More and more is being written about exchange rates. The US is accusing other countries of illegally manipulating their currencies and gaining unfair advantage in trade. Could this be another deflate-gate? Or is it just another attempt to deflect and persuade? In truth, most of us know little about exchange rates and wouldn’t know a manipulation if it twerked right in front of us.
So let’s begin at the beginning. The Lord created man and then the exchange rate. ... OK, not really. The modern exchange rate became useful after countries moved from barter to currencies, and people starting trading across borders. As you can imagine, Germans preferred being paid in dm (note: dm stands for deutsche mark. And yes, I know there are no longer dms or French francs or French fries). If Pierre wanted to buy a beer in Berlin, then he needed to swap some of his francs for dm. The exchange rate would determine how many dms Pierre could get in return for one franc.
Let’s suppose a beer cost 10 dm in Berlin. If the exchange rate was 1.0, then that would mean Pierre would need 10 francs to acquire 10 dm, and therefore buy one beer in Berlin. Let’s now move forward and think of a hypothetical time after the French government flooded the country with francs. Now each individual franc is worth less. Now it takes, say, 20, francs to buy a beer in Berlin. If it took way too many francs to buy dm, then Pierre might not buy that beer in Germany, save his francs, and buy a Fischer's back home.
The above example illustrates the following. First, currency exchange is a common everyday practice relating to trade across borders. Second, the exchange rate is impacted by markets and governments. Third, in the above example a surplus of francs relative to the demand for francs can cause the franc to depreciate in value against the dm. Fourth, I can’t remember the fourth one. Oh yes. The depreciated franc makes foreign goods more expensive to Frenchies.
The exchange rate can be impacted by many events. For example, let’s suppose French people decide that French goods are inferior to German ones, and they shift their buying preferences toward German goods. If they are going to buy more German goods, then they will need to exchange more francs for dms. Thus the market value of the franc falls and the value of the dm rises.
The above applies simple ideas about supply and demand to exchanges of currencies. If demand goes up for a currency then its value rises. We say it appreciates. Supply of a currency goes up and its value falls. That's called a depreciation.
WAKE UP. This is not over yet. The fun is about to begin. Let’s suppose you are a German and the value of the dm rises. You might have one of two reactions. If you love to buy French wine, you are very happy because a stronger dm buys more francs and therefore more French wine. If Juergen sells machinery to French buyers, he is very sad because now his goods cost more to French persons and he worries they will stop buying his equipment. Every time the exchange rate changes, some people are benefited while others are hurt.
That means that the value of a country’s exchange rate is always and everywhere a policy/political indicator. Since those who are hurt by exchange rate swings always yell louder than those cheering, we have an opportunity for politicians to ride in and save the damsel in distress.
So what can a good politician do? Ha ha – a good politician! I'll drink to that! Anyway, there are two typical ways a country can address an exchange rate problem. First, the country can intervene in exchange markets. If their currency is too strong and muscular, they print up lots of bright shiny notes and sell them in the market. Thus they acquire foreign currencies as they reduce the luster and price of their own. If their currency is instead weak and puny, they can sell the foreign exchange and buy their own currency from the markets, thus raising the value of their currency.
The second way to manipulate the value of a currency is through the use of monetary or interest rate policy. Compared to the first way described above, this approach is less direct yet just as effective. When the Fed engaged in all manner of monetary increase after the great recession of 2008/2009, the result was to reduce US interest rates, cause world investors to invest elsewhere, reduce the demand for dollars, and viola!, reduce the value of the US dollar. The Fed said this policy was necessary to stimulate the US economy by the usual domestic policy means. But the larger truth is that it was also aimed at reducing the value of the dollar so that US exports would be better priced in world markets. There is no question that the Europeans, Japanese, and others have caught on to this gambit and are now imitating the Fed.
Let’s face it. If a country is facing a very weak economy or a recession, it is going to use one or both of these methods to stimulate its economy. The more important are exports to that country the more the temptation. Thus currency manipulation is like the last JD of the evening. You swear you will not do it and decry its worth, but once the party gets going and the Stones are on the Victrola, you are the first to pour one last nip.
It is truly ironic that the US is making such a fuss over currency manipulation when our own actions are so responsible for the vagaries of the high dollar today. It was us who used monetary policy to cause the dollar to swoon faster than a pelican above a catfish farm. It is again us today with our stronger economy and rising interest rates that now makes the dollar rise. To be sure, other weaker economies are contributing to the rising dollar with their own manipulations, but pointing a finger of blame at them is like getting mad at your children for raiding your unlocked JD cabinet while you are at open mic night at George and Wendy's.