The fact that the value of dollars and the supply of dollars are two completely different things is a very hard pill to swallow. For example, during the past period of quantitative easing, the USD has functionally not budged. It's sat right around the CAD, and the Euro has been volatile against the dollar which has actually created periods of flight to the USD, increasing its value. The USD is a reserve currency. Economists like to state that "The demand generated from its prime reserve currency status has added significantly to the value of the U.S. dollar over the past several decades." Now I'd like to say something about that last linked article... it's another one of the "scare you into buying my favourite investment" sites, so take it all with another mound of salt. Also notice that they talk extensively about the Euro becoming a more important reserve currency than the USD. Well, given the recent trouble in the Eurozone, the Euro's status as a reserve currency has become somewhat dimmed. The question is - how much value does being the world's reserve currency grant you? I wager it's actually one of the single most powerful tools in a state's arsenal for maintaining a steady currency value: has printing more money had an overall negative effect on the USD? Absolutely not. It hasn't because the supply of dollars doesn't matter. People who want the gold standard back, or who want to scare you into trying to buy gold, will tell you that the supply devalues the currency... but it hasn't. Neither has the creation of money out of nothing that private banks perform on a daily basis.
So what is it that people are buying in USD that they can't get in other currencies? Well, lots of stuff. The USA is still a massive producer of really really sweet and awesome stuff. The classical American of yesteryear was a successful entrepreneur, building cars, computers, and toilet seats. Nowadays, though, a major contributor to the price of the dollar is the global demand for oil. That's something rather major, and it's denominated in USD. Buyt that's not all. Lots of stuff is denominated in USD even though it has nothing to do with the USA! A fully 85% of transactions, to be specific.
Furthermore, sins against supply and demand are possible by fiat: the Yuan, for example, is pegged to a "basket" of currencies... because the Chinese government says so. Yes, it has adequate reserves to fend off any form of speculation that could change the Yuan's government-controlled value... but the important thing is that the yuan's value has nothing to do with anything... it's just set where the Chinese government wants it. Fine, you may say... a central government of a well-known authoritarian state can control its currency's value by fiat, but thats not possible in a democratic free market econom... oops. Switzerland.
...so, as we were saying, some government simply has to say "we'll buy or sell our currency as much as needed to make certain it stays at a give value", and the currency is pegged. They don't HAVE to do any buying and selling, just threaten... and speculators will keep the peace for fear of getting burned. It's like having a financial nuclear arsenal: I'm a country, I can tax, offer bonds, and even print this stuff if I need to, and I will use it to enforce my fiduciary will.
What's the situation then? We can say the following things are probably true:
1) Currency values are not based on their money supply versus their reserves. We know this theoretically because banks are allowed to create money out of nothing, and that money does not affect currency values. We know this practically, because the USD went through a significant period of quantitative easing and came through more or less unchanged in value.
2) Some currencies are "reserve currencies", and these currencies gain value by this status alone. The USD has certainly benefited from this situation, as has the Euro, which has, many have complained, been artificially inflated against the dollar.
3) States can peg their currency by fiat. They may use tools like China or like Switzerland, but it remains a fact that state actors have the ability to exercise the muscle of their reserves in order to maintain the value of their currency at a given level. Canada even did this for a long time, and Hong Kong still does.
4) The currency supply does not influence currency value so long as there is a demand for the currency in business transactions. The strength of a currency is therefore more linked to how much business is being done with that currency than how much of that currency exists. This explains why it is in China's long-term interest to keep propping up the US through loans, because a majority of their reserves are held in USD, and a huge number of USD flow to China to purchase goods. If we look at this loop backwards, we see that since the majority of China's foreign currency reserves are held in USD, and their ability to peg their currency depends on the USD's ability to maintain value. They loan cash to the US so that the US will continue to buy Chinese goods, which increases the Chinese USD reserve, which further ties China to the fate of the USD. If they would let their currency float, they would actually be able to unhinge themselves from the dollar and let it drop; sadly for them, they believe it necessary to peg for the good of their manufacturing sector.
Perhaps the greatest example of supply and demand in currency values being completely unhinged is the most recent (and oft-mentioned) episode of quantitative easing the US unleashed. Important to understand is that we would never have known how much money the US Treasury created out of thin air unless Sens. Paul, DeMint, Sander, and Grayson chased down the Fed and forced it to produce a reckoning of the full amount. It was the first ever audit of the Fed in its close to one century of operation. That, in itself, is huge news. The full audit report is here and the recommendations here, but the main feature is the full amount of the bailout.
To put things in perspective, Canada's annual governmental operating budget - to run the entire country in 2011 - is:
$235,600,000,000 CAD ($235 billion)
Canada's national debt is:
$586,000,000,000 CAD ($586 billion)
The amount that the American congress' Supercommittee failed to address is:
$1,200,000,000,000 USD ($1.2 trillion)
The USA's current debt - that is to say, all the money that the USA owes to everybody, is (at the current second):
$15,094,945,129,699 USD ($15 trillion)
The amount given to banks by the fed in the aftermath of the global financial crisis was:
$16,000,000,000,000 ($16 trillion)
Again, to put this in perspective - they could have paid off the entire US debt.
The amount given to CITIGROUP ALONE (2.5 trillion dollars) could have run Canada for ten years without any taxes on our population whatsoever. It was not voted upon, it came from nowhere, and it was simply dumped into the global economy without so much as a blip in the value of the USD that could be attributed to it. This is perhaps one of the most exasperatingly obvious examples of the failure of the international monetary system. While a bunch of senators argue about 1.2 trillion dollars and don't come to an agreement about what to cut, the Fed can print more than 10 times that and not be brought to task. The more you think of it, the more absurd it becomes.
Have you seen it in the news? No?
I might wonder why that is.
At the end of all this, what can we say money is? I think we can classify it more for what it does: it's a tool for the redistribution of wealth. Wealth, of course, is all the stuff in the world that lets us live happy and healthy lives. Here's the rub: there's only a finite world with a finite amount of wealth, and we've already seen that there is a functionally infinite money supply. Economic growth is great, but the planet isn't getting any bigger, and there quite simply isn't enough wealth in the world to be bought by all those dollars. If all the wealth in the world was worth a quadrillion dollars, and we could print ten quadrillion (which we can), would that mean there was all of a sudden ten times more wealth? No. It would simply mean there would be nine quadrillion dollars with nothing to buy, or everything would have to be priced 10 times greater. Money supply is not simply unhinged from its value; it's unhinged from the amount of food in the world. It's unhinged from our health. It's unhinged from our ability to access an education. It's unhinged from our ability to maintain the vital environmental services that protect our ability to live on this planet. The travesty of creating money does not rest with the simple lack of correspondence between the market forces of supply and demand on currency value. It lies in the fact that money is simply a tool to redistribute wealth in an economy, and we can't eat it. When the amount of money in circulation doesn't have anything to do with the amount of real wealth in circulation, wealth is not being distributed correctly. There's a problem here, and it isn't going to be solved by quantitative easing.
The Green Gap
In the Cold War, we feared a Missile Gap was a strategic weakness. Nowadays, we must awaken to the fact that the Green Gap is true strategic weakness: the nations whose economies will thrive in the coming years will not be those with the biggest factories, but those with the most sustainable, efficient, and ecological markets. What we require is a Strategic "Green Reserve" of ecological design to weather the coming changes that both climate and resource scarcity will force on the international economy.