Wednesday, June 3, 2009

The problems with currencies

As everyone is aware, the world's economic transactions are performed in a variety of different currencies. Currency traders share a generally accepted range of possible exchange rates for different currencies with respect to each other. If a new event occurs that appears to weaken a particular currency, currency traders are liable to buy and sell in a pattern that adjusts the exchange rate to devalue the currency.

Frankly, I would expect the value of a given currency with respect to another to depend on the size of the economy (a measure like GDP gross domestic product would be a common one) and the amount of money that exists in that economy. I would expect that the exchange rate of any given pair of currencies ought to reflect the ratio of the GDP type measure to the amount of that currency in existence for the two currencies. The only 'value' in a given currency is speculative. At present, exchange rates are heavily affected by the GDP value of a given currency – typically scaled on a per capita basis. I'm saying that for comparative purposes a more telling measure would be to scale these GDP values by the amount of that currency in existence.

When a central bank adds new loans to its books (in my understanding, typically) it is creating money that didn't exist before. So if a central bank adds a new loan for the value of 90% of every mortgage (see post on the economics of mortgages). Then that central bank has printed a huge amount of money – it helps its own citizenry to enjoy a good standard of living by facilitating them to become home-owners. It's also an amazing service that the banks exploit to charge the customer exorbitant amounts of money just to hand the customer some government money.

Now I don't know the inner workings of the bookkeeping of central banks. When a citizen pays their mortgage to a normal bank that bank in turn pays back the central bank (90% of the mortgage was provided by this government institution). When the central bank receives these funds what does it do with them? My understanding is that the money never really existed in the first place so it is accounted for as such in a ledger somewhere. But the sum of all the active loans the central bank has issued is the same as having printed that money.

When the central bank provides 90% of the mortgage funds it is all done on paper between them and the commercial bank. This is the same as the central bank printing some extra cash for those mortgage funds and handing it to the home buyer (through a bank which charges you interest on the government's money). The home buyer then hands it over to the home seller. Since 90% of the cost of the mortgage on every house is provided by a loan from the government, the central banks have been 'creating' loads of money. To get a good idea of the appropriate value of any given currency we would need to have a good idea about how much money the central banks have 'created' in this fashion and how much the commercial banks have created through their own loans. I would find this information fascinating.