A history of currency and monetary exchange rate systems

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Do you get confused by currencies? Why and how do they move? What is the role of Governments? Knowing a brief history of currency exchange rate systems can help you understand today's three vexing questions which are, will:
1) the US dollar retain it's status as the world's reserve currency?
2) the Euro collapse within the next 5 years?
3) the China remninbi (yuan) be a potential challenger to replace the US dollar in the future?

Take the US dollar for instance... each 10, 20, 50 and 100 dollar note assures you, the cherished owner, the right to redeem it for…5, 10, 20, 50 and 100 dollars respectively. It's purchasing power today should not be confused with its intrinsic value (the amount of collateral it's backed by).

Is this just a simple “I-give-it-to-you-so-that-you-can-give-it-back-to-me” manoeuvre or are there other odious forces involved you are not aware of?

Let's take a look at this graphic which does a quick roundtrip of this quirk and recounts the evolution of currency systems from 1821 to the present day.

As it turns out this history is far more exciting than is usually let on (think political thriller as opposed to economic textbook!). For a rivetting exposé, I recently read and recommend a book by James Rickards (an American economist and 35+ years Wall Street investment banker), author of the New York times bestseller published in 2011 Currency Wars.

 Infographic: hat tips to greshams-law.com and goldmoney.com  

China's devaluation dilemma: where next with the yuan, dollar and the euro?

The yuan is currently pegged to the US dollar in order to keep Chinese goods comparatively cheap in the key North American markets. As long as the US dollar is weak, the Chinese yuan is weak and therefore competitive in European markets. While complaints abound from the US about this "unfair" trade advantage, is it possible China has been blind-sided by the recent euro woes?

The US$-euro exchange rate is also a pillar to global trade. As the euro falls, countries are also under pressure to weaken their currencies. Specifically, China is under pressure to weaken its currency because Europe is the largest consumer of Chinese goods. In order to remain competitive, Chinese companies must reduce their profit margins or hope to make up reduced profits by increases in volume.

To weaken one's currency, one has to sell it and buy another currency. If you're China, would you rather sell the yuan to buy the euro, yen, or U.S. dollar? In this trio, the US dollar is king because it's the least worst scenario being the global reserve currency.

The Chinese government is now confronted with a policy dilemma because it has painted itself into a corner. Which exchange rate should it "manage" for the long term benefit of its export industries? It can either target the US$-yuan or the euro-yuan. It cannot aim for both as it has no influence over the US$-euro rate. As this chapter unfolds, distant images of how another major economic power blew up in the late 1980s with failed exchange rate targetting, from which it has never recovered, loom ever larger: Japan. This lack of control worries Chinese policymakers. This could be one reason why Chinese entrepreneurs have recently voiced their increasing concerns over their own government's US$-yuan policy. There are now bigger and wider issues at stake because entrepreneurs are not willing to invest in a climate of uncertainty.

Every country desires a weaker currency so it can export more goods. However, the only way to weaken one's currency is to sometimes make bad investments. Such economics make sense to a central banker: more exported goods mean more jobs, social cohesion and a higher GDP. So why would you fundamentally weaken your entire nation for one good year of exports? Imagine breaking all the windows in your city so that you will experience a building boom.

If market forces to allow the exchange rate to find their comfort levels are not the answer for China's zest for "control", then an alternative outlet needs to be created to protect the general Chinese investor community from the future vagaries of their export sectors. A safety valve that can stand the test of time. Precious metals are one such avenue.

What is currency debasement and why gold will be the next world currency?

If the 2008 financial crisis was characterised by private debt being bailed out by public debt (ie borne by the long suffering taxpayer), then who will come to the rescue of sovereign debt? Which government(s) is going to foot the tab on another's profligacy? It seems another floor has just been built on the house of cards.

With this new set of economic machinations, the chart above points to next year’s sovereign debt estimates for the G7 and other key global economies. The U.S. debt in 2011 would be about equal to GDP (US$15 trillion) while the debt loads carried by Japan, Italy and Greece would exceed GDP.

There is a concern among investors that not all is right with the financial world and they don't fully understand it. They think central bankers might be debasing their currencies and so there is an interest developing in gold. If their personal wealth can be affected by the future inflation spawned by the trillions of dollars and euros created to finance economic rescue plans, then the potential implications for gold are profound.

What is currency debasement and how does one measure it? This may once have been the domain of a few old Germans, Latin Americans and Asians to think about. The recent ferocity in which it has struck Mittel Europa has un-nerved many who are slowly coming round to the view the Euro is heading inexorably towards Argentine peso status. It won't be just clattering pots and pans in the streets...the trade union molly-coddled Greeks can attest to something more vigourous.

Here’s one way to look at currency destruction. 10 years ago this week, US$1,000 bought nearly four ounces of gold and today US$1,000 won’t even get you a single ounce (today's spot price is US$1,215). Gold is money, so when you look at the gold-US dollar exchange rate, the dollar’s value has fallen by a startling 70%+ just in the past decade...and that's the global reserve currency!

To hold gold is not about getting rich, but a means to diversify assets and protect wealth.