The Fine Art of Currency Manipulation

This is the fifth post in a series entitled Currency, Money and the Economy.

When President Nixon took the dollar off the gold standard in 1971, he effectively made every single currency in the world a fiat currency. The price of the US dollar and every other currency in the world is backed only by the faith and credit of each nation. The price of each one of these currencies can be measured relative to one another through foreign exchange rates and can be traded on the foreign exchange markets, also known as FOREX. In theory, based on the amount of currency each nation has printed, the exchange rate between two countries is set by the supply and demand for each currency on the FOREX market.

When you travel overseas and need to exchange US dollars for Euros, you are actively participating in setting the foreign exchange rate. When one country has accumulated currency of another country, under the rules of international trade, they are required to trade back the other country’s currency for their own currency so they can reinsert it back into their own economy. However, in recent years, central banks in every country have developed methods to manipulate the price of their own currency to suit their economic needs.

Why would a nation want to manipulate its own currency? The reason is simple. The price stability of the goods and services of its country must be maintained in order to maintain political stability. Economic instability has been the downfall of many a nation throughout history. To reiterate a couple of definitions, when a country is a nation of savers, inflation is the enemy because for each unit of currency a country prints, it devalues every other one being held in a bank deposit account. When a country is a nation of spenders, deflation is the enemy because falling prices increases leverage on debt. Therefore, a country will usually manipulate its own currency when it is trying to avoid these outcomes.

The easiest way for a country to manipulate its currency is through the issuance of national bonds, or a simpler definition, IOU’s. For the United States, it issues US Treasury bonds in all shapes and sizes. For example, let’s say Brazil has accumulated $100 million US through international trade. In theory, Brazil is supposed to go to the FOREX market and trade the US dollars that it has for Brazilian reals. However, this action would weaken the US dollar and strengthen the Brazilian real from a supply and demand perspective. Since Brazil likes the current relationship with the US dollar because it allows for cheaper exports to the United States, it does not want to weaken the US dollar. Therefore, Brazil loans back the $100 million US for US Treasury bonds and will wait a number of years for the currency back with interest. Therefore, Brazil and the United States short-circuit the currency trading aspect in order to maintain the strength of the Brazilian real relative to the US dollar. How does Brazil make up for the Brazilian reals they were theoretically supposed to receive for trading US dollars? That’s easy. Their central bank simply prints more of them!

By bypassing the supply/demand rules of the free market system by issuing national bonds, all countries are guilty of currency manipulation. The best analogy is to get twenty people in a room and have them start writing IOU's as fast as they can and pass them off to one another. By writing an IOU, they avoid having their currency weakened. And by buying someone else’s IOU, they are allowed to print more currency into circulation (historical playbook, step 5)! If you and I were to do that, we would be arrested for check fraud. Yet central banks around the world do it every day. Is it illegal? Not to them. Is it immoral? You can decide that for yourself.

In the next post, we will look at some of the more creative currency manipulation examples.