Airs – Ian Lance Taylor

Floating Currency

We’ve gotten used to floating currency, but what does it really mean? The dollar has fallen with respect to the euro. If I want to buy something from Europe, I now have to pay more dollars than I did before, and/or the seller has to receive fewer euros. In a free market, prices should always move toward a mean governed by supply and demand. What does that mean when the buyer and seller are using different currencies?

Let’s assume the price in euros stays the same. Then the price in dollars goes up. Normally when the price goes up we would say that is because demand had gone up or supply has gone down. Neither has happened here. In fact, quite the opposite: it is likely that the higher price will cause demand to go down, and it is likely that the lower demand will cause supply to go up. Thus the likely effect is for the price in euros to go down, heading back toward some sort of equilibrium.

Of course the real world is much more complicated. Buyers will look for substitutes that they can buy in dollars instead of euros. Sellers will look for new markets. Most of us buy things only in our own currency. In that case, the only effect will be indirect, for goods which are traded across currency zones.

On average, though, the effect of a change in currency rates is to adjust the balance of trade between currency zones. In a global system, a trade imbalance means that currency is moving from one country to another. Since the currency is not directly useful in other countries, the only benefit of moving the currency is to invest it back in the original country. At some point that becomes undesirable. Then people refuse to accept the currency, so the price falls. In principle this corrects the trade imbalance. That appears to be what is happening today with the dollar. It will be interesting to see whether it goes far enough to make the U.S. a net exporter. That would be quite a significant change.

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Ian Lance Taylor

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3 responses to “Floating Currency”

  1. ncm Avatar
    ncm

    For many years China has been propping up the dollar, in order to help keep Chinese exports attractive to American buyers, and to maintain the value of its huge dollar holdings. They have been, effectively, taxing their own population and, indirectly via wage pressure, American labor, for the benefit of their exporters and, indirectly, American importers and, even more indirectly, American consumers (who are also workers under that same wage pressure).

    Obviously this support can’t be sustained indefinitely, and has begun to fail. China must find ways to reduce their dollar holdings, but only certain commodities are practically usable without crashing the dollar. One is real estate, but Americans pay rent in dollars. Another is stock in U.S. corporations, but they’ve faced political opposition to taking controlling interest, and corporate officers often act against the interest of non-controlling stockholders.

    Because rates for USD vs. CAN or EUR are dominated by Chinese manufacturing imports and the petroleum, they cannot respond naturally to imbalances.

    The Chinese elite have traditionally had a lot more freedom to impoverish their country’s population for their own benefit than have the American elite, but that’s become much less true in recent decades.

  2. Ian Lance Taylor Avatar
    Ian Lance Taylor

    I wonder how many of those Chinese dollars will eventually be transferred to petroleum owning nations. And I wonder what those nations will do with them.

  3. ncm Avatar
    ncm

    Rereading my comment, I see that my last paragraph could be misconstrued to suggest the Chinese government has less latitude to screw its own population. I was referring, instead, to our own weakened democracy, and the correspondingly increased power of the American elite. This weakening may be traced to decades-long, markedly successful programs to weaken education and to concentrate ownership of mass media.

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