Balance of payments and the exchange rate: is there a connection?

According to conventional analysis, a key factor in exchange rate determination is the state of the balance of payments. It is held that as long as the US continues to run a large trade account deficit, which stood at $48.5 billion in January 2017, this is likely to keep pressure on the US dollar exchange rate against other currencies.

Following this logic, an increase in imports gives rise to an increase in a demand for foreign currency. To obtain the foreign currency importers will sell the domestic currency for it. Obviously, this will lead to the strengthening in the exchange rate of the foreign currency against the domestic currency, so it is held.

Conversely, if there is an increase in exports, all other things being equal, then once the exporters exchange their foreign currency earnings for domestic currency this sets in motion a strengthening in the domestic currency exchange rate against the foreign currency.

In this way of thinking, exporters determine the supply of foreign currency whilst importers determine the demand for foreign currency. Hence, the interaction between the supply and demand establishes a foreign exchange rate.

Following this logic, it makes sense to conclude that the state of the balance of payments, which is the result of the interplay between exports and imports, is a key in determining the foreign exchange rate.

Importers and exporters and the demand and supply of foreign currency

Is it correct to say that the supply of foreign currency is determined by exporters whilst the demand for foreign currency is set by importers?

For instance, the demand for the Yen emanates not only from American importers of Japanese goods and services but also from the Japanese themselves.

Every bit of economic activity that takes place in Japan gives rise to demand for Japanese money – the Yen. For instance, a Japanese producer of shoes exercises his demand for money by selling his product (shoes) for Yen, which in turn he could employ some time in the future, in order to be able to buy other goods and services.

Likewise, the producers of other goods and services exercising their demand for money by exchanging their produced goods and services for money, which in due course is going to be exchanged for other goods and services.

What is the source of the supply of foreign currency such as Yen and the Euro? In the modern monetary system, the source is central bank monetary policy and fractional reserve banking. The quantity of Yen and Euros is set by the relevant central banks and fractional reserve banking and has nothing to do with the activity of exporters.

Moreover, we suggest that, with all other things being equal, the respective monetary policies of central banks determine the respective purchasing power of money. This in turn determines the exchange rates. Here is how.

The relative purchasing power of money and the exchange rate

A price of a basket of goods is the amount of money paid for the basket. We can also say that the amount of money paid for the basket of goods is the purchasing power of money with respect to the basket of goods.

If in the US the price of a basket of goods is $1 and in Europe an identical basket of goods is sold for 2 Euros then the rate of exchange between the US$ and the euro must be two Euros per one dollar.

An important factor in setting the purchasing power of money is the supply of money. If over time the rate of growth in the US money supply exceeds the rate of growth of European money supply, all other things being equal, this will put pressure on the US$.

Since a price of a good is the amount of money per good, this now means that the prices of goods in dollar terms will increase faster than prices in Euro terms, all other things being equal.

Another important factor in driving the purchasing power of money and the exchange rate is the demand for money. For instance, with an increase in the production of goods the demand for money will follow suit.

The demand for the services of the medium of exchange will increase since more goods now are expected to be exchanged. As a result, for a given supply of money, the purchasing power of money will increase.  Less money will be chasing more goods now.

Within any domestic economy, every individual is both an exporter and an importer. Individuals that produce and sell goods and services to other individuals can be regarded as exporters of these goods and services whilst individuals who buy these goods and services can be regarded as importers.

Since in a domestic economy every individual is both an exporter (a seller) and importer (a buyer), the state of this selling and buying can be ascertained by the domestic balance of payments. Note that the balances of payments do not alter the purchasing power of money in that country. This is because, for a given money supply, an individual that sold his goods has increased his demand for money whilst an individual that bought these goods has reduced his demand for money. Consequently, no change in the overall demand for money takes place.

This means that for a given supply of money and an unchanged demand for money the purchasing power of money remains unchanged.

As with the balances of payments within a country, the balance of payments between countries does not cause changes in the respective purchasing power of money and hence does not determine the currency rates of exchange.

Indeed we can observe that a narrowing in the US trade account deficit with Japan between June 2007 and February 2009 was actually associated with a decline in the exchange rate of the US dollar versus the Yen – less Yen per US dollar (see chart), the exact opposite of the popular conceptualization.

Now, from March 2012 to January 2017 a narrowing in the US trade account deficit with Japan was associated with a strengthening in the US dollar versus the Yen, which is in line with the popular framework. What is clear that there is no observable clear relationship, which supports the popular thinking regarding the balance of payments and the exchange rate.

Printing money and the exchange rate

Let us assume that the rate of exchange between the U.S. dollar and the Yen is 1:1, i.e., one dollar for one Yen, and it is in line with the respective purchasing power of the U.S. and Japan.

Now let us further assume that money is created out of “thin air” in the U.S. American importers employ the new money to buy Yen. In the process, the exchange rate of Yen against the dollar appreciates to $2:1Yen. With the Yen, Americans now buy Japanese goods. The trade balance between the U.S. with Japan moves into deficit. Observe that what we have here is an exchange of nothing for something. Americans exchange their money, which is unbacked by production, for Japanese goods.

The Japanese would then have difficulty in securing real goods from Americans for dollars they have received since these dollars are unbacked by production. This is manifested by an increase in the prices of goods in the U.S. Hence, by means of empty dollars, Americans have diverted to themselves real resources from Japan.

Consequently, what we have here is a fall in U.S. money purchasing power, a fall in the U.S. dollar rate of exchange against the Yen and the U.S. trade deficit with Japan.

Note that conventional thinking would attribute the weakness in the US dollar versus the Yen to the US trade deficit.

As we have seen, this logic is an erroneous explanation of the fall in the US dollar because it ignores the decline in the relative purchasing power of the dollar. Any deviation of the exchange rate from the rate set by the relative purchasing power of money will set in motion an arbitrage, which will undo the deviation.

Trade balance as an indicator of wealth redistribution

Note, that while the trade balance does not determine the exchange rate, it does provide an indication of the extent of monetary abuses by the central bank. It provides an indication regarding the diversion of foreigners’ real wealth to the country that is engaged in reckless monetary policy.

Since the U.S. dollar is the most accepted medium of exchange, the U.S. central bank’s monetary policy is an important means in the diversion of foreigners’ real wealth to the Americans.

In Q3 2016, holdings of US dollars as a percentage of the world total foreign reserves stood at 63%. Note that in Q2 2001 this percentage stood at almost 73%.

The diminishing popularity of the US Dollar is an important vehicle for the decline in the diversion of real wealth from foreigners to Americans.

All other things being equal, this decline continues to undermine the living standard of Americans who have been benefiting from the diversion of real wealth from the rest of the world to them.

Now, within the framework of a fixed exchange rate excessive monetary pumping by a country’s central bank will lead to a run on the currency of that country and thereby put a halt to that loose monetary policy.Again, by printing the most popular international medium of exchange, the US central bank enables the first receivers of dollars, which happens to be Americans, to divert real wealth from the rest of the world.

However, in the framework of a floating exchange rate system, the adjustments in the rates of exchanges are smooth and it takes a long time before the crisis point emerges.

Moreover, if all central banks are coordinating their monetary policies, as is the case at present, the crisis can be averted for a long period.

Only if central banks stop coordinating their policies can a currency plunge and an economic crisis emerge – this follows when one central bank pushes its monetary pumping more aggressively.

In the floating exchange rate framework, by means of monetary policy coordination central banks can create the illusion of currency stability.

The longer the current floating exchange rate regime is allowed to function the more damage that is going to be inflicted on wealth producers. The way out of this mess is to revert to a market-chosen money, which happens to be gold.

Summary and conclusion

Contrary to a popular belief, the state of the balance of payments has nothing to do with the determination of exchange rates. The key factor behind the rate of exchange determination is the relative purchasing power of various monies. The trade balance statistics could be however useful in ascertaining the diversion of foreigners’ real wealth from the rest of the world to the US given that the US dollar is the most popular money created out of thin air by the US central bank and the US banking system. As long as the floating exchange rate regime is allowed to function the more severe damage is inflicted onto the process of real wealth generation. One way out of this mess is the introduction of a gold standard.