How quantitative easing works — or doesn’t (Part Five: Currencies)
Although world market prices tend to be denominated in dollars, it would be a mistake to conclude that the formation of world market prices is a consequence of the use of the dollar in transactions. Rather, world market prices are increasingly denominated in dollars because the production process has become globalized. Since the price of a good is only the expression of the value (or, socially necessary labor time) embodied in the good, which can never be directly measured, the value of a good expresses itself in the material bodily form of some other object whose use is to serve as money.
But, the world market is composed of dozens of countries each having their own national currency. Given the myriad of currencies, the denomination of goods in the currency of the dominant nation simplifies the task of comparing production costs across nations, each nation having its own specific conditions of production.
By quoting the cost of labor power and commodities in a single currency, global corporations can more accurately compare their costs of production, and measure their return on investment using a single yardstick. This single yardstick then becomes the preferred unit of measure and denomination of prices.
This is necessary to point out because of a persistent myth spread by economists that the object serving as money is money owing to some legal requirements established by the State — for example, this view holds that dollars are money because they are declared legal tender by the federal government of the United States.
The laws of the United States apply only to the United States; they do not apply to France, Brazil, Senegal, Bhutan or any other nation. Yet, despite this apparent limitation on the reach of US law, it does not matter in the least how many euros, pounds, yen, yuan, or reals you have in your possession when you go shopping in the great global mall of the world market; the world market prices of goods are denominated and payable in dollars. For example, if Senegal wishes to buy 100 barrels of oil, its currency, the CFA Franc, is useless unless it is first converted into dollars. This requirement is imposed on Senegal by existing world market conditions without respect to the laws on its books concerning what legally constitutes money.
In the previous chapter, we showed that should the Bank of England undertake to impose a price inflation rate of 2 percent a year on the British economy the policy would ultimately fail to prevent deflation because, frankly, there is no such thing as a British economy, and, in any case, the price of goods are not determined within the confines of Great Britain but within the world market as a whole. Yet, the myth of the national economy persists as a habit of thinking although national economies have long since been replaced by a global production process.
If the Bank of England were to take the total supply of pounds and double it — or cut it in half — the net effect on real prices for output would be zero. Whatever inflation the Bank of England were to generate in domestic prices would be offset by the decline in the exchange rate of its currency.
We want to be clear that what we said for the Bank of England also applies to the Federal Reserve of the United States: an attempt by the Federal Reserve to create inflation of 2 percent in the US economy will have exactly the same effect on the dollar as it has on the British pound. As in the case of Britain, should the Federal Reserve Bank undertake to impose a price inflation rate of 2 percent a year on the American economy the policy would ultimately fail to prevent deflation because, frankly, there is no such thing as an American economy, and, in any case, the price of goods are not determined within the confines of the United States but within the world market as a whole.
Likewise, if the Federal Reserve were to take the total supply of dollars and double it — or cut it in half — the net effect on real prices for output would be zero. Whatever inflation the Federal Reserve were to generate in domestic prices would be offset by the decline in the exchange rate of its currency. So, to the extent certain commodities are priced both in dollars and, for example, euros, the ratio between the dollar price of the commodity and the euro price of the commodity will adjust appropriately.
There is, however, one important difference between the United States and Great Britain: although, US prices have indeed risen against world market prices, to the extent these world market prices are denominated in US dollars, no change can take place in the exchange rate of the dollar.
Instead, world prices are depreciated against all currencies other than the dollar, or, what is the same thing, the purchasing power of all other currencies appreciate. If you have been a close reader of this blog you will know that the appreciation of the purchasing power of money is an indicator that an economy is contracting — i.e., that the economy is falling into a depression. Here, however, rather than the appreciation of a national currency resulting from an economic contraction, the economic contraction is imposed on the economy by the increase in the purchasing power of its money.
How does this happen?
As in the case of Great Britain, there is nothing a country can do through its monetary policy to affect the new world prices which emerge once the Federal Reserve has successfully created an inflation of 2 percent. Should, for example, China attempt to devalue the yuan against the dollar to maintain its export surplus, it would find the domestic rate of inflation rising. Should it attempt to contain domestic inflation, it would find that the exchange rate of the yuan with the dollar is rising.
The loss of control over its own monetary policy is absolute — without warning, and quite suddenly, every other nation on the planet finds the Federal Reserve unilaterally dictating monetary policy for the entire global economy.