Intro to Accounting for Foreign Currency and Inflation: The Value of Money in a “Floating Rate” World

1. Intro to Accounting for Foreign Currency and Inflation:The Value of Money in a “Floating Rate” World Overview & History Floating vs Fixed Rates Economic Effects of a Floating Rate System

2. A Few Basics about The Concept of Money • One of the main functions of the idea of “money” is to make exchange (trade) more efficient. • A major innovation is in allowing timing differences between production and consumption • The idea of “money” is itself not tangible. • The “worth” of money can be measured based on what it can be exchanged for.

3. A few Basics about the Concept of “Paper” Money • Anything can serve as money. • Traditionally, and perhaps because they were rare, portable, and with fixed and limited supply, gold and other rare minerals often served as money. • In recent times (since 1700s), paper has traditionally been used as money, along with, or as a substitute for, physical gold.

4. The Problem with Paper • Paper is readily, and cheaply, obtainable. Thus, in and of itself, it has little inherent worth”.

5. The Solution to the Problem • To make paper rare and believable as a thing of stored value, it was specially imprinted and designed, issued as a draft, or note, by a bank, and/or made convertible into physical gold or other precious metals. • The advantage of paper over gold is that the supply can be increased on demand, as needed. • This can be helpful when economies and markets are expanding quickly- paper can easily be supplied to meet demand for additional cash to facilitate trade and other financial activity.

6. The Concept of Foreign Exchange • Modern economies usually have a central bank that issues the paper money of that nation (or in the case of the EU, that confederacy of nations). • The central bank, ideally, issues enough paper to meet the demands of trade, but not so much that the currency is cheapened (too much money chasing too few goods) • Foreign exchange involves the exchange of one currency for another. • Direct and indirect rates of exchange are quoted for this purpose.

7. International Foreign Exchange- History1800s and early 1900s • In 1800s, pound sterling was the reserve currency of the world. • Most currencies were linked to sterling and/or gold.

8. International Foreign Exchange- HistoryThe Depression Years (1930-1940) • Depression years saw many currency devaluations as countries tried to compete in weak global markets. • Rather than face severe economic decline, UK abandoned the gold standard. As a result, Sterling lost its seat as the world’s reserve currency. • Many countries, starved for gold reserves, and facing severe deflation, sought to abandon the gold standard.

9. International Foreign Exchange- HistoryThe Depression Years (1930-1940) • In the US, in 1933, American citizens were required to sell their gold at a price of $ 28 per ounce. Thereafter, American citizens were not allowed to own gold, except in the form of jewelry. • The confiscated gold was then used to back the issuance of much more currency (convertible at $35/oz) - this to fund the “new deal”, in the hope of reviving the economy, and mitigating deflation. • It didn’t work- the country stayed in depression for ten painful years. • The depression finally ended with the advent of WWII.

10. International Foreign Exchange- History1944-1967 • During WWII, the USA produced arms and sold them to the Allies in exchange for physical gold and promissory notes. • By the end of WWII, much of the gold in the world was now stored in American vaults. • This imbalance created a need for some other monetary basis. As a result, the “Bretton Woods” agreement emerged. • The US $ was tied to gold. Other currencies were linked, at a fixed rate of exchange, to the dollar. The dollar thus became the new reserve currency of the world. • For more than 20 years, this system worked well and responsively, in the face of rapid expansion of the world economy, amazing new innovations, and rising standards of living in many industrialized countries.

11. International Foreign Exchange- HistoryThe Inflation Years 1967-1980 • In the mid 1960s, trouble began as world economies became overextended and equity markets peaked. • In the mid 1960s, The USA became involved in Vietnam. By 1967, the war was in full swing. Much more paper was needed to finance the war than gold reserves would allow. • At first, the US printed paper anyway. • When markets became aware of the increased amounts of currency, countries began to come to the “gold window” to exchange US $ for gold. • Massive amounts of gold began to leave the country.

12. International Foreign Exchange- HistoryThe Inflation Years (1967-1980) • In 1974, to stop the gold drain, President Nixon abandoned the gold standard and closed the gold window. The “Bretton Woods” agreement collapsed. • In its place a “Floating Rate” system was installed.

13. International Foreign Exchange- HistoryThe Concept of a “Floating Rate” • From 1974 on, the US $, and thus most other currencies, were no longer backed by gold. Paper money, although formally a form of credit, is now really backed by nothing except “faith”, i.e., the collective conscience of society concerning its worth. • Advantages: • No reserve of gold is needed to back currency. • Greater freedom to create money and stimulate demand. • Disparate inflation rates can’t, as easily, disrupt capital flows and trade.

14. International Foreign Exchange- HistoryThe Concept of “Floating Rate” • Disadvantages of a floating rate system- • No restraint on governments’ propensity to devalue currency- usually to finance govt spending or to avoid politically unpalatable economic pain. • Can induce greater asset price volatility, especially when coupled with a fractional reserve money-creating mechanism (i.e., the creation of credit). • Foreign exchange rate volatility and risk are now directly borne by market agents, i.e., companies, investors, etc.

15. How Money is created in a “floating rate”, fractional reserve system • The central bank “buys” something, usually government debt, from banks, arbitrarily creating currency for use in the swap. • The bank adds the currency to its reserves and lends the money out. • Since reserves of 10% or less are typically needed to support a given level of lending, the amount lent is significantly more than what was originally created by the central bank. • Other banks, upon receiving newly borrowed funds as deposits, also lend more. • The result? 1 US dollar initially created by the central bank can end up adding 10-15 times as much to the money supply. • The flood of new funds lowers interest rates, stimulating new investment, consumption, and lending, which in turn drives up prices. • As prices rise, and the value of money falls, lenders respond by increasing interest rates in order to earn a fair rate of return on their loans.

16. International Foreign Exchange- History1980-Today • The nation, and world, began to experience certain phenomena: • Booms and busts around the world. Credit (and economic activity) in the system sharply expanding, followed by marked contractions as investors, fearing credit was over-extended, called loans and sought safety and liquidity. • Imbalances in trade relationships began to occur. • Assets of various types (housing, stocks, bonds, oil, gold, etc.) began to cycle through periods of boom and bust. • On average, however, prices rose (inflation), reflecting a long term trend of the devaluation of paper money. • High levels of debt and reduced savings became commonplace. • Major shifts occurred in the value of one currency versus another as nations attempted to manipulate the rate of exchange, trade, and/or the business cycle. • Hyperinflation was experienced in many developing nations.

17. Traditionally: • Fiat currency, including paper, while theoretically a valid form of money, has always become worthless over time (example: China, Rome). • The ancient Chinese Empire, for example, was forced to abandon fiat currency because they found it was “inflationary”. In other words, such money could not hold its value. • Similar devaluations have been experienced in numerous other civilizations, including Rome, the UK, and many others. • The US is no exception! The US $ has lost 98% of its value over the last 100 years!

18. Why Fiat Money is something all politicians secretly love: • When money is devalued, it amounts to a kind of tax. • People respond to that tax by making adjustments to lessen it. These include buying real goods, even if not needed, over-borrowing, and over-investing. • Thus, and strangely, the tax occurs in a way that can actually stimulate the economy and increase trade. • Unfortunately, as we all inherently know, there is a cost to all forms of tax. Its only a question of when it will be paid, and by whom……

19. The Question of Who Pays and Who Benefits: • In a “floating rate” system, if you are fortunate enough to be the world’s reserve paper currency provider, you can: • Exchange paper, with no inherent value, for real goods and services. • Control economic activity and capital flows. • To the extent others cooperate, you can export some of your inflation to other countries. In effect, then, the tax is itself exported. • The exporting of such reserves cause the boom and bust cycle to manifest elsewhere. • This actually stimulates world trade, making it attractive for all concerned.

20. Causes of Exchange Rate Movements • Only well understood reason: Inflation • Other possibilities: • Trade imbalances • Demand and supply of investment cash flows • Fiscal deficits • Economic growth • Interest rates • Political turmoil and stability • ………………and so on.

21. Euro Versus US Dollar

22. Japanese Yen Versus US Dollar

23. British Pound Versus US Dollar

24. Mexican Peso Versus US Dollar

25. The Problem of Making Sound Economic Judgements in a World of Floating Rates • Its hard to determine the “real value” of goods and services produced and given. • One way is to value things in terms of something traditionally monetary and real, e.g., gold. • Example: • You buy a house for $ 200,000. • It appreciates to $ 380,000 over 5 years, or 90% • $/oz of Gold increases from $265 to 590 (125%) • House in gold oz: Before= 755 oz, After=644 oz • Conclusion: House depreciated 15% in terms of gold.

26. Gold Versus US Dollar

27. Light Crude Oil Versus US Dollar

28. The Problem With Floating Rates • Another example: • You get a 25% raise over 5 years. • Gold appreciates 125% • Gasoline increases from $ 1.25 to $ 2.50 (100%). • Houses and many other real goods and services increase 100% or more in the same 5 years. • Conclusion: You may have actually taken a significant pay cut while “feeling” your income, and wealth, was increasing!

29. Why do governments devalue currencies? • Disincentive for saving. • To prevent economic decline. Borrowing and spending are encouraged. • Creditors are better protected (assets securing loans grow in nominal terms). • Goods and services are more competitively priced to overseas buyers. • Discourages buying of imports

30. In fact: • Currency devaluation (manipulation) is a classic response to worldwide economic decline (instability). • The reason: Its politically more palatable for everyone to take a pay cut, and prices (nominally) to rise, than for some (in 1933, 25%) to lose their jobs and for prices to decline sharply, forcing large-scale bankruptcies and defaults. • To accomplish this, there has to be great quantities of something (government debt) around for the central bank to buy. In 1933, this “trick” was not possible because there was little government debt and the world’s currencies were tied to gold.

31. An example of the measurement problems inherent in a floating rate system • Has the national debt really grown? What if: • Total government debt has grown nominally by about 1/3 (6 trillion in 2002 to 8 trillion (?) in 2006) in 4 years? • The value of the dollar, in terms of gold has decreased by more than 50% over the same time frame. • In terms of gold, the national debt has thus shrunk considerably.

32. The Problem with Currency Devaluation (revaluation) from an Accounting Standpoint • One of the assumptions behind all financial reports is that the monetary unit is the same. • If currency changes value over time, the monetary units ($) represented on financial statements are not the same. • As such, they cannot be added or interpreted meaningfully.