Long-Term Factors of Currency Movement

* Long-Term Factor #1: Production and Consumption. The ultimate mover of a currency's value is the age old give and take between production and consumption.

It follows the natural law that governs all work and economic productivity: a person cannot consume what he does not produce. If a person does consume more than he produces, he has two choices and two choices only: One, he must increase income to meet or exceed consumption, or two, he must borrow to meet the discrepancy.

Ultimately, of course, the choice comes down to #1, because for an individual, borrowing can go on only so long before reckoning takes place. Governments, however, sometimes think they can borrow indefinitely, bolstered by their ability to create money from thin air and by their power to tax (and raise taxes) on citizens.

What is production? It's the creation of goods and services, the creation of new ideas that improve goods and services, and the distribution of these goods and services. Production involves the entire range of a country's economic activity: from the development and distribution of raw materials, to the formation of these raw materials into desirable, useful products, to the development of stable banking and insurance networks that finance and protect investors' capital outlay.

When a country has little actual growth in production, theoretically it should not increase its money supply. Unfortunately, this is the very time governments need money the most. Few can resist the impulse to print a little extra to tide them over.

If a government does not impose discipline to assure that no money is produced unless some production takes place, that currency will eventually fall in value compared with currencies that are based on more productive, stable values.

This is especially so of governments that use fiat currency. If a currency is based on gold, silver, or another hard asset, it is not possible to simply print whenever more is needed. The gold or other hard asset represents productivity, because no person or government is going to give away gold unless some productive value is exchanged. Fiat currencies have no base of hard assets, and the printing presses can churn it out unencumbered by small details. There is no worry such as is the currency really worth anything.

Fiat currencies are very sensitive to the emotions of fear and greed in the foreign exchange markets, because the only real value these currencies have is confidence. If an investor is confident that a Fiat currency will rise, he will buy it. If the investor fears that the currency will fall, then he will sell.

If all currencies were tied to a hard asset, there would not be so much fear that a country is creating more currency than productivity warrants. Nor would there be as much desire to speculate for profit on a currency's parity motion. Value would always remain steady.

What would this do for the world? It would ensure that governments would be more honest with its citizenry. Governments would not be able to expand beyond their citizens' desires to pay for governmental services. Governments would issue money based only on production. Certainly they could still borrow, and certainly they could adjust taxes from time to time. But overall, basing currency on hard assets would force governments to maintain fiscal discipline.

However, such discipline is something that few governments in history have maintained for any reasonable length of time. We must assume that the U.S. government will not suddenly gain this discipline and that growing U.S. debt will eventually destroy the remnants of the world's currency system as we now know it.

Important Point to Remember: Most governments today are accustomed to a system of borrowing far more then they can ever repay. This is a trend that has been promoted since the 1940s. Politicians have become hooked on budget deficit spending. Until this trend reverses itself, currency turmoil is almost certain because all the governments are spending more then they produce.

*Long-Term Factor #2: Government Debt. The fundamental basis for international currency movement may be trade and the resulting surplus or deficit in a country's balance of payments. However, the real world involves real governments, run by real people with real needs, short and long term. For this reason, the most fundamental basis of currency movement is government discipline (or lack of).

Governments today produce money out of thin air to fund their activities (as seen in the previous section on the U.S. Federal Reserve and fractional reserve banking). If governments produce money that is not backed by precious metal or by the productivity of their own people, the money created will eventually become weaker versus money issued by governments that produce money backed by precious metal or productive work.

The most fundamental law of money is that something cannot be consumed unless it is first produced. This simple, common sense law seems so obvious that it hardly needs stating. Yet ignoring this law has led (and will continue to lead) currency after currency to destruction!

Money, above all, is a form of discipline. In its most pure form, this discipline is aimed at stopping members of a community from taking more than they have produced.

For example, any government can add a new department and staff it, paying for the expenditure by simply printing (or creating) new money. But when a currency is tied to gold or silver, the government cannot simply manufacture it out of thin air. The government must first produce or earn the gold, then print the money. This keeps a government honest. It disciplines a government not to consume until it has produced. Gold or silver, in themselves, are merely representative of production accomplished.

If a government does not impose discipline on itself to assure that no money is produced unless some production occurs, that currency will lose its purchasing power versus currencies whose governments do maintain discipline. Some governments impose less discipline than others. The less discipline there is, the weaker the currency will be and the faster it will fall versus other currencies.

There are numerous ways to spot future weakness in a currency.

First, look for deficits in a government's annual budget. If a country has a deficit, it is producing money without discipline. As a rule, the larger the percentage of the debt compared with the country's gross national product, the more likely the country's currency will fall vs. other currencies.

Second, spot potential weak currencies by looking at a country's accumulated debt. If a country has a debt it must start running a budget surplus before it can pay down the debt. This can only be accomplished by either a slow down in spending or by an increased income. In either case, such discipline balances the budget. If a government does not balance its budget, it has to borrow to meet payments.

Third, look out for a government with both an accumulated debt and a deficit in its annual budget. This country is already in debt and the debt is increasing!

Unfortunately your task of finding such governments will be all too easy. Government deficit financing is now a normal part of most economies. Huge debts are being created by governments all over the world.

These debts create all kinds of economic problems. They interfere with private industry. This was one factor that seriously hurt bond prices in 1994. The huge demand by governments for financing of their debt attracted funds that once went to private bond issues. When governments borrow more and more money, this pushs up the yield on treasury issues, competing with bond issues and making them less attractive.

Government debt affects currency values in many ways. Some countries, especially developing countries, create so much debt that they cannot produce enough goods to service their debt (principal or interest). In these cases, the currencies of the countries are seriously affected. Even major nations are affected. The numbers below show the huge debts that major governments around the world have taken on.