Why and How All Currencies Devalue and Die
It is a common misconception that a currency is a permanent thing and cash is a safe asset.
Every currency is susceptible to devaluation or complete dissolution.
When this occurs, cash and bonds (promises to receive currency) become worthless or significantly devalued.
This phenomenon is largely tied to debt burdens and how economies manage these liabilities.
The printing of an excessive amount of currency and devaluing debt are often used as tools to alleviate or even erase these debts.
Once the debt burdens are sufficiently reduced or eliminated, the cycle of credit and debt expansion can continue again.
Below, we’ll explain this in a bit more detail.
Key Takeaways – Why and How All Currencies Devalue and Die
- Currencies are not permanent and can devalue or even cease to exist.
- History shows that the majority of currencies have either been significantly devalued or no longer exist.
- Currency devaluation often occurs due to excessive debt burdens and poor economic management. Governments may resort to printing money, causing inflation and a loss of confidence in the currency.
- When a currency devalues or dies, cash and bonds also lose value.
- However, this cycle allows for the reduction or elimination of debt burdens, paving the way for new credit and debt expansion cycles to begin.
- It’s important to be aware of this cycle when making financial decisions. Currency diversification is important.
The Impermanence of Currency
People’s belief in currency as a fixed thing is largely predicated on the inherent trust in the stability of their country’s economy and the faith they have in their government.
While those in emerging economies may experience currencies losing all their value, those in developed countries rarely do. In fact, it may never happen in their lifetime.
But no currency is permanent.
Of all the hundreds of currencies that have existed since 1850, approximately 80% of them don’t exist anymore.
The remainder have all been significantly devalued or merged into others – e.g., the French franc (1795-2002) and Spanish peseta (1868-2002) were merged into the euro, which began in 1999.
Why Currencies Devalue
The devaluation of a currency can occur for several reasons.
Most commonly, it is driven by a country’s economic policies, particularly those related to debt management.
Governments often resort to printing more money when they are unable to pay their debts with earned money.
This practice, known as debt monetization, increases the amount of money in circulation, thus devaluing the currency.
A report by the International Monetary Fund (IMF) found that 55% of emerging market and developing economies used this policy during the COVID-19 pandemic, causing significant devaluation of their currencies.
Moreover, high levels of inflation can also devalue a currency in real terms.
If the interest rate paid on it is low relative to the rate of inflation, it will devalue. This is also known as negative real interest rates.
Inflation often arises from a combination of excessive government spending, increased production costs, and high demand for goods and services.
For example, during the hyperinflation period in Zimbabwe between 2007 and 2009, the inflation rate reached an astronomical 89.7 sextillion percent per month, rendering the Zimbabwean dollar worthless.
There are also some impressive stats regarding the infamous Weimar Germany inflation of the 1920s.
For example, Germany’s entire money stock in 1919 would have bought you a single loaf of bread by 1923.
The Death of Currencies
In more extreme cases, currencies don’t just devalue, they cease to exist entirely.
This generally happens when the value of a currency drops so much that it becomes completely useless, leading to its replacement or abandonment.
A striking example of this is the German Mark during the Weimar Republic in the 1920s.
Faced with huge war reparations from World War I, the German government started printing money indiscriminately, leading to hyperinflation.
By 1923, the Mark was so devalued that people were using it as wallpaper or burning it for warmth.
It was ultimately replaced by the Reichsmark in 1924.
The Cycle of Devaluation and Death
When a currency devalues or dies, cash and bonds are also devalued or wiped out, affecting individual savings and investments.
This has a profound effect on the overall economy, creating a period of instability and uncertainty.
However, these periods are usually followed by the introduction of new monetary policies or even new currencies.
The reduction or elimination of debt burdens allows the cycle of credit and debt expansion to begin anew.
According to a study by Carmen Reinhart and Kenneth Rogoff, over eight centuries of financial history, such cycles are not only common but an almost inherent part of financial systems globally.
Step-by-Step Process of Why Currencies Dissolve
Here is a step-by-step explanation of how currencies can die due to excessive indebtedness:
- Government takes on too much debt – A government starts accumulating large debts due to excessive spending, reduced tax revenue, bailouts, wars, etc.
- Bond yields start rising – As debt grows, investors become concerned about the government’s ability to repay and demand higher yields on bonds, making it more expensive for the government to borrow.
- Central bank steps in – To keep bond yields from spiraling out of control, the central bank starts printing money and buying up bonds through what’s commonly known today as quantitative easing (debt monetization).
- Money printing causes inflation – Increasing the money supply to monetize debt and keep bond yields down leads to higher inflation. Prices start rising as the purchasing power of the currency declines.
- Loss of confidence in currency – With high inflation, citizens start losing confidence in the currency and flee towards more stable foreign currencies and non-financial assets like land, real estate, and gold. This creates even more inflation. People generally find it more advantageous to borrow in the currency than own it.
- Hyperinflation takes hold – Sometimes, uncontrolled money printing leads to hyperinflation, where prices rise extremely rapidly rendering the currency almost worthless. Life savings get wiped out.
- New currency introduced – With the old currency collapsed, the government has no choice but to introduce a new currency (often with removed zeros or a new unit of account entirely) and start over, though economic pain can last for years. Often it’s backed by something tangible, like gold and/or silver, to engender confidence in it.
- Currency death – The old currency become useless, people stop accepting it, and it ceases to have any value, effectively dying as hyperinflation makes it worthless. A new currency takes its place.
This shows how unsustainable debt loads can set off a spiral of rising yields, printing money, loss of confidence, hyperinflation, and eventually the abandonment of a currency altogether once it becomes worthless.
Curbing debt growth early is key to preventing currency destruction.
Fundamentally, it’s like the root of virtually all financial and economic problems – expenses rise above incomes and liabilities rise above assets.
What Do Countries Do When Their Currency Needs to Be Abandoned and Replaced?
The abandonment and replacement of a national currency is a big undertaking that is typically triggered by severe economic crises such as hyperinflation, war, or political transition.
Countries undertake a series of steps to ensure a smooth transition from the old currency to the new one.
Identifying the Need for Change
Firstly, a country must identify the need for a new currency.
This usually occurs when the old currency has lost its value and confidence to a point where it is no longer feasible to maintain it.
For instance, Zimbabwe abandoned its local currency in 2009 after hyperinflation rendered it worthless.
Policy Decisions and New Currency Design
Once the decision has been made, the country, typically through its central bank or monetary authority, will design the new currency.
This includes making policy decisions about the currency’s value, whether to peg it to another stable currency, or to let it float freely in the foreign exchange markets.
They will also determine physical aspects like the design and denomination of the new notes and coins.
Public Awareness and Distribution
A critical step in the process is creating public awareness about the new currency.
Governments typically launch extensive public information campaigns to educate the public about the new currency, the exchange process, and the timeline for the transition.
Following this, the new currency is distributed through the banking system, and the old currency begins to be phased out.
There’s typically a period during which both currencies are legal tender to allow for a smooth transition.
This occurs during mergers as well.
For example, when the French franc and Spanish peseta were being phased out in favor of the euro, there was a transition period between the euro’s introduction in 1999 and the franc and peseta being phased out by 2002.
Exchange of Old Currency
The government will set a deadline by which all old currency must be exchanged for the new currency.
This process may involve simply exchanging old notes and coins at banks for the new currency, or in more complex situations, assets and debts may need to be re-denominated in the new currency.
Economic Stabilization Measures
Alongside the introduction of the new currency, governments often undertake broader economic stabilization measures to restore confidence in the country’s economy.
This might include fiscal reforms, structural adjustments, or seeking assistance from international financial institutions like the International Monetary Fund.
Example: The Euro
One of the most prominent examples of currency replacement in recent history is the introduction of the Euro.
In this case, multiple countries simultaneously replaced their national currencies as part of the move toward greater economic integration in the European Union. The process was carefully coordinated, with old currencies gradually phased out over a period of several years.
What Can Traders Learn From All This?
Currency diversification is a critical strategy for traders and investors looking to safeguard their investments from the risk of a single currency’s devaluation or collapse.
This strategy involves spreading one’s investments across multiple currencies rather than holding all in one currency.
In investment management, this is often called “currency overlay.”
By diversifying their currency holdings, traders can offset potential losses in one currency with gains in another.
This is especially important in a globalized world where economic conditions and monetary policies vary across countries.
A country facing economic challenges may resort to devaluing its currency to mitigate debt and stimulate economic growth.
Traders who have diversified their investments can therefore reduce the impact of this devaluation on their overall portfolio.
Currency diversification also allows traders to capitalize on opportunities arising from potential changes in exchange rates. For instance, if a particular currency is expected to strengthen due to favorable economic conditions or sound fiscal policies, traders can adjust their holdings to take advantage of this potential appreciation.
Even having some portion of one’s portfolio in an asset like gold is an easy way to get currency diversification.
Therefore, learning from the cycle of currency devaluation and death, it becomes evident that currency diversification is a key tactic in the risk management toolbox of any trader or investor with a broad historical perspective.
It helps to reduce exposure to currency risk, enhance potential returns, and ensure the preservation of capital during periods of economic instability.
FAQs – Why and How All Currencies Devalue and Die
Why do all currencies devalue over time?
All currencies tend to devalue over time due to inflation.
Inflation is the general increase in prices and fall in the purchasing power of money.
It’s primarily caused by an increase in the supply of money, which occurs when governments print more currency.
This process decreases the value of existing money, leading to higher prices for goods and services.
Governments often use this strategy to reduce the real burden of debt, as the value of the debt decreases with the devaluation of the currency.
Thus, holding cash over long periods could mean losing value in real terms.
What does it mean when a currency dies?
A currency dies or collapses when it loses its status as a medium of exchange and a store of value.
This usually occurs in situations of extreme inflation, also known as hyperinflation.
Under hyperinflation, the value of the currency falls so rapidly that people lose confidence in it and stop accepting it in exchange for goods and services.
The loss of confidence prompts people to spend the currency quickly or switch to more stable foreign currencies or other means of exchange, causing the local currency to effectively die.
Why would a government print a lot of currency if it leads to devaluation?
Governments may resort to printing more money in response to economic crises or when they lack sufficient revenue to meet their expenses, including servicing national debt.
By increasing the supply of money, governments can stimulate economic activity in the short term.
However, if the increased money supply leads to spending outstrips economic growth, it will lead to inflation, which in the long run can undermine the value of the currency.
It is also perfectly fine for governments to spend more than they earn if such spending is going into projects and investments that yield positive ROI.
What are the signs that a currency might be in danger of devaluation or death?
Several signs might indicate an impending currency devaluation or death.
First, there are generally fiscal deficits.
There is generally not enough organic demand to buy the debt that’s produced as a result of these deficits.
Second, there are generally sellers of existing debt since the holders are receiving poor real returns on it.
This puts the central bank in a position to either let interest rates rise (which would create economic weakness) or buying the debt to keep interest rates down, which devalues cash and credit in that currency.
If inflation starts to get out of control and the government doesn’t take appropriate measures of tightening policy, the currency might be at risk.
How does devaluation affect cash and bonds?
Currency devaluation can erode the value of cash and bonds.
Cash loses its purchasing power as the prices of goods and services rise.
Bonds, which are essentially loans that investors give to the issuer in exchange for periodic interest payments and the return of the principal at maturity, are repaid in the devalued currency.
Thus, the real value of the returns from bonds is reduced, making them less attractive as an investment.
How can individuals protect themselves from currency devaluation or death?
There are several strategies individuals can adopt to protect themselves from currency devaluation.
One is to invest in assets that tend to increase in value over time in real terms.
Owning inflation-linked bonds can also help.
Other options include investing in commodities like gold, which often retain their value or increase in value when currencies are devalued (as a type of inverse money asset), or in stable foreign currencies.
Diversifying investments across a range of assets and currencies can also help to mitigate the risks associated with currency devaluation.
How does the cycle of currency devaluation and death lead to new credit/debt expansion cycles?
Once a currency has been devalued or has died and debt burdens have been reduced or eliminated, there’s typically a period of economic adjustment.
During this period, governments often implement a new currency and reforms to restore confidence in the economy. Generally, previous governments are replaced with new ones – sometimes violently through revolutions or sometimes peacefully through elections.
Once confidence has been restored, the cycle of credit expansion can start again, with new loans being made and new money being created.
However, if lessons from the past aren’t learned, these new cycles can eventually lead to another round of currency devaluation or death.
Conclusion
While it may be disconcerting to acknowledge the impermanence and volatility of currencies, understanding this economic reality is important.
Devaluation and death of currencies are essentially safety valves for economies, allowing for the resolution of excessive debt burdens and the opportunity for economic reset.
As such, it’s essential for individuals and institutions to consider this inherent risk when making investment decisions, particularly those involving cash and bonds.