What Makes a Currency Valuable?

What Makes a Currency Valuable?

June 18, 2020 0 By aure

Tl;dr: the value of currencies depends on the size of the economic area they’re used in, on the rarity of the goods they can buy, and on the political system of the jurisdiction that administers it.

As the stock market nose-dived in March 2020, the Fed eventually rolled out “unlimited quantitative easing”, meaning they would print unlimited money to lend it to the government that would subsequently buy stocks and bonds to support businesses during what is now known as the Great Lockdown.

Following this unprecedented move, some have wondered whether the USD wouldn’t lose value.

To answer this question, we first need to understand what makes a currency valuable, and that has a lot to do with what the economy (that prints the currency) makes, and what type of political system is in place.

Let’s start with the value of a currency from an economic standpoint.

The Value of a Currency From an Economic Standpoint

Let’s imagine that country A is the only country in the world that has oil and all the other countries need that oil.

Country A’s currency is highly unlikely to lose value because everyone needs country A’s currency to buy oil, that’s our first lesson: the importance of a currency has a lot to do with (1) what the economy makes.

Brazil, for example, mainly exports raw materials.

If the Brazilian currency suddenly became more expensive, buyers of raw material would go buy it where it’s cheaper.

It means that overall, the Brazilian currency is not worth much because there is nothing in Brazil that I can’t get elsewhere: the Brazilian currency is not really “important”, I don’t “need” it hence, it doesn’t have much value.

This is not the case with the euro, for example.

Should you wish to buy Italian cars, French luxury goods, or Belgian chocolate, you’d need to buy them in euro because no other countries on the planet are making these goods.

A second reason that explains the strength of the euro is (2) the size of the market that uses the euro: it’s big.

One of the biggest in the world.

Since it’s big, almost all companies around the world want to sell in the EU, and will probably have to buy from the EU as well for their dealings.

To summarize this part, the euro is a high-value currency because (1) it manufactures products and sell services of high-value and only made in the EU and nowhere else, and (2) because of its size that makes it a de facto market for goods and services around the world.

The euro is therefore unavoidable, hence demanded, hence valuable (although as you’ll see, it’s more complicated than that).

The Strange Case of the USD

Now, let’s talk about the king of all currencies: the USD.

The USD is king because such as for the euro, it is simply almost impossible for anyone in the world to avoid the US economy due to (1) the value and rarity of the goods and services they produce, and (2) due to its size.

There is, however, a third reason why the USD is even more valuable than the euro: (3) it is the world trade currency and makes up about 70% of the world’s total currency reserve.

What does it mean?

It means that everyone uses it: it is not rare to see two companies from two different countries that have nothing to do with the US selling and buying goods in USD.

Why?

Because they know they will need USD at some point to buy from the US and they probably sell in the US, get paid in USD, and therefore have USD to buy stuff with.

As such, when Jerome Powell, the Fed chairman, prints trillions of dollars, it is not so much for America that he prints, but for the entire world economy.

Side note: using a country’s currency for world currency ultimately leads to the Triffin paradox.

Indeed, in our case, the US must print USD and spend them abroad so that foreign countries have USD they can shop within other countries and the US.

This leads the US to always buy more abroad than they sell abroad, which leads to a negative balance of accounts and a long-term weakening of the currency and the economy.

China and the Impossible Trinity Theory

“But, what about China then? Isn’t it a big economy too?”

Are you familiar with the impossible trinity?

The impossible trinity is a macro-economic theory that says that a country can choose between three artifacts for its economy:

1. free capitals entering and leaving the country

2. fixed foreign exchange rate (deciding that your currency is worth x USD, for example, and maintaining it that way through currency volume control)

3. free monetary policy (printing money, or burning it at will).

While most developed economies chose to have free capital flows (1) and free monetary policy (3), it means they won’t be able to control the price of their currency against other currencies.

Sweden, for example, is different.

The Swedish krona follows constantly the value of the euro (2) while Sweden allows for free capital outflows and inflows.

It means that the Swedish are not free to lead any (3) monetary policy they desire.

China, finally, is also different.

They want to control the price of their currency (2), they want to keep it cheap so the economy can export and the CCP can buy social peace.

Since they want a fixed exchange rate (2) and free monetary policy (3), they have no choice but to control capital (1): you can’t randomly come to China with money, nor can you leave China with money.

Since China is artificially lowering their currency (China IS indeed a currency manipulator, correctly labeled by Trump), no one wants to trade in the renminbi (Chinese currency) because its worth depends on the mood of the Chinese Central Bank.

There is though, with China, an element that adds to the value of their currency: the renminbi you may have in your wallet doesn’t belong to you, unlike the USD.

You won’t have passed off the fact that China is not a democracy, that the judiciary, the executive, and the legislative powers are all in the hands of the Communist Party, and that if China wants to seize any house/company in China tomorrow, they can.

Why?

Because China is a communist state where the Communist Party has the last word on everything.

While there are some laws that the people must respect, there is no rule of law, meaning that the government is not bound to respect the law if it is deemed important not to: they can do what they wish.

It means that what the Chinese have in China does not belong to them, it belongs to everyone because China is a communist country where private property doesn’t exist and everyone is equal, free, and happy. 

Ha, you wish.

What I meant was that what the Chinese have in China could be seized any day at any time.

That explains the Chinese’s propensity to invest overseas (Aussie, Kiwi, and Canada’s real estate greatly suffered from it).

If a Chinese buys an apartment in Sidney, that apartment belongs to that Chinese because unlike China, the Australian government can’t randomly seize people’s assets.

Chinese’s assets overseas are guaranteed, while Chinese’s assets in China, aren’t.

To conclude, even if you owned renminbi…you wouldn’t really own them.

Who would like to own something, “but not really”?

Not many people, which explains why Chinese money, even if it wasn’t manipulated, wouldn’t worth much anyway.

The Political System

In the US, unlike China, there is rule of law, and the government can’t just randomly seize your house because you uploaded a Winnie the Pooh meme on Weibo, and, let’s pretend that they did, you would then go to a judge to complain, the judge would look at the law and say “the US government can’t do that” and you’d have your house back.

Rule of law is a beautiful thing, it protects you against your own government.

In fact, as I’m writing this, President Trump has seen his wish to abolish the “Dreamers” visa program rendered impossible after the Supreme Court ruled it to be illegal.

Whether one agrees with this or not doesn’t matter, what matters is that in the US, no one is above the law, not even the president.

The rule of law protects you against everyone that would seek to infringe your rights.

As such, when I own USD, I own them.

The rule of law is a beautiful thing.

The Stock Market Crash

As the stock market crashed, there was an urgent need for fresh money in the system to avoid mass bankruptcy.

Jerome Powell rolled up his sleeves and got to work by pushing on the “on” button of the money printer.

His unlimited money printing (fancily called “Quantitative Easing”) bailed out the financial market (which is illegal, but well, we’ll talk about it another time) and US companies at the same time.

Now, you might think that with unlimited printing, the volume of USD must increase, which leads to a loss of value…well, yes, the volume of USD did increase, but no, it did not lose value.

As we said, the value of a currency depends on the extent to which how many people want it, and how much they want it.

When worldwide markets crashed, there was a shortage of USD, everyone was looking for them because the economy had virtually stopped.

The fact that the world uses dollars and that the world was looking for dollars allowed Powell to order an unlimited amount of ink and paper on Amazon to print money, which is why the Amazon stock shoot to the stars like that (I’m kidding).

I mean that it allowed Uncle Jerome to print a lot of money without fearing devaluation because the entire world was looking for dollars anyway, even more than usual. After all, as everything was crashing, people relied on the bedrock of the world economy: the USA.

As such, people quickly developed more faith in the US economy than in their own economy, because of all of the elements I explained above.

The consequence is that while most currencies lost value, the USD gained value during March and May 2020.

What Now?

The USD is unlikely to lose value unless the world loses faith in the US economy which it won’t because in times of crisis, ‘Merica’s economy looks safer and more robust than all the other economies around the world (well unless Powell prints really too much money.)

Furthermore, the USD is not likely to be replaced as the world currency in the near future.

If we have a quick look around other major currencies, the pound will crash because of Brexit, Scottish upcoming independence, negative trade balance, mismanagement, and very soon, social unrest.

The Japanese economy is not growing as the country battles with a tragic lack of demographic renewal.

As for the euro, there is always the problem that it is a currency adopted by a bunch of sovereign countries that could tomorrow decide to leave it or worse, expel a country from it. 

As such, the euro is only as strong as EU countries (*cough* Germany *cough*) keep it and use it as currency.

Since the risk to see a country abandoning the euro is higher than to see the US abandoning the USD, the USD remains the uncontested king.

The Bottom Line

As we get further into this crisis, I’m afraid the times are going to get darker and darker.

The wave of redundancies around the world is only beginning, there is a strong ethnic-racial social unrest which is (let’s not kid ourselves) a long-awaited consequence of social-economic inequalities.

Countries around the world have contracted a level of debt they will never be able to get rid of.

About that, there is a very big meteorite headed our way called “Italy’s debt”, approaching at light speed.

We should not forget that this won’t be Italy’s problem, but the entire eurozone (and world’s) problem to deal with in regard to the Italian economy’s size.

But well, we’ll talk about it another time.

Photo credits: Photo by Christine Roy on Unsplash