In my post on currencies a couple of days ago, in which I discussed the strength and weakness of various currencies with respect to one another, the question I left unaddressed is what determines those relative values and whether there is in fact a “right answer” as to the value of each currency.
As is common with economic questions, there are several right answers, depending on how you look at it. One way to consider the value of one currency relative to another is to look at the markets—how many yen will it take to buy a dollar? The foreign exchange, or forex, markets are among the largest in the world. When currencies are allowed to freely float, or trade at will, the markets will determine what a currency is worth. This is the most transparent and informative way to set values, as it reflects a wide, liquid market with many participants.
Unfortunately, the market can deliver results that are inconvenient or damaging for governments, the issuers of the currencies. In a middle world, governments can attempt to change the value of their currencies in various ways. The simplest way is to create more of that currency, which, by increasing the supply, will lower the price if demand remains constant. The Swiss government recently did this in response to the strengthening of the Swiss franc, which was making Swiss exports too expensive in terms of other currencies.
The flip side is to attempt to restrict supply of a currency in an attempt to strengthen it. An example would be a country spending its foreign currency to buy up its domestic currency. This both increases demand for the domestic currency and reduces supply and can be effective in supporting the value of the domestic currency—until that government runs out of foreign currency to do so. Then the market takes over again, often with a vengeance. Until recently, Venezuela was doing this, among other things, to support the value of its currency.
Finally, countries can agree on an exchange rate that they will mutually support, either at a fixed rate or within a band. The reason to do so is to minimize the uncertainties and costs for businesses or individuals trading among the countries. The euro, for example, was preceded by just such an agreement among the European countries, and the Chinese currency was formally pegged to the U.S. dollar from 1994 to 2005; even now, it appears to be managed closely by the Chinese government—much to the U.S. government’s stated unhappiness.
There are other ways to affect exchange rates that are less explicitly interventionist, most of which have other primary objectives. Higher interest rates, for example, make a currency relatively stronger, and strong growth in a country can also increase demand for a currency, making it relatively stronger. On the other hand, higher inflation rates make a currency relatively weaker. At the end of the day, exchange rates are a result of multiple factors, which makes it hard for a democratic government to manage them closely for long. We have seen this most clearly in the building economic imbalances in the eurozone, which may yet collapse. The peripheral countries have historically rebalanced their economies by devaluing their currencies. With the euro, they no longer have that option—and the process of rebalancing through reducing wages and consumption is politically much more painful.
Even as countries attempt to manage their currencies, they are implicitly doing so against what they perceive as a “fair,” or properly valued, exchange rate. One way of determining such a fair exchange rate is to compare the ability of a currency to buy things. This is not a perfect mirror, since wages, regulations, and actual supplies of different materials vary from country to country, but it is a reasonable proxy. This method is known as “purchasing power parity,” from the idea that equivalent buying power should result in an equivalent cost in each currency.
There have been many versions of this, each of which attempts to account for the problems I mention above in a different way, but my favorite is presented by The Economist magazine, which presents the cost of a Big Mac hamburger from McDonald’s as the base asset and compares that across currencies and countries; view the index here.
From the index, you can see that the Swiss franc, for example, remains overvalued, as does the Venezuela bolivar—although for opposite reasons. You can also see a very wide range in valuation.
Over time, markets do tend to get currency values right, but they can also be way off. The Big Mac index, although certainly not perfect, provides one way to look at just how out of whack markets are at any given time; it also provides some context to the contention, for example, by the European Central Bank that the euro is too strong. And it can provide some guidance as to where the U.S. dollar is and what that might mean for import costs—especially for oil—going forward.