. This serves to distort the simple trade-driven equilibrium mechanism that we presented above, and explains how a trade deficit can not only exist for an extended period of time but also accelerate during this period.
Monetary unions, such as the European Union, also highlight the challenge in using trade as the primary driver of exchange rates. Under a monetary or currency union regime, a set of countries agree to use the same currency. Since the single currency should reflect the collective performance of the union, individual country imbalances can last much longer than if individual currency regimes were maintained. In the case of the EU, the difference in the performance of the core and periphery countries is a prime example of these imbalances, which was responsible for the sovereign debt crisis that gripped the world in 2010.
As can be surmised, there are many factors in determining exchange rates, with inflation, terms of trade, interest rate differentials, outstanding debt, financial markets, government debt, and political stability just some of the obvious factors that we have not discussed extensively. Ultimately, while a currency reflects the strength of an economy and its citizens, there is a level when a currency gets too strong. In those instances, exports are curtailed, possibly increasing the odds of a recession, while also limiting inflation, which can impact wage growth. The response from a government may be to try and push its currency value lower, either by intervening directly in the FX markets or possibly through a lower interest rate regime.
Faced with a rising unemployment and/or a recession, central bankers have also attempted to stimulate their economies by increasing the money supply and lowering interest rates. These stimulative policies continue within some of the largest central banks despite our being ten years removed from the financial crisis. As interest rates were essentially set at zero in the world’s largest economies, these same central banks started an unprecedented asset accumulation process, which grew the balance sheets of the G-4 central banks to over $14 trillion, a 250% increase from before the crisis. While the subsequent increase in their respective money supplies have yet to ignite inflation, there have been many periods of excess inflation being driven by large increases in the money supply. The inability to control these external forces has become one of the main appeals of crypto currencies, which by design avoids many of the monetary and fiscal pitfalls discussed above.