Money, wealth, and currency risk
A common misconception is that money and wealth are the same thing. While they are related, there is a significant difference. Money is a medium of exchange and a storehold of value. However, wealth is the reward for productivity. According to billionaire investor Ray Dalio, this difference is the biggest driver of economic cycles.
The difference between money and wealth is best expressed by the two economies we live under. The real economy is based on supply and demand, as taught in school. In contrast, the financial or artificial economy is the one we experience. Central banks control this economy through inflation and credit [Dalio 2021].
When central banks raise or lower the supply of money and credit, it alters the demand and production of assets, goods, and services [Dalio 2021]. This artificial economy is the driver of the real economy. For example, when money is hard to borrow, companies cannot expand to meet new demand. At the same time, customers cannot borrow to purchase, shrinking the market. Thus, a new equilibrium is created by the artificial economy.
Value of Money
Supply and demand in the artificial economy applies to money, too. Expert on World Economies Kimberly Amadeo explains, "The value of money is determined by the demand for it, just like the value of goods and services." It is measured by comparing it to other currencies, the market for Treasury notes, and how much other countries hold [Amadeo 2023].
The value of money in the artificial economy is constantly changing, so that money today is worth more than money held in the future. This is because inflation steadily declines the value versus the opportunity to invest and grow the money. This is known as the time value of money.
Money can be a driver of economic activity. When invested, money acts as a catalyst for the real economy. However, when the artificial economy is restricted through inflation, money is used instead for inflation-hedge assets. This deflates the real economy and is the leading cause of inflationary depression.
Price vs. Value
There is a difference between the price of something and its value. When money is more available due to low-interest rates in the artificial economy, people tend to spend more [Dalio 2021]. This drives up prices and creates the illusion of wealth for those already owning assets. For example, when mortgage rates drop, people are more likely to purchase houses. This drives up the price of homes and makes those already owning a home appear to gain wealth.
However, this wealth is an illusion because the borrowed money must be paid back. This lowers the asset price because the price does not affect the value. The house selling for $100,000 more because of market conditions has not increased that much in value. After the buying frenzy slows, mortgage defaults appear, or interest rates rise, the price of those homes will align with the actual value of the asset.
The difference between your assets value and the current market price is calculated wealth [Dalio 2021]. Calculated wealth measures the value of assets one owns at a given time minus the debts [Kelly 2023]. The critical consideration is that wealth measures asset value, not price.
The Caffeine Effect
Just like a person needing to gain quick energy with a cup of coffee, the central bank uses money to jolt a sluggish economy. It does this with the stimulant of credit. However, like the end of a sugar rush, the economy slows when the money has to be paid back.
As markets rise, the central bank reduces the amount of the credit stimulant. This leads to the cyclical rise and fall of money, goods, services, and assets. The real economy gets the jitters when it cannot produce at the rate the artificial economy is pushing.
These boom and bust cycles from credit caffeine are divided into long and short-term cycles. The short-term cycle lasts approximately eight years, whereas the long-term cycle takes 50 to 75 years to complete [Dalio 2021]. We live at the tail end of the debt cycle created by the 1944 Bretton Woods Agreement—the one where the US dollar (USD) was chosen as the world's reserve currency.
A Change of Plans
Before 1944, countries tied their currencies to hard assets such as gold. After World War II, most countries agreed to fix exchange rates relative to the US dollar (USD) [Ghosh 2021]. In turn, the US provided gold on demand in exchange for USD. This worked until 1971, when President Richard Nixon revisited the deal to remove USD from the gold standard. As a result, currency values now fluctuate in price.
This difference in price between currencies created the Foreign Exchange Market (FOREX). Since a central bank controls the USD and most other currencies, the 1971 Bretton Woods Agreement created a gap between the value of a currency and its price. One that is regularly altered by monetary policy and the supply and demand of sellers and buyers [Jackson 2023].
In 1992, billionaire fund manager George Soros shorted the British pound by billions. As a result, he became famous for breaking the Bank of England, an event known as Black Wednesday, when a pound sterling collapse forced Britain to exit the European Exchange Rate Mechanism (ERM) [Kenton 2022].
Black Wednesday damaged the reputation of British Prime Minister John Major, who reportedly called Soros, begging him to stop the short. While newsworthy, this was just one of many currency crashes after separating the USD from gold. For example, in 1994, the Mexican peso (MXN) crashed to the point of needing external assistance from the US Congress and the International Monetary Fund (IMF) [Dornbusch, Goldfajn, Valdes 1995].
The crash of the MXN was not due to speculation. Instead, it resulted from high inflation, slow economic growth, and government debt—problems shared among many countries.
The Role of Speculation
Asset management firms, global corporations, and financial traders all speculate on currency for their specific purpose. Looking back at Soros's Bank of England attack, the conditions included misaligned exchange rates and ready financing to produce the imbalance [Dornbusch, Goldfajn, Valdes 1995]. George borrowed billions to short the pound sterling and, after the dust settled, pocketed over a billion dollars.
What Soros did to Britain can be done to any currency where the issuing country allows international capital to speculate. If the central bank controlling the money fails to ensure a healthy economy, it creates the events for the currency market to react. This speculation strategy makes self-fulfilling results uncorrelated with standard risk factors [Burnside, Eichebaum, Kleshchelski, Rebelo 2006].
In contrast, much of the currency speculation is in the line of business for international trade. Any company that imports or exports parts must create speculation strategies. To do this, these companies rely on currency traders. A middleman that often takes the opposite side of the trade [Weller 1998]. While risks occur, these transactions are not usually detrimental to an economy.
The Pressure of Debt
Money is tied to debt. A central bank prints money to lend it out to other banks who lend it to corporations and consumers. Individuals and businesses like the debt because it gives them more buying power than they would typically have. It also leads to assets rising in price and a feeling of prosperity.
The adage, "gold is the only financial asset that isn't someone else's liability," is illustrated by the fact that gold can be purchased and sold freely. In contrast, paper money is a debt asset [Dalio 2021]. It is not backed by anything of value and is always someone's liability.
Debt erodes earnings because income must be spent to pay the debt. As consumer debtors run into trouble when their income stops, countries can face problems when the money lent is not paid back. The usual solution for this is to print more money. A cyclic condition that creates more debt and eventually leads to the destruction of the monetary system like Mexico in 1994.
The supply and demand of printed money makes it difficult to measure the risk. Ray Dalio explains, "printing money is the most expensive, least well-understood, and most common big way of restructuring debts." It equally affects one's ability to buy groceries and a company's ability to grow.
Therefore, wealth must be held outside of money. In history, this has been wheat, cattle, land, gold, and even knowledge. For companies, it can be an intellectual property (IP) portfolio, hard assets, or even secret knowledge like Coke-Cola.
Amadeo, K. (2023) What Gives Money Its Value. the balance. https://www.thebalancemoney.com/value-of-money-3306108
Burnside, C., Eichebaum, M., Kleshchelski, I., Rebelo, S. (2006) The Returns of Currency Speculation. Northwestern University. https://www.kellogg.northwestern.edu/faculty/rebelo/htm/returns_currency_speculation.pdf
Dalio, R. (2021) Principles for Dealing with The Changing World Order. Avid Reader Press
Dornbusch, R., Goldfajn I., Valdes, R. (1995) Currency Crises and Collapses. Brookings Institute. https://www.brookings.edu/wp-content/uploads/2016/07/1995b_bpea_dornbusch_goldfajn_valdes_edwards_bruno.pdf
Ghosh, A. (2021) From the History Books: The Rethinking of the International Monetary System. International Monetary Fund. https://www.imf.org/en/Blogs/Articles/2021/08/16/from-the-history-books-the-rethinking-of-the-international-monetary-system
Jackson, A. (2023) A Basic Guide To Forex Trading. Forbes. https://www.forbes.com/advisor/investing/what-is-forex-trading/
Kelly, R. (2023) Understanding Wealth: How Is It Defined and Measured? Investopedia. https://www.investopedia.com/terms/w/wealth.asp
Kenton, W. (2022) Black Wednesday: Definition, Causes, Role of George Soros. Investopedia. https://www.investopedia.com/terms/b/black-wednesday.asp
Weller, C. (1998) Currency Speculation - How great a Danger. Dollars & Sense. https://www.dollarsandsense.org/archives/1998/0598weller.html