Tuesday, November 01, 2011

Explaining Currency Valuation

My attempts to explain currency value continue. I was thinking how we tend get caught up with mechanical determinants of currency value. One way of thinking about currency is to think about two different things. First being capability of the nation and second being a mechanism to measure it.

Capability
Capability refers to ability of the country to produce surplus benefit. I am deliberately using vague terms because what one nation construes as benefit may not be the same for others. But key term is surplus. Surplus implies the nation must produce more than it needs for subsistence. So benefit must be discretionary.

The Mechanism
The mechanism to measure it is simply numerical denominator of that value into discrete quanta. If the denominator is high, we can split the value into smaller parts - more numerous shares within the pie but size of the total pie remains the same.


Understanding the complexity of currency valuation
Imagine there are 100 units of currency and 100 widgets (all exactly the same). The equivalence is 1unit of currency for 1 widget. This is a stable version of ideal.

Let us introduce a slight complexity. Imagine, suddenly we have 200 units of currency instead of 100, the equivalence will be 2 units of currency for 1 widget. This is called inflation.

Let us bring add a little more complexity. In this, the number of widgets also keeps growing as does the currency. Now there are three scenarios. 
  1. Widgets grow to 200 and currency also grows to 200. Here we have continuity in ideal situation.
  2. Widgets grow to 200 currency grows only to 150. Here we have deflation.
  3. Widgets only grow to 200 but currency grows to 400. This amounts to inflation.
Now imagine instead of just one type of widget we have two types of widgets. First one is food widget which is highly in demand and other is fun widget which comes after food. Now imagine if an economy produces only fun widgets and there are not enough food widgets for the population. In such case, food inflation will spike up - i.e. currency value of food widgets will grow higher and that of fun widget, naturally, will grow lower.

Now reality is far more complex. Instead of few types of widgets, we have vastly innumerable and ever expanding universe of products and services. Further, each product does not have same relative position to the universe, they keep changing. In other words its chaotic.

The question, therefore, is how to ascertain how much increase in currency is ideal. Clearly, there is no easy answer.

Cannot decipher if currency is correctly valued 
Never, and I am going out on a limb here, is a currency correctly valued as per its fundamentals. Rather, the value of currency is the opinion of select few stating that value is within ball-park. It is relatively easier to know when a currency is not in ballpark of its fundamental value.  In other words, while we cannot determine what the value of currency should be, we can be reasonably certain what it should NOT be. Any analysis beyond this is self-justification or retrofitting explanation to suit analysis.

Borrowing from Physics, currency values seem to obey something similar to the Heisenberg's Uncertainty principle. We can predict the value of any currency generally, but never exactly. And just like the Heisenberg's principle, the very act of determining the value upsets the value.

What should NOT be the value of the currency?
The key lies in looking at the "benefit" we stated earlier. "Benefit" is net of two things. On one hand, lets call it the income side, it includes the ability to produce larger number of widgets (productivity), the ability to produce wider variety of widget (innovation) and the ability to produce unique widgets (strategic advantage). On the expense side, we have committed expenditure including non-discretionary spending and part of income committed to taxes and debt repayment. Benefit, to reiterate, is net of these two things.

When we compare currencies of two nations, if the difference in benefit is largely or appreciably in favour of one, then the currency of that nation should be strong and other should be weak. Again, we cannot exactly determine the difference as discussed earlier but only generally.

About US dollar
My contention is that US Dollar is artificially high considering US economy offers no particularly differentiated benefit as compared to other economies. This is also generally true of all developed nations. That is why I am skeptical of developed economy currencies.