How much is a dollar worth?
Photo: Katrina Tuliao. Source: Wikipedia
One of the most vexing problems in economics is accounting for exchange rates. In theory, currency exchange rates should harmonize the value of goods and services across countries. That is, foreign exchange rates should rationalize global trade and investment.
But the volume of foreign exchange transactions dwarfs that of global trade. Annual currency transactions equal almost 50 times what is necessary for international trade and direct investment. The exchange rate markets are driven by people trying to figure where higher rates of return will be available in the future, while simultaneously trying to manage their various risks.
That’s why currencies are so volatile. They quickly react to any new information about their respective economies – and often in ways you might not expect. During the Financial Crisis, many thought that the value of the US Dollar would plunge, since US real estate was the epicenter of that financial earthquake. After all, economic growth should be lower if you have to recover from a burst asset bubble.
But instead of falling, during the crisis, the Dollar rose. Its safe-haven status trumped muted growth expectations. And that often seems to happen: the US is the most stable and open economy on the planet. As a result, when there is an emergency, assets come rushing onto our shores – kind of like the way political refugees flee danger in their home countries. This means the Dollar tends to be overvalued when there is financial instability anywhere around the world.
Every time an exchange rate moves, some segments of the economy win and others lose. An overvalued currency favors importers; an undervalued currency favors exporters. About one-third of the countries in the world have totally floating exchange rates – most manage their currencies, at the risk of being labeled “manipulators.” They don’t dare leave themselves open to all the fluctuations of the marketplace, but they also don’t dare lock in a rate that can’t adjust to changes in interest rates, economic growth, and other financial variables.
Long experience has taught that having fixed exchange rates among many countries for an extended period of time is impractical and can have some very bad consequences. That’s what happened with the global gold standard in the late 19th century and the Bretton Woods agreement in the mid-20th century, and what may be happening with the Euro today. An exchange rate is a price – a relative price between two economic zones. Fixed prices create distortions that only worsen over time.
An economist once quipped that there are three great questions: what is the meaning of life, what is the central equation in quantum mechanics, and what’s happening in the markets. The volume of forex transactions makes short-term fluctuations inevitable. But when we focus on the fundamentals, longer-term trends become clear. The Dollar had been weak for a while. But it looks now like it’s getting stronger.
Douglas R. Tengdin, CFA