It is estimated that the foreign exchange market trades about $4.0 trillion daily. Furthermore, in spite of the euro entering the global stage in 1999, up until recently, the U.S. dollar was considered the world’s premier reserve currency. The flip side of this statement is that, since 2001, the greenback has shed quite a bit off its value, declining over 30%. Actually, since the Federal Reserve was created in 1913, the dollar has lost over 96% of its value. It may not feel that way to some, but that is only because so few investors truly understand what determines the value of any currency.
In order to trade internationally, and pay for goods and services domestically, every country in the world has its own currency. However, when President Nixon stripped the gold standard in 1971, what was also stripped was any intrinsic value of the U.S. dollar. The International Monetary Fund (IMF) delivered the final blow to gold’s monetary status in 1973, permanently removing gold from the monetary system.
The primary reason for removing the gold standard is that, when a currency is backed by gold, it can expand only as much as the gold backing will allow it to expand. Consequently, the economic growth is inherently restricted, because the money supply is restricted to how much gold a country holds in its treasury.
On the other hand, when currencies are no longer constricted by gold or silver held in treasury vaults, what they morph into are fiat currencies. The simplest definition of a fiat currency is that it is a medium of exchange (for goods and services); only its intrinsic value is not determined by something tangible and valuable, such as gold, for example.
Instead, fiat currencies are based on something intangible and essentially valueless, because whoever has printed the money does not promise to either redeem it through a commodity or through any other fiduciary monetary form. As a result, since no fiat currency has any direct and/or legally binding connection to a tangible asset (the “commodity money” placed in the redemption context), no fiat currency has any real economic costs and, thus, there is no self-limit in terms of its supply.
How else can fiat currencies be valued? The only way fiat currencies can have value is when they are issued in a country that is economically healthy and politically stable. As these two major factors fluctuate, so does the value of fiat currencies. This why and how the value of currencies have such a huge impact on governments, businesses, financial systems and, ultimately, every man, woman and child on the planet.
Compared to stocks and bonds, which are typically traded in local markets during business hours in their respective time zones, currencies trade virtually around the clock, 24/7. It may sound as if global currency markets exist in their own world. On some level, that is true. But, in this day and age, no market is isolated from global financial systems. For example, U.S. Treasuries impact the value of the U.S. dollar, which in turn impacts trading in FX markets, which in turn impact the trading of stocks and commodities.
The U.S. dollar is still considered the world’s reserve currency. Therefore, if something is amiss with the dollar, it resonates deeply within the global monetary system. Of course, such interconnectedness cannot work in one direction only, as changes in the global monetary system also have significant impact on the dollar. In this loop are often factors such as changes in interest rates, corporate earnings, equity prices, currency prices, bond yields, inflationary pressures, deflationary pressures, unemployment, moneysupply, a credit crunch, debt levels, international trade…and the list goes on and on.
(To be continued in Friday’s issue)