In the foreign exchange market, we can express an exchange rate in either of two ways; how much Currency A it takes to buy a unit of Currency B, or how much Currency B it takes to buy a unit of Currency A. From the standpoint of A, you could call the exchange rate the “price” of B, or from the standpoint of B, you could call the exchange rate the “price” of A. The numbers are reciprocals of each other. We could for instance say the “price” of a euro is 1.128 or that the “price” of a dollar is 0.887.
This second terminology – calling it a “price” – has a subtle defect. If you call the exchange rate between A & B the “price” of B, you’re putting all the focus on B, giving short shrift to the equally important role of A. You could just as easily have considered the same quantity, inverted, as the “price” of A, omitting mention of B. Either way, you’d be putting all the emphasis on only one of an equally important pair of commodities, leaving out the the other. This is particularly the case when considering the all-importing direction of movement, say of “increasing oil prices”. What may be increasing in one currency may be decreasing in another.
So this, unsurprisingly, is not the rule in the forex markets. Traders and media refer to cross rates in more balanced terms, such as “dollar/yen”, or “euro/dollar”, recognizing that the number stated is function of both, reflecting the relative value of the two.
But a little reflection reveals that in fact every “price” is an exchange rate. We casually refer to the “price of oil”, for example, as if there were only one commodity under consideration. It’s as if the value of the other, the unstated currency, were irrelevant. This omission becomes glaringly obvious if the currency at bar is rapidly depreciating, as in hyperinflation. If you were carting a wheelbarrow full of trillion mark Weimar notes to the grocery store to buy a loaf of bread, you’d be forced to recognize that the value of the bread is nearly irrelevant, that instead the value of your currency dominates the “price of bread”. Attributing a price in trillions to the bread itself is obviously absurd.
So where is the cutoff? Exactly at what point does the value of the currency become irrelevant in stating the price of anything? The simple answer is never.
There is simply no such thing as the price of something being solely a function of the something being identified. It is always a ratio of two market values, one in terms of another. This does not magically become true once the thing whose price is named merely isn’t another currency. Our habit of referring to such things as the “price of oil”, the “price of bread” or the “price” of a share of stock has a profoundly addling effect on our cognitive process. It leads us to overlook the role of the other commodity – the one in which we’re setting the “price” – as an equal partner in determining the number we’re citing. Strictly speaking we should always ask what currency is involved in determination of this thing you call “price”. This is made abundantly obvious by the fact that the “price” of any of these things will vary dramatically depending on whether the unstated commodity happens to be, say, dollars, or yen.
Moreover the value of those dollars or yen themselves are changing quantities. Prudent cognitive hygiene demands we say something like “the exchange rate between a barrel of oil and a US dollar is X”. Or if we need more detail, plot a chart as a function of time … but crucially it’s always and everywhere a rate of exchange between two commodities. Our linguistic illusion of the “price” of something as an isolated community is a fantasy … it doesn’t exist.
But okay, Finster, you may be thinking. You’re theoretically, technically, correct, but why make such a big deal of it? So what?
It’s the biggest, most consequential conceptual distortion in finance and economics.
It leads us to celebrate an increase in the value of our investments when in fact we have no proof whatsoever that our investments have increased in value. We haven’t considered the possibility that the commodity in which we price them has instead deceased. We celebrate currency depreciation so long as it’s showing up primarily in asset prices, failing to realize it will ultimately show up in less fun places.
It also accounts for untold numbers of failed market forecasts. A highly reputed commodities analyst will, for example, delve deeply into the supply and demand dynamics of oil, but fail to consider the supply and demand dynamics of that other crucial commodity involved in determining a “price” … those of the currency the price is to be reckoned in. Result: the forecast comes out wrong, even if the analyst gets all the oil factors right. If even acknowledged, the error get chalked up to unexpected developments.
Worse yet, our headlines chalk up every surge in price to oil fundamentals. They’re constantly in flux, but they take on an exaggerated role in the public mind when the dollar is depreciating. In the inflationary seventies, the world was convinced it was running out of oil. Peak oil hysteria peaked again in 2008 as inflation rose and oil prices hit $147 a barrel … mere months before a deflationary crash saw them pummeled into the twenties. We’ve seen it again in 2022, in the wake of the biggest explosion in monetary and fiscal profligacy in history.
So awright, Fin, what you gonna do? Change the whole language of finance?
If only we could! But failing that, we can at least have our antennae up. Because of our long and ongoing immersion in the illusory world of single commodity values, it takes a sustained effort, but we can constantly remind ourselves of one crucial axiom of value: It’s all relative.
If we are reading an erudite analysis of oil prices, we can look for evidence the analyst has considered supply and demand variables for both commodities, and weigh our opinions accordingly. If our investments have been “going up” for years, we can be on the lookout for signs that currency depreciation might be about to spill over into consumer prices, and react accordingly. Even if most analysis of the investment outlook is distorted by the price fallacy, our own need not be. We can use our clarified insight to give us an edge over the crowd. Just by reminding ourselves:
It’s all relative.