Best of the Week
Most Popular
1.UK House Prices Momentum Crash Threatens Mini Bear Market 2017 - Nadeem_Walayat
2.Perfect Storm - This Fourth Turning has Over a Decade of Continuous Storms to Come - James_Quinn
3.UK House Prices Momentum Crash Warns of 2017 Bear Market - Video - Nadeem_Walayat
4.Billionaire Investors Backing A Marijuana Boom In 2017 - OilPrice_Com
5.Emerging Markets & Basic Materials Stocks Breaking Out Together - Rambus_Chartology
6.Global Currency Reserve At Risk - Jim_Willie_CB
7.Gold and Silver: Your Stomach Is Probably Wrenching Right Now - The_Gold_Report
8.Warning: The Fed Is Preparing to Crash the Financial System Again - Graham_Summers
9.Basic Materials and Commodities Analysis and Trend Forecasts - Rambus_Chartology
10.Discover Why A Major American Revolution Is Brewing - Harry_Dent
Last 7 days
The Stock Market Guns of August, Trade Set-Up & Removing your Rose Tinted Glasses - 16th Aug 17
Stocks, Bonds, Interest Rates, and Serbia, Camp Kotok 2017 - 16th Aug 17
U.S. Stock Market: Sunrise ... Sunset - 16th Aug 17
The Next Tech Crash Could Delay Your Retirement by a Decade - 15th Aug 17
Gold and Silver Precious Metals Nearing Breakout - 15th Aug 17
North Korea Showdown: Pivotal Market Turning Point - 15th Aug 17
Tech Stocks DOT COM Bubble Do-Over? - 14th Aug 17
Deep State Conspiracy or Chaos - 14th Aug 17
From the Trans-Atlantic Axis and the Trans-Asian Axis - 14th Aug 17
Stock Market Intermediate Correction Underway - 14th Aug 17
The Islamic State Jihadi Pivot to Asia - 13th Aug 17
Potential Pivots Upcoming for Stocks and Gold - 13th Aug 17
North Korean Chinese Proxy vs US Military Empire Trending Towards Nuclear War! - 12th Aug 17
Gold Stocks Coiled Spring - 12th Aug 17
Neil Howe: The Amazon-Walmart Rivalry Will Determine the Future of Retail - 12th Aug 17
How to Alton Towers Half Price Discount Entry 2017 and 2018, Any Time, No Pre-Booking! - 12th Aug 17
Top 3 Technical Trading Tools Part 2: Relative Strength Index (RSI) - 11th Aug 17
What Makes Women Better Investors - 11th Aug 17
Crude Oil Price Precious Metals Link in August - 11th Aug 17
Influencer Marketing Predictions All Businesses Should Take Into Account - 11th Aug 17
Really Bad Ideas - Government Debt Isn’t Actually Debt - 10th Aug 17
Gold Sees Safe Haven Gains On Trump “Fire and Fury” Threat - 9th Aug 17
Why Is The Stock Market Not Trading On Fundamentals Lately? - 9th Aug 17
USD/CAD - Can We Trust This Breakout? - 9th Aug 17
New Monthly Rebate to Help Reduce Your Trading Costs - 9th Aug 17
Stock Market Divergences Are Now Appearing! - 9th Aug 17
Is Inflation an issue or did the Fed Mess Up? - 8th Aug 17
Top 3 Technical Trading Tools Part 1: Japanese Candlesticks - 8th Aug 17
Researchers Find $10 Billion Hidden Treasure In A Dead Volcano - 8th Aug 17
What Happened to Thousands of Sheffield's Street Trees 2017 - Fellings Documentary - 8th Aug 17
Solar, Bubble, Banks, War, and Legal Tender: Five Reasons Why You Should Buy Silver Now - 7th Aug 17
CRASH - If Some People Do It, Nothing Bad Happens, But If Everyone Does It, All Hell Breaks Loose - 7th Aug 17
Gold and Silver : The Battle for Control - 7th Aug 17
Precious Metals Sector is on Major Buy Signal - 7th Aug 17
Stock Market - Has Time Run Out? - 7th Aug 17
Get Ready for an Historic Upside Gold and Silver Run - 7th Aug 17
BOOM! Bitcoin Rockets To New All-Time High As Cryptocurrencies Surge Higher! - 7th Aug 17
U.S. Dollar: This Crash Signals the End - 6th Aug 17
Predicting The Price Of Gold Is A Fool’s Game - 6th Aug 17
Asda Sales Collapse and Profits Crash! UK Retailer Sector Crisis 2017 - 6th Aug 17

Market Oracle FREE Newsletter

3 Videos + 8 Charts = Opportunities You Need to See - Free

The Currency Debasement Fallacy

Currencies / Fiat Currency Jul 25, 2012 - 08:00 AM GMT

By: Chris_Marcus

Currencies

In Frédéric Bastiat’s 1850 essay Ce qu'on voit et ce qu'on ne voit pas, the famous economist introduced the parable of the broken window. He illustrated the principle that intentionally breaking a window just so that someone can subsequently fix it did not actually represent an increase in the net wealth of an economy. Today we will examine a similarly misguided fallacy that has been the foundation of an equally disastrous pattern of economic policy. We will call this the fallacy of the debased currency.


It is accepted by the vast majority of economists and, more importantly, politicians that currency debasement is a desirable weapon to be used to combat recessions. In the last few years printing money for deficit financing has become normal in Europe and America. Moreover, many take the view that currency debasement can serve as a means of increasing exports. In the past year the Swiss and Japanese have intervened to weaken their currencies as they rose in response to US dollar and euro weakness. This was done in order to promote exports. And while the Federal Reserve and European Central Bank have been less explicit in linking money printing to boosting exports, they are just as eager to reap the same supposed gains. President Obama’s 2010 State of the Union pledge to double exports in five-years, QE1, QE2, Operation Twist Part 1, Operation Twist Part 2, and a perpetual zero-interest rate policy are not unconnected.

Governments and central banks globally believe that if their currency is too strong it will hurt exports. The easy solution is to debase the currency and watch the problem self-correct. However this line of thinking misunderstands the relationship between a currency and the underlying economy. The currency is a reflection of the strength of an economy. As an economy becomes more productive and produces goods that its trading partners want, the demand for that currency increases.

Imagine two simple economies. The Land of Arcadia has 100 apples while the Village of Keynes has 100 oranges. We will assume that the citizens of both towns are indifferent to either fruit and simply seek to maximize the total amount (a citizen from either would prefer two apples to one orange or alternatively two oranges to one apple). This also means that the trade value of one apple is equal to the trade value of one orange. Each economy has 100 units of its own paper currency that are backed by individual pieces of fruit. Therefore one apple costs “one Arcadian Note” while each orange cost “one Keynes Note”.

One day the emperor of the Village of Keynes decides that it wants to increase exports and in order to do so it prints another 100 Keynes Notes. Think about the mechanics of what actually happens. There are 200 Keynes Notes in circulation but still only 100 oranges. There is additional currency chasing the same underlying basket of production. This naturally bids up the price of oranges to two Keynes Notes each. But consider the perspective of the Arcadians. Despite the currency machinations, the Arcadians are still willing to trade one apple for one orange. So now a one Arcadian Note apple is equivalent to a two Keynes note orange.

Now consider the way the export data would be reported if the villages used our current system of nominal export values. The trade of an apple for an orange is unchanged, yet because nominal prices have risen in the Land of Keynes the emperor would report that exports have doubled. In nominal Keynes Notes they have increased exports by 100% without ever changing the underlying transaction. However, from the perspective of a citizen in the Land of Keynes import prices have also risen as it now costs two Keynes notes to buy an Arcadian apple.

If the newly printed currency was distributed equally then the problems might be somewhat limited. But consider the actual mechanics of a central bank bond purchase. The central bank uses the new money to purchase the bond from the balance sheet of a commercial bank. That means that the banks have the first shot at the distribution of this new money, and as one might guess it is not distributed evenly to the population. While nominal wages will rise, the government and the banking sectors are the only ones who derive a purchasing power increase from the new money, as they are the first receivers of the new currency.

Alternatively, if the Village of Keynes leaves the price of an orange at one Keynes Note then demand for oranges will increase. Remember the Arcadians are still wiling to give one apple for one orange. But because the supply of Keynes Notes has doubled each note is now worth less. If the Arcadians are going to accept Keynes paper then they will want two Keynes Notes for one apple. If the Keynesians continue to sell their oranges for only one Keynes Note then they have effectively put their goods on sale at half price. We know this because one Keynes Note now only buys half an apple.

The takeaway is that if it sounds silly or absurd to hear governments and central banks talk about debasing the currency in order to drive exports or boost growth that’s because it is. One of the exciting facets of economics is that it is a logical science that follows with logical arguments and assumptions. When in doubt, think about what you know and what makes sense based on what you believe as opposed to following the logic of someone who has fallen victim of the parable of the debased currency.

Chris Marcus

http://www.goldmoney.com/

"Chris Marcus is a trader, economist and financial educator, who has worked for several years as an equity options trader and has also studied and taught economics. He is the founder of Arcadia Economics Consulting, and a contributor to GoldMoney - The best way to buy gold online."

© 2012 Copyright Danny Schechter - All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


© 2005-2017 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

Catching a Falling Financial Knife