Sunday, 26 March 2017

Exchange Rates and Balance of Payments

Translation and Comment on:

“Summary and conclusion (as posted by FRANK SHOSTAK  on Cobden Centre 13 MARCH2017)
"Contrary to a popular belief, the state of the balance of payments has nothing to do with the determination of exchange rates. The key factor behind the rate of exchange determination is the relative purchasing power of various monies. The trade balance statistics could be however useful in ascertaining the diversion of foreigners’ real wealth from the rest of the world to the US given that the US dollar is the most popular money created out of thin air by the US central bank and the US banking system. As long as the floating exchange rate regime is allowed to function the more severe damage is inflicted onto the process of real wealth generation. One way out of this mess is the introduction of a gold standard.”

Let me try to understand what is being said in the above quotation.  I shall simplify by dropping the first 5 words, as they declare themselves to be irrelevant.  I shall next suggest that the “state of the balance” is “the balance”.  Perhaps “the determination of exchange rates” can be understood to mean “determining exchange rates”. For “monies” I shall write “currencies”.  For his “... rate of exchange determination” perhaps we could try “The key factor determining the exchange rate between two currencies is their relative purchasing power.”   So it seems that Shostak is suggesting:
The balance of payments has nothing to do with determining exchange rates. The key factor determining the exchange rate between two currencies is their relative purchasing power.
I disagree with both statements. I think the Trade Balance is a major factor determining exchange rates (ER), while not the only factor. And I think the link between exchange rates and relative purchasing power is so close as to make it hard to decide which "causes" which. (Does sunset cause the onset of night or vice versa?)

I believe the exchange rate US$:Yen is determined by a number of factors all round the world among which I would include: the desire of the Japanese to acquire dollars, and their desire to sell goods to the USA, and reciprocally the need in the USA for yen, and their need to sell goods to Japan; plus a host of smaller influences like tourism and trade flows with third countries. But there are two other big influence that need to be recognized: capital flows, and reserves. If Japan has a positive trade-balance with the States they will have dollars to: [1] sell, or [2] to invest, or [3] to keep in reserve. If Japan sells their dollars for Yen the exchange rate will be affected (the dollar will devalue). But Japan may be content to keep the dollars as “quasi-gold”, or they may invest in the USA to gain interest.  (Of course, the States may reciprocally hold Yen or invest in Japan.)

The Balance of Trade used to be the main ‘determiner’ of the exchange rate, but now there is (apparently) far money shooting round the world looking for ‘interest’, than looking for ‘goods’. Many countries maintain a trade imbalance for many years, because capital flows and interest rates are not taken into account.

Suppose a basket of mixed goods costs 550 Yen in Japan and 5 US$ in the United States. However, the current ‘exchange rate’ in the money markets is 111 Yen:US$. The “real exchange rate (RER) is calculated by correcting the ratio of the basket-prices by the ratio of the currency-prices to produce a dimentionless number. In theory, with perfect markets and large baskets, the “real exchange rate” is 1.0 ; in our example 550/5 x 1/111 = 0.991. It can be imagined that if the basket contained tuna the ratio of the prices (Japan:USA) might be 650/5, and our view of the “real exchange rate” would be distorted by the Japanese love of tuna. We need a large basket.

RER(Japan:USA)= 650/5 x 1/111 = 1.171.

Likewise, if interest rates were higher in the USA than in Japan the desire to hold US$ could distort the “real exchange rate” the other way. In time, and with perfect markets, the RER should relax towards 1.0

RER(Japan:USA)= 550/5 x 1/121 = 0.909

In short: I think Shostak underrates the role of trade-balance in determining exchange-rates; it remains funtamental, though it is by no means the only factor. For me, the value of his article is that it has forced me to go elsewhere to understand the matter.  I suspect it has only won a place on the Cobden Centre website because of the miraculously irrelevant mention of gold. 

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