PING: Economics Guys (Re: International Currency Valuation)

[albionmoonlight]

A thread title that probably won't get as many hits as "Who is this hot chick (SFW Pic inside)?" But if you are here, at least you know what you are getting for your money.

I was listening to the radio this morning, and they mentioned that China was getting ready to "float" the Yuan against a limited basket of currencies. This is supposedly a good thing for the U.S. because we have been claiming that China has kept its currency artificially devalued by linking it to the dollar. China, therefore, has been able to produce goods for export cheaper than the rest of the world.

I have several questions. First, how are currencies valued against each other generally? What makes the dollar go up or down relative to the Euro or the Peso? This is the kind of thing I should know, but never got around to learning.

Second, the valuation of a country's currency is important. Everyone seemed to think that it was a bad thing when post-Soviet Russians had to take wheelbarrows of Rubles to the store for a loaf of bread. But China seemed able to control the value of its currency. Why doesn't every country do that? And why did China stop doing it? There must be advantages to having your currency float free, but what are they?

Finally, people now seem to be saying that a weak dollar is good for America because it will make our goods more competitive on the international marketplace. But I grew up hearing that we needed a strong dollar and hearing the dollars value vs. the yen used as a benchmark for how we were doing vs. Japan. What are the advantages/disadvantages of a strong or weak currency vs. the rest of the world?

Basically, as the tread title suggests, I'm looking for an understandable summary of international currency valuation.

Much thanks.

[QuikSand]

Originally Posted by albionmoonlight

I have several questions. First, how are currencies valued against each other generally? What makes the dollar go up or down relative to the Euro or the Peso? This is the kind of thing I should know, but never got around to learning.

In a nutshell... supply and demand. No, really.


Imagine that you have a bunch of money in an American bank. You are earning interest on that money, and it is of coursein US dollars. You do some investigating, and see that you could get a higher rate of interest if you put your money into a bank from, say, Japan. So you do so -- and in the process, you convert your US dollars into Japanese Yen. Simple enough.

If the climate in the two countries remains disparate enough like this, then there ought to be plenty of people doing the same thing -- moving their US dollars into Japanese yen to get the better effects of that particular economy. Here we would have a supply and demand situation -- more people want yen at the current exchange than want dollars. So, the international market adjusts to this, and to try to level the supply and demand for yen relative to dollars, the echange rate will go down a bit, and your dollars won't get quite as many yen as before. Eventually, this adjustment will make "buying" yen less attractive to US dollar holders, and the market will balance out again.


What makes a particular curreny attractive? It might be the interest rates yielded in banks using that currency, or it might be the overall buying power of that currency (for those who intend to use their money rather than just invest it passively). But essentially, this is how the market works -- exchange rates move up and down (more or less like stock prices) to keep the number of would-be "buyers" and "sellers" of any currency more or less equal.

[QuikSand]

Second, the valuation of a country's currency is important. Everyone seemed to think that it was a bad thing when post-Soviet Russians had to take wheelbarrows of Rubles to the store for a loaf of bread. But China seemed able to control the value of its currency. Why doesn't every country do that? And why did China stop doing it? There must be advantages to having your currency float free, but what are they?

There is a price for the sort of "stabilization" that China pursued with the yuan. It is a lack of self-determination. If you don't really allow your currency to float, then you don't get to control your monetary policy very well -- you can't really influence things through a central interest rate (like the Fed does here) since your currency is essentially in someone else's hands. For an economy like China's through the last 40 years, that hasn't been a huge sacrifica, and their ability to sell to the US was probaly more important. As they move ahead, and become more sensitive to world markets, it's probably a logical step to let the yuan float and take the reinas themselves, as they become more of an active player in international finance.

[Blackadar]

Wow, those are some tough questions and you could write a book with the answers. So here are some very simplistic answers - however, the truth is much tougher.

1. The exchange rate between currencies is determined on the open market, much like stocks. Economies and governmental policies greatly determine this value.

2. I don't think China allowed it's currency to be traded - or essentially refused to let the open market dictate the value.

3. A weak dollar helps with the value of your import/exports. However, a currency that is too weak leads to rampant inflation.

[John Galt]

The answer is simple. George Soros and the Illuminati control the international money markets. And the grey aliens too.

[Crapshoot]

Quicksand pretty much explained it. What China has done is to slightly reward the speculators who've been sitting on the yuan, but it should help the economy from overheating and lower the deficit slightly.

[MalcPow]

Quiksand covered most of what you're asking, and obviously the answers get more nuanced and complex the deeper you go (and at a certain point things drift into quasi-unexplainable territory where "market forces" determine everything). A currency can rise and fall based on government instability, or systemic shocks, anything that increases the risk associated with that currency's value. It can also be affected pretty heavily by governmental policy, as speculators evaluate the implications of monetary decisions, will this or that lead to inflation (essentially devaluation) and should we sell our dollars (or whatever) before that happens. And obviously those issues work in tandem as well. Terrorist attacks on the financial center of our country led people to question the certainty of our nation's stability (at least in some kind of short term), and by extension the ripple effect of the attacks were clearly going to have a heavy impact on various sectors of the US economy which raises questions on what kind of policies might be enacted to balance that etc etc and all of a sudden a currency becomes a more uncertain investment. The same thing with something like the Iraq war, speculators wonder whether we're getting involved in a quagmire that will be a huge drain on the country, increased taxes, less consumer spending, an economic recession, and then drastic changes to economic policy to try and readjust. The same sorts of things are happening now to the euro with the new uncertainties around the EU's structure, unity, effectiveness and in Britain with the pound because of the natural uncertainties arising because of an attack. As far as China goes it's ultimately a good move for them to float, and it's nice for everybody that they're doing it in a kind of piecemeal way so that the global economy (or us and them mainly) can adjust to what would otherwise be a pretty big valuation shift overnight. Nobody really know what's going to happen, but the consensus is that not rocking the boat too too much is a good idea.

[albionmoonlight]

So, if, for example, Mexico wanted to try to strengthen the peso, it could raise interest rates, which would make investing pesos in Mexican banks more lucrative. They cannot, however, raise interest rates too much, however, because eventually it would cost so much to borrow pesos that no one would be able to do it. And if no one is borrowing pesos, no one is taking out loans to engage in economic activity.

Low interest rates, if I understand it, allow people to borrow money cheaply which stimluates the economy by encouraging loans for starting businesses, large consumer purchases, etc. If the rates stay low for too long, however, you run into a risk of inflation because more and more people will be wanting to switch over to other currencies in order to lend them out at a higher interest rate than they can lend out dollars. And the less people want dollars (relative to other currencies), then the less dollars are worth relative to other currencies. Is that a decent nutshell?

What about global recessions? Does that have to do more with people feeling that there is too much risk for them to invest money at all so that they just sit on their currency and put it out there investing in economic activity (regardless of the currency in which they hold the money)?

[QuikSand]

That's not bad, albion, for someone who claims to be just learning this stuff.

Most of this thread has been vastly oversimplified, however. I used the example of interest rates as a simple proxy for "the return you can get by holding that currency" earlier. That oversimplifies what drives currency demand, though. There are passive investors, who put money into banks, but there are also people who want to use their money actively. If I want to use my money to buy lumber, for instance, for my construction business in New York... I might want to consider whether it makes sense to buy it in Canada, and the currency exchange might play a role there. I'd be considering the buying power of my cash in CAN$ rather than US$, so I'm not (in that case) looking at interest rates so much as immediate buying power -- how much will my lumber cost me in CAN$ compared to buying it in US$?

And in some situations, what you're also factoring in is whether the currency will retain any buying power at all. If you are considering whether to buy a currency from a small country, you might need to consider whather the government can live up to its obligations in the future -- otherwise, the currency might lose its value completely. This is a bit ovrstated, but it's essentially the reason why a country with serious instability suddenly might see its currency get eaker on the open markets -- as people would generally prefer to have their money held in a place where it is more secure.

This is where, as MalcPow suggests, the onion proves to have many layers -- all these factors work at the same time, and it's not a very simple thing to really understand. Suffice it to say that it's all part of a complex machinery, the "invisible hand" of the open free makrtplace.

[MalcPow]

Originally Posted by albionmoonlight

So, if, for example, Mexico wanted to try to strengthen the peso, it could raise interest rates, which would make investing pesos in Mexican banks more lucrative. They cannot, however, raise interest rates too much, however, because eventually it would cost so much to borrow pesos that no one would be able to do it. And if no one is borrowing pesos, no one is taking out loans to engage in economic activity.

Low interest rates, if I understand it, allow people to borrow money cheaply which stimluates the economy by encouraging loans for starting businesses, large consumer purchases, etc. If the rates stay low for too long, however, you run into a risk of inflation because more and more people will be wanting to switch over to other currencies in order to lend them out at a higher interest rate than they can lend out dollars. And the less people want dollars (relative to other currencies), then the less dollars are worth relative to other currencies. Is that a decent nutshell?

What about global recessions? Does that have to do more with people feeling that there is too much risk for them to invest money at all so that they just sit on their currency and put it out there investing in economic activity (regardless of the currency in which they hold the money)?

You've got a good working understanding here. It's important to keep in mind that there are simply factors beyond the realm of interest rates, lending, etc at play that make dollars valuable. As the world's biggest economy if the dollar went to total crap the global economy is going to go (or has already gone) to total crap as well, so it's a safe place to have your money in that sense. The fact that many of the world's markets, especially the energy market, are priced in dollars makes holding dollars simply more convenient in a lot of ways as well. We more or less built this global economy so we have structural advantages as a currency that we don't necessarily "deserve." It would probably be more efficient, and will probably happen (someday), that some kind of Asian super currency (a China-Japan-SK etc kind of EU) as well as the growth of the euro will bring balance to the force as it were and we'll have to play by the same rules as everyone else. But for now we've got a good deal, and we'll take it. There's a point though where trying to understand how things "really" work hurts your basic understanding of the concepts at play.

[Runtheball]

I've been struggling to understand these issues lately myself (even dusted off the old Economics text). The answers provided here are helpful, but I'd like to learn more in-depth. Can anyone recommend a good book or website that explains the whole global currency market for non-economists?

[Cringer]

Originally Posted by John Galt

The answer is simple. George Soros and the Illuminati control the international money markets. And the grey aliens too.

Clearly the only one here who knows what he is talking about.

[weinstein7]

Originally Posted by Runtheball

I've been struggling to understand these issues lately myself (even dusted off the old Economics text). The answers provided here are helpful, but I'd like to learn more in-depth. Can anyone recommend a good book or website that explains the whole global currency market for non-economists?

Economics Explained by Lester Thurow and Robert Heilbroner is a pretty classic layman's text. Not sure how much detail they go into regarding currencies though.