The Illusion of Value
George J. Paulos
Currency prices are established in an international currency trading system that is structured as an auction market. Traders call this the FOREX market, short for foreign exchange. This free-floating currency market is considered to be the best way to evaluate currency exchange rates. The primary currencies traded around the world are the US Dollar, the Japanese Yen, and the Euro. These are also called reserve currencies because they are held by central banks to facilitate international trading. Some smaller countries peg their local currencies to one of the reserve currencies in order to exploit their strength. The FOREX market is huge, with trillions of dollars worth of transactions daily. They never stop. Transactions are conducted 24 hours a day all over the world. Despite all of this intensive activity, currency exchange rates don't usually change drastically from day to day. A 1% daily move is pretty major except under extraordinary circumstances. Virtually all FOREX trading is done electronically. Moving vast sums of paper cash is too slow and costly for the hyper-speed currency markets. Currency trading is difficult and risky. Traders must keep track of numerous economic indicators including interest rates, balance-of-payments, and GDP growth to evaluate the relative strength of each country's offerings.
The FOREX market is the largest and most dynamic market on earth. Amazingly, all of this extraordinary effort is made to trade items that have absolutely no objective value. Other financial instruments such as stocks and industrial bonds represent the plant and equipment of their issuing corporations. Currencies represent nothing. They are entirely theoretical constructions that are nothing but a vague IOU for an undefined amount of value. Economists call them fiat currencies, created by government decree and controlled by politicians. The popular expression "hard cash" is an extraordinary oxymoron when viewed in this perspective. Yet the world totally relies on these imaginary entities to value all assets, conduct transactions, and save for the future.
In principle, all currencies are equal in the sense that no one currency is an absolute benchmark of value to measure the others by. Using that assumption, economists have developed elaborate theories expressing the mathematical relationships between currency exchange rates, interest rates, budget deficits, and trade flows. Currency valuation theory is analogous to Einstein's Theory Of Relativity where there is no preferred frame of reference. Put simply, Einstein's relativity states that if there are two objects traveling away from each other in space, there is no way tell which one is in motion and which one is standing still. Similar relationships govern currencies. Is the dollar rising against the yen, or is the yen falling against the dollar? Either view is valid depending upon perspective. The standard economic theory of currency exchange rates is based on this concept of relativism. However, any currency speculator attempting to apply these theories to real-life trading is a taking a shortcut to the poor farm. Currency markets are heavily influenced by governments who attempt to manipulate their currencies, sometimes quite successfully, to achieve political objectives. Governments use many tactics for currency manipulation including interest rate policy, import/export regulations, money supply, and central bank gold trading. All of these policies dramatically affect currency exchange rates and make the idealized economic theories mostly useless for analysis.
The United States has unquestionably been the most successful government at managing its currency. Declining interest rates, chronic balance of payments deficits, and massive money supply growth should in theory lead to a weak US dollar. Instead, the dollar keeps climbing against almost all other currencies. Despite frequent predictions of doom, the dollar has remained the king of currencies for the better part of a century. Is the dollar strong or are the other currencies weak? One could make an argument for either, depending upon perspective. Surely there must be a more objective benchmark of value than the ephemeral currency market.
Objective value could be evaluated by measuring the purchasing power of a currency. The US Government compiles purchasing power statistics for the dollar using measures called the Producer Price Index (PPI), the Consumer Price Index (CPI), and the GDP Deflator. These statistics are designed to measure the purchasing power of the dollar from several different perspectives using standardized baskets of goods. These are intended to be broad measures of average the purchasing power of a dollar across the entire country. The existence of various price indicators implies that purchasing power is also a relative measure. Purchasing power can differ significantly for different groups. For example, a sharp rise in the price of cigarettes makes the smoker's average dollar purchasing power less than the non-smoker's. A sharp rise in the cost of home heating oil makes the Minnesota homeowner's dollar purchasing power less than the Californian's. A decline in the cost of Mercedes-Benz automobiles makes the millionaire's dollar goes farther than the wage-earner's. Even considering these inconsistencies, the price index statistics give us some indication of absolute value. When the statistics are compiled for a long period of time, the dollar shows significant loss of average purchasing power. Calculating from 1940 using the GDP Deflator, the dollar has lost 90% of its purchasing power. If this same benchmark is applied to other currencies, it is clear that all currencies have lost significant purchasing power over the long-term.
An alternate benchmark of value could be the precious metals. Gold and silver have remained a trusted store of value for millennia. Many currency traders dismiss gold as an anachronism, but most follow the gold price as a tangible benchmark to evaluate the currency market. At one time, many currencies were pegged to a fixed quantity of gold. Today the gold price is set by auction in the same way that currencies are. The precious metals are treated as commodities and subjected to the forces of supply and demand to evaluate price on a continuous basis. The value of gold and silver are measured in terms of currencies, usually the US dollar. But the dollar benchmark of value is misleading for all of the reasons outlined above. If the purchasing power standard is applied to precious metals, the picture looks a little clearer. Metals can vary quite substantially in purchasing power over shorter periods of time, but turn out to be relatively constant over the long run. Although imperfect, this characteristic makes precious metals the most accurate tangible long-term benchmark of value.
In essence, people have made an investment decision when they choose to hold currencies as a store of value. Currencies possess many of the same characteristics as stocks and bonds. All are intangible assets that represent some form of a promise. The relationship between currencies and investments is the same as that between the various currencies themselves. Are stocks expensive or is the dollar cheap? Once again, it depends upon perspective. A bull market in stocks could be interpreted as a bear market in currencies. Indeed, during the stock market bubble of the late 1990's many transactions were made solely with stock because skyrocketing asset prices made cash less potent. Companies traded goods, services, and even themselves through stock-only transactions. Some Silicon Valley entrepreneurs boldly rejected cash payments from corporate customers, demanding stock instead. Investors shunned stocks that paid out cash dividends. The stock market bubble may have been a repudiation of cash as much as it was an embrace of securities.
The ambiguity underlying the fiat money system can be disturbing. Societies rely so completely upon the fundamental yardstick of monetary value that it becomes an article of almost religious faith. This faith can be broken if a society and its governing body mismanage the economy through misguided intervention or widespread corruption. If a currency loses credibility, the consequences are tragic. Savings vanish and businesses fail. Countries go to war and economies unravel. People resort to tangible currencies such as gold and silver because they don't represent a promise of any sort. This leads to culture of mistrust that undermines the society.
Many people suggest that fiat currency is fraudulent by definition. They believe that only tangible assets represent value. It is true that fiat currencies can be depreciated to zero whereas tangibles always retain some value. However, there are enormous advantages to the use of modern fiat currencies. Their perfect liquidity allows for convenient transactions that incur a minimum of economic friction. Unencumbered by physical limits, they can be transmitted all over the globe in a microsecond. Fiat currencies represent a culture of optimistic faith that encourages economic growth. But a fiat currency is like economic nitroglycerine. Mistreat it and it blows up, destroying everything in sight. The illusion of value is derived from the quality of the faith and credit of an economic system. Currency is an accounting system for that faith. Can you bank on the promises of the people and institutions within the society? If not, then the illusion of value is destroyed. As such, all people participate in the maintenance of currency value. What are your promises worth?
gpaulos@freebuck.com
March 5, 2002
Copyright 2002 George J. Paulos, All rights reserved.
The information contained herein is deemed reliable but no guarantee is made about its completeness or accuracy. The reader accepts this information on the condition that errors or omissions shall not be made the basis for any claim, demand or cause for action. Any statements non-factual in nature constitute only current opinions, which are subject to change. The author/publisher may or may not have a position in the securities and/or options relating thereto, & may make purchases and/or sales of these securities relating thereto from time to time in the open market or otherwise. Neither the information, nor opinions expressed, shall be construed as a solicitation to buy or sell any stock, futures or options contract mentioned herein. The author/publisher of this letter is not a qualified financial advisor & is not acting as such in this publication. Investors are advised to obtain the advice of a qualified financial & investment advisor before entering any financial transaction.
Email this Article to a Friend 
Also by George J. Paulos
Printer Friendly Version