Saturday, August 17, 2013

Foreign Currency Exchange

In the previous post John and Luigi both made purchases in their domestic markets using their domestic currencies, and sales in foreign markets for the foreign currency.  They did this because they knew that their bank would exchange the foreign currency for their respective local currencies.  Most likely they checked on the exchange rate before they made the sales so they would know how much of their domestic currency they would get for the foreign currency.  So, for each of them, when they converted the foreign currency to their domestic currency is was just like they had sold their goods at home.  Luigi sold soccer balls and ended up with Euros, and John sold lamps and ended up with US dollars.  Both of them counted on getting the expected exchange rate when they traded their currencies.  In this simple example the exchange of currencies exactly balanced out, 700 EUR for 1000USD, so all currencies returned to their country of origin.  This point is crucial, the currencies came from their country of origin and then were traded back to their country of origin so that none remained overseas.  But what happens if this exchange doesn't balance out?

Today currencies are exchanged by large international banks, such as Deutche Bank, Barclays, and Citi, on free floating "over the counter" foreign currency exchanges (FOREX), in direct deals between the banks, without a central exchange.  The Bank of International Settlements estimates that $4trillion a day of currencies were traded in 2010 (1).  This market is generally unregulated, but most transactions are posted for others to see on the biggest markets, such as in London.  The rate of exchange changes continuously on these markets due to demand for certain currencies and the desire to divest of others. John and Luigi's local banks did not likely participate in one of these major markets, rather they delt directly with a major bank in their home country to execute the exchange.   Clearly the exchange of currencies and the rates of these exchanges have a major impact on trade between nations, as the currency exchange rate determines the equivilent price of goods and services in foreign markets.  That is, as the value of your domestic currency increases relative to a foreign currency, goods and services from that country appear cheaper to buy and your goods and services appear more expensive to sell, with the converse also being true.

Notice that the exchange of currencies is independent of the trade of goods.  That is, the banks had no idea where Luigi got USD or John got EUR, they just execute the exchange.  Notice also that the exchange rate could have change between the time John and Luigi checked the exchange rates and decide to sell and when they too their foreign sales money to the bank for exchange.  If this happens then one of them will get a bit more than expected, but the other will get a bit less.  Perhaps that will influence their decision to buy and sell in the future.

What if John decides he wants more soccer balls but Luigi doesn't want more lamps?  John does the same as before and buys soccer balls from Luigi for USD.  Luigi takes the USD and trades them for EUR, but this time there are no EUR in the US bank to exchange because Luigi didn't buy lamps.  The USD stays in the foreign bank and the trade is unsettled.  For a small exchange like this the bank handles the exchange from its reserve of currency it keeps on hand.  But the imbalance remains, in that Luigi's bank now has an extra USD1000 on its balance sheet in a country where noone uses USD.  Well, letting that money just sit there doesn't make the bank happy, so it buys a USD bond with it so it will at least earn some interest. But this doesn't remedy the currency imbalance.  Indeed, it just makes it worse, if the money is there earning 5%, at the end of the year there is USD1050 sitting in the account.  And that increased sum represents the sale of the same soccer balls the previous year.  The imbalance has only gotten worse!  What if this one sided sale is repeated over and over again?  Then a large imbalance builds up.  Potentially tens or hundreds of billions of US dollars a year.
According to the popular theory in economics an imbalance in currencies and trade should only be transient as the market will take care of these imbalances by altering the exchange rates such that the trade will once again be in balance.  In the above example the value of the USD should have fallen after John purchased soccer balls in USD but Luigi didn't buy lamps in EUR.  This is because the European bank wanted to get rid of its excess USD1000 and acquire EUR. So, perhaps it is willing to take EUR600 for the USD instead of the previous EUR700.  Maybe then a US bank with EUR agrees to the exchange and the USD are repatriated to the US.  But the trade isn't really settled as the US bank drew from its foreign reserves of Euros to make this exchange rather than getting them from bank customers who sell to Europe.  Thus this pool is limited and these kinds of trades can only be made for a short time baring some other intervention.

Again, according to the popular theory, the lower exchange rate for USD to EUR should induce Luigi to buy something in the US as its now cheaper relative to before the rate change.  That these sales will provide the Euros to the US bank to exchange, because John brought them in to exchange for USD, and that the trade will once again be balanced.  In other words, according to current theory, only very small trade and currency fluctuations can ever exists, and no significant deficit can build up over many years.

Yet, the US has accrued a $9887B (2)(3) trade deficit over the last 30 years!  How can that be if the popular theory is correct?  And what does that mean for US production of goods and services?


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