Saturday, October 24, 2009

Just admit the free market works!

To all those out there complaining about the rise of the Canadian dollar, or to those in the US insisting that a lower dollar is beneficial: admit that the free market works!

Monetary values are driven by a few different factors. Supply and demand, of course, being the core function. In the past, demand for the US dollar was predicated on a false notion of security; that the US was home to the freest market and the strongest economy. Something a self-fulfilling prophecy has been propping up this perception for quite some time now since the fall of the Bretton Woods agreement, and certainly since the asset bubbles of the past 15 years.

When money creation is coupled with production, the demand for a currency can be retained. In a sound money economy, production increases over time (think electronics for the simplest example) as the money supply remains constant. This means that higher quality goods are produced in higher quantities, and the prices actually drop as supply is driven up against a constant money supply. But when dollars are produced by fiat at the printing press, the incentive to produce is weakened. Afterall, the inflation of the money supply will not be immediately felt, rather prices throughout the economy will be gradually bid up by consumers with more currency in their pockets. In the meantime, with more dollars and therefore better [temporary] purchasing power to buy foreign goods, it becomes cheaper to import than to produce at home. Why work harder to grow production when you've got more dollars and a higher purchasing power on others' production?

Of course, what happens over time is that prices are bid up to the extent that any increased purchasing power is wiped out as a new equilibrium is found. Now, with the dollar no longer beign stronger, it's time to go back to work and produce. And in fact, the foreigners now hold the dollars you spent to get their goods, so they have a stronger purchasing power and can have their turn at sitting back and waiting for the fruits of your labour to arrive at their doorsteps.

This is not the way it really works in global trade. Over the past many years, the US has convinced foreigners to accept their dollars for real production, and then to not spend those dollars, but rather invest them back into the American economy. This has created the bubble we are not even close to putting behind us.

But what if there were no increase in the money supply? China still has a relatively poor population compared to the people of the US. Their labour still would have been cheaper and would have produced goods that could compete for American dollars. The reason why a weak dollar is incorrectly perceived as a good thing is because it encourages exports, i.e. it ensures more jobs in production. A weaker dollar is the same as a lower wage, when it comes to the global marketplace. If Canadians have a strong dollar, it means we have a bigger wage to spend in the global market. If Americans have a weak dollar, it means they have lower wages. The problem is that in our current economies, dollar values are set by central bankers not the market.

Canadian manufacturers who are clamoring for a weaker dollar are in fact clamoring for a lower wage, plain and simple. Instead of having each labour group bargain its own wages with each management group, we have a monolithic central bank setting the price level. Unfortunately, that is not going to be enough, the bank cannot meet everyone's demands and find a common equilibrium. Only through the market can this be achieved.

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