Exchange rates reflect national prosperity. If a country is prosperous it will create surplus goods sought by the rest of the world. The rest of the world will need to purchase domestic currency to pay for those goods, and that will cause the currency to rise in relative value. Third World countries find that their currency is worthless compared to industrialized countries—because they create little that the rest of the world desires.
Exchange rates are determined by balance of payments
Exchange rates are determined by supply of and demand for currencies. When Europeans want to buy goods from Americans, they need U.S. dollars in order to do so. This creates demand for U.S. dollars. When Americans want to buy goods from Europeans, they need euros to do it, so they offer to sell American dollars in exchange for euros. This creates a supply of U.S. dollars. There will always be slight trade imbalances, however, as Milton Friedman explained: “In the real world, as well as in that hypothetical world, there can be no balance of payments problem so long as the price of the dollar in terms of the yen or the mark or the franc is determined in a free market by voluntary transactions.” (Free to Choose: A Personal Statement, 1979.)
When exchange rates freely float against each other, those countries that live beyond their means (importing more than they export) are gently chastized by the prices of imported goods rising. Countries that export more than they import are gradually rewarded by their currency being able to buy more and more foreign goods.
The futility of intervention
There is no way in which one can buck the market. I might add that if you try to do so, the market will buck you. The belief that the laws of economics and the judgments of the markets can be suspended by clever people … is a perpetual temptation to folly.
—Margaret Thatcher. The Downing Street Years, 1993.
Government should never meddle with exchange rates. Exchange rates should always be left to find their own level. If not, the result is inevitably detrimental to the country doing the meddling.
There are seven main ways exchange rates are tampered with:
- Government buying and selling of currency
Central bank intervention in the currency market is disastrous because the government is using public funds to subsidize exporters or importers (depending on whether they are trying to raise or lower the value of their currency). This results in a massive wealth transfer from the taxpayers to the importers or exporters (depending on which way the tide is flowing), and to speculators.
- Interest rate manipulation
Manipulating interest rates to ‘stimulate’ prosperity is disastrous because it triggers wild credit booms followed by busts which impoverish the nation by causing mal-investment. As a short-term policy, it is equally futile. British Prime Minister John Major discovered this on Black Wednesday (September 16, 1992), when he raised interest rates from 10 percent to 12 percent then to 15 percent, all in a single day. When a currency is overvalued (and therefore doomed to drop), raising interest rates is like repeatedly reducing ticket prices on an airplane everyone knows is going to crash.
- Currency controls
Currency controls are disastrous because they encourage organized crime, create contempt for the law and, where importers and exporters are not prepared to break the law, stifle trade.
- Monetary inflation
Monetary inflation reduces the relative value of a currency. This occurs because the world recognizes that the government of the inflating country is trying to cheat it by printing worthless scraps of paper. It responds by devaluing that paper accordingly.
- Import quotas
Quotas are disastrous because they encourage smuggling and stifle trade. They mean people are unable to buy the cheapest goods available and therefore are able to buy less with their limited money, which makes them poorer in real terms.
Tariffs and subsidies are disastrous because they cause price inflation and distort the market, leading to inefficiencies which impoverish the nation.
- Persecuting speculators
The persecution of speculators is the persecution of scapegoats, with all the injustice and futility that entails. Speculators can do nothing to affect the underlying supply and demand of a good, they only profit when they discern imbalances. By profiting, they remove imbalances and as such are essential to the proper functioning of the market. Referring to them as greedy is no more true than referring to the shopkeeper, coal miner, or anyone else who seeks to profit from the market, as greedy. A speculator’s prescience is a valuable service to suppliers and buyers, as it allows them to make their dispositions to changing circumstances earlier and thereby be more profitable.
Governments often claim that they are intervening to prevent hard landings. However, it is precisely government interference in markets that creates the large imbalances which cause hard landings. Moreover, the very act of preventing a hard landing is itself a distortion of market forces. Companies will be encouraged to make bad currency bets, knowing that if they are wrong the government will fight a rear-guard action for them at the public expense.
Governments also claim that they intervene to prevent inflation (for example, the claim made by John Major on Black Wednesday). (Statement made on September 16, 1992.) However, exchange rates have nothing to do with monetary inflation, only price inflation. Further, price inflation is a reality which currency intervention cannot alter. A country is wealthy or poor. No tinkering with interest rates or printing presses can alter that underlying reality. To make a country wealthy requires that good government be implemented, and that markets be left free to find their own levels.