Inflation,. Floating Exchange Rates, and Competitive Devaluation

Often, there appears to be confusion regarding the USDX going up or down and deflation or inflation, respectively.  The USDX and inflation/deflation are two different, though related, things.

What is the value of a dollar, or any currency?  By itself--nothing.  Since Nixon removed the dollar from the gold standard in 1971, the world has moved on to floating exchange rates, which began in 1973.  In fact, currencies now only have value against one another or tangible things--in and of themselves, their value is relegated to the belief that the supporting government will tax its people to provide more paper currency.  Currencies are usually quoted against one another as pairs; for example the euro versus the US dollar (aka, EURUSD) or the US dollar versus the Canadian dollar (USDCAD).

Sometimes, it makes more sense to look at the value of a currency relative to many other currencies.  The US dollar index (USDX) is a measure of the US dollar (USD) against the currencies of its key trading partners, including the euro (EUR), the Japanese yen (JPY), the Canadian dollar (CAD), the Swiss franc (CHF), British pound sterling (GBP), and the Swedish krona (SEK).

There are some countries, notably Saudi Arabia and China, which peg their currency to the US dollar.  If the US inflates its money supply, these countries must also inflate their money supply so that the value of their currency is some multiple of the US dollar.

The value of a currency is analogous to the value of a stock in a company.  Ultimately, it's a voting record.  The value of IBM stock, for example, is very much related to the earnings, dividend payments, and future prospects of the company.  The stock has no real inherent value in and of itself--it is worth what people think it is worth at that time.  Currencies are very similar.  They are the stocks of the nations from which they are issued.  The value of the currency is largely arbitrary, but is based on economic prospects of the country, interest rates on the government bonds (like US Treasuries or UK gilts) that it pays, etc.

When the dollar (or any currency) goes down relative to another currency, the only real effect is that it benefits the US' export competitiveness and makes imports from the other country more expensive.  For example, if the US dollar goes down relative to the euro, then goods from the US are cheaper for European consumers, which is good for US exporters.  The reverse is also true, though--imports from Europe are more expensive to US customers.  Given how many goods are imported into the US (and most of Western Europe), this means a general rise in prices for consumers of those goods from countries whose currencies are rising relative to the US dollar.  Note that China has a peg with the US dollar (at least right now), so Chinese imports will stay cheap in dollar terms as long as Chinese labor stays cheap and the currency peg is maintained.

This condition of floating exchanges rates and artificial pegs to some currencies has had the effect of inducing business to outsource its labor throughout all of the higher cost, "first world" countries.  If one can make a widget in China cheaper than in the US, even after taking into account the cost of foreign production, management, and shipping it across the ocean, then business will naturally gravitate toward lower production costs (which is great for consumers of the product).  If the Chinese renminbi were allowed to float against the dollar, free market currency flows would strengthen the renminbi relative to the dollar, making the cost of Chinese-produced widgets more expensive, and the outsourcing from US business would slow until there was a market-based equilibrium.  Of course, if all countries were trading based on gold and not on floating currencies, this would be a non-issue anyway.

Contrast this concept with inflation.  Inflation is an increase in the supply of money.  Much like a company that issues more and more stock, the remaining pool of stocks is diluted and worth less.  It is simply a supply/demand issue.  In this way, inflation can influence the value of the currency from a floating exchange perspective because as the supply of money increases, currency traders are more reluctant to hold that currency.  This is how inflation and the value of a currency in floating exchange terms are related.  However, they are not the same thing.

This is all very important in our current environment, and when we look at a measure like the US dollar index (USDX).  The USDX is a measure of the value of the dollar against some major trading partners for the US, heavily weighted toward Europe and then Japan.  Most of the industrialized world is deeply in debt.  Inflation erodes debt because once a debt is undertaken, it is typically paid back at a fixed rate of interest.  If you can simply print more currency, then the value of each unit of currency becomes less, and by implication, the total amount of outstanding debt is less, relative to the amount of money.  The debt, in essence, becomes cheaper to pay for.  Of course, the creditor is paid back in devalued money, which is not a good for the creditor.  The result is that any country that is known to be inflating its currency rapidly will also lose currency value relative to other currencies with lower rates of inflation.

What we see today is a state of competitive devaluation where all countries are inflating their currencies to some degree.  As one country outpaces another in the inflation department, the value of that currency falls.  Fact is, though, that all of the currencies together are becoming less valuable.  However, relative to one another, they may be holding ground.

This is an area in which gold is particularly valuable since it is the most inflation-free money in the market.  Currently, the USDX is generally declining.  Occasionally, it rises relative to other currencies for various reasons (for example, a liquidity crunch).  All the time, the general number of dollars is rising along with the number of other currency units (euros, yen, francs, etc).  Thus, the USDX is a reasonable measure of dollar performance versus other currencies, and by proxy a measure of the health of the economy versus other countries, but it is not a measure of inflation, per se.  Gold, on the other hand, is relatively fixed in quantity (new supply is limited to a few percent a year), so what we see today is gold holding its value relative to many currencies, even if the value of those currencies relative to one another holds steady.  One of the interesting properties of gold is that it really isn't used for much of anything other than a currency of last resort--a store of value when other currencies are being inflated away.  An excellent illustration of this property was gold holding its value during the credit crisis.  This is the primary reason that so many pure commodity traders misunderstand gold.  Gold is not a commodity.  It is a currency.  It is the only trustworthy currency when economic times are stressed.

Let's take a look at the dollar now against several other currencies over time.

The first is the USDX in various forms of measurement against various baskets of currencies.  Note that this chart is from inception of the dollar as a floating currency, unbacked by gold, in 1971.

Note the dotted line labeled "Interpolated USDX" which is our own measure of the USDX that is designed to smooth the curve fit between different periods of measuring the USDX different ways.  It generally tracks with the "G-10" and "Major Currencies" measure of the USDX.  By that measure, the USDX peaked in early 1985 and has been on a rampant decline versus most all major currencies since then.

The second chart here is the same USDX measurement from above since the year 2000.

You can easily see the credit crisis that started to set up in March/April of 2008 as the dollar was bottoming, and then rose until March of 2009, when it resumed its decline.

It is easier to see it on the technical chart below, which is just a blow-up of that period of time until now.

The next few charts show the US dollar paired against select currencies from 1999 to present.

Against the euro.  The euro, except for during its inception period and during the credit crisis, has generally been rising against the dollar.  Note that this chart shows the euro in dollar terms, so it is rising (meaning a falling dollar.)

Against the yen.  The trend has been a weaker dollar relative to the yen since 2002.  This chart is the dollar in yen terms, so the dollar is falling relative to the yen.

Against the Swiss franc.  Part of the Swiss currency is backed by gold.  The dollar has fallen against the Swiss franc since the gold market started to take off in 2001.

The British pound may be the only currency in worse shape than the US dollar.  The pound generally rose against the dollar until the crown's profligate spending and borrowing exceeded that of the US, on a relative basis.  There was some recent strength again, but it appears to be short lived.

Against the Canadian dollar (the loonie).  Canada is a natural resource-based economy, so the dollar has done poorly against the loonie except during the credit crisis.

 

 While not part of the USDX, the Australian dollar, like the Canadian dollar, is resource based.  The Aussie dollar has done very well against the US dollar except during the credit crisis.

Outside of gold, the Aussie dollar and the Norwegian krone (value relative to oil) are the only currencies we would own.

All of these currencies can be seen on the chart below.

 Now, let's look at things in terms of the currency of last resort--gold.

As the reserve currency, gold is priced in US dollar first and foremost.  Here is the Gold/USD chart as a basis.

Gold priced in euros.  Gold is up against euros, but up against the dollar even more, meaning that the euro (as can be validated from the chart above) is up against the dollar.

Gold priced in Japanese yen.  Again, the yen has fared better than the dollar, and gold has fared better against both.

 

 Gold in Swiss francs.  Even though the franc is partially backed by gold, the Swiss government has continually worked to devalue it relative to the euro and dollar, for trade purposes.  No fiat currency is a safe haven.  Gold has risen against both.

Gold in British pounds.  The pound is trying hard to devalue more than the dollar, and gold is up against both.

Gold in Canadian dollars.  We don't like the loonie as many as some because the US is Canada's largest trading partner.  There is an incentive for the Canadian government to keep the loonie devalued.  Again, gold beats both.

Gold in Australian dollars.  The Aussie dollar has done well, but we can see the general trend is that gold will outperform.

A summary chart of gold in various currencies.

Here's the takeaway.  The dollar is falling against all major currencies.  This makes things in dollar terms more expensive.  Gold is rising against all currencies.  This is a long term trend, not a short term trend.

Gold is the currency of last resort as the other currencies are inflated away.