Is the value of every currency entirely made up?

C

cuttle

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I know this is such an embarrassingly basic question it must have come up and have been answered but I can't find a simple answer:

If every unit of currency is relative to every other unit, and isn't anchored to any underlying stable-valued commodity, isn't the entire global monitory/financial system inherently unstable? Is it fair to say that any given unit of money literally has no value beyond a kind of global folk-consensus?
 
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Books shelves have been filled with answering this question. An inadequate explanation is currency's value is relative to the production output, demand & scarcity of the currency. The value arises not inherently from the currency, but rather what it can buy. So for example, the dollar is needed to buy oil as oil is sold in dollars. The Euro is needed to buy Euro products and likewise for all other currencies etc . If I have euro and need dollars to buy oil,then I must buy them (as the oil has an underlying value) and likewise if I need to buy any other American product. Similarly an American or a Japanese will need to buy Euro in order to get a BMW. This creates a value for the currency. The less of the currency in circulation will also impact on the value ( hence the problem with printing money or quantative easing) just as cross or bi-currency demand impacts on value. Also perceptions of safety, and interest rates offered by a Central Bank will come into play.

So in effect, currencies are based on commodities to a large extent, but they may be intangible commodities, such as "services", as well as tangible commodities such as products. There would be little point for example, in having large numbers of Afghanis, as little is produced in Afghanistan of real tradable value to the outside world, and thus there would be little demand for them in order to purchase goods. However, currencies are often pegged to stronger currencies in order to create stability. So for illustration, Brazil may keep a ratio of 2 reals to every US dollar, meaning that for every 2 reals in circulation, the Brazilian Central Bank keep 1 dollar in reserve. This helps to underpin the currency. This is a very inadequate account, but it might throw some light on the issue. It's also worth bearing in mind that the dollar is somewhat exceptional, as it is the dominant tradable world currency. As such, it is somewhat immune from some of the normal rules (like quantative easing) that may apply to other currencies.
 
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Some good points already made by horusd, but on one item I totally disagree. That is that the US$ is "immune" to quantitative easing. The dollar's "value" (if you can even say that) has deteriorated by 95% since 1914 if you trust the US governments own fudged calculations. (calculator on the right: http://www.minneapolisfed.org/)
The loss of value has accelerated in recent years. While the US government claims that price inflation is low, this statement is only possible because the government is making the fudged calculations. Commodity prices for energy, metals and food products are in a lot of cases at record highs, which is a clear indication that monetary inflation has already started the process of higher prices.
Bottom line is that all the world's fiat currencies are I-Owe-You-Nothings, they are promises that are only as good as the central banks that make them.

A very good introductory book on money is Rothbard's "What has government done to our money": http://mises.org/books/whathasgovernmentdone.pdf
 
I haven't had a chance to view that youtube video yet but, Chris and horusd, I appreciate that the many variables that determine a currency's value make it a complex subject but is there anything in my OP that is just completely wrong? (The likes of "in effect the values are based on actual goods or services" is not what I mean by anchored. I mean actually, legally, permanently, related to something real by some formula or other).
 
Chris thanks for that link Rothbard. I look forward to reading it. What I was saying about the dollar in broad strokes was that it was "somewhat" immune, not totally. I take your point, but what I was referring to was the fact that as the dominant tradable currency internationally and therefore neccessary in ways that almost no other currency is. This gives a certain latitude to the dollar not available to other currencies.

Cuttle when you say "actually, permenantly related to something "real"..." I assume you mean something like gold or another valuable commodity? And the formula and anchoring you mean is like a ratio between gold reserves and the volume of currency in circulation ?

This first part of this question is almost philosophical. A "real thing" is something that people value. Value itself is not vested in anything other than what we place it in. Gold is often used as a commonly accepted repositery of value. But gold itself has no inherent value (or any substantial real use) except it's perception in people's minds and scarcity. If I had all the gold, diamonds, pearls, oil, silver, platinium or whatever in the world, and no food it would quickly become apparent that they are all completely valueless. I would give all of these for a slice of bread! This makes it clear that "real "things of value is a relative term. Such an absolute situation doesn't happen, but it makes the point of value and the effect of demand crystal clear,(as does the expression "your money or your life") and it does happen to various degrees in the real economy. So the "real" thing you refer to, is in fact "demand" and this changes.

Russia lost a huge amount of it's grain this yr, and has banned it's export. They must now import grain to feed themselves. They trade oil and gas, and use these sales to buy grain. Broadly speaking, the balance of demand for what they sell, and what they must buy determines the value of the rouble. They need Euro's to buy grain from Europe and Europe need roubles to buy oil and gas. Therefore nothing has real permenant value, and any formulae are relative, so it's not that simple. Demand is the driver and therefore it would be impossible to say that something is "...actually,legally and permanently, relatedto something real..."

Nobody can fully answer your questions on this in a post. You probably need to read up on it. As I said, it's complex, but also fascinating.
 
cuttle, I think the simple answer is that fundamentally there is nothing wrong with your original statement. Fiat currencies are technically worth nothing as there is no guaranteed backstop, as the most recent hyperinflation in Zimbabwe shows. However, I think the instability of the global currency system stems more from fractional reserve banking system. As horusd already mentioned, currency systems are very complex and complicated to get your head around, but once you do it is quite eye opening.
It is also important to bear in mind that fiat currencies can only survive because of legal tender laws, which basically force an economy to use a certain currency.

horusd, I agree with your points, and the dollar's reserve status certainly does allow the US to print money at higher rates than would be possible elsewhere for a certain amount of time. Eventually even they will run into big big trouble, and given their policies I think this is becoming increasingly more likely.
If you like the Rothbard book, you might also want to look at a more complex one he wrote called "The mystery of banking": http://mises.org/Books/mysteryofbanking.pdf
 
Thanks folks. Yes, you're right. It would be necessary to have the value relate to something real for which both supply and demand, globally, are reasonably stable. That was the idea behind the gold wasn't it? But subjectivity and context will always be a problem there. As you say a scarcity of food will have a pretty severe impact on the demand for gold at any given point in time.

You're also quite right that I need to read up on it more. But the more I try to understand the more I fear that this complex, fundamentally flawed, system is always in danger of just imploding. I'm not posting because I've any idealistic solution to offer. I'm just trying to make sense of it all. You've helped to point.

(Perhaps I just worry too much! )
 
The advantage with a gold backed currency, that cannot be inflated, is that if there is a shortage of food, the price of food in gold will go up. But as the amount of money in circulation doesn't change, the price of other goods has to go down. Under a credible gold standard you cannot have a situation where all prices rise together.

I know exactly where you are coming from. I started studying economics and the monetary system more in depth about 4 years ago. Especially the monetary system seemed to create 10 more questions for every question answered. It took me a long time to get my head around it. But once you do it is eye opening to see, as you say, the "fundamentally flawed" system.
 
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