Emerging Market Time Bomb: "Dollar is Our Currency But Your Problem" Take II
President Nixon's Treasury Secretary, John Connally, famously told famously told a group of European finance ministers worried about the export of American inflation that the "dollar is our currency, but your problem."
On August 15, 1971, in what's known as Nixon Shock, president Nixon directed Treasury Secretary Connally to suspend, with certain exceptions, the convertibility of the dollar into gold or other reserve assets, ordering the gold window to be closed such that foreign governments could no longer exchange their dollars for gold.
The immediate result was a prolonged period of "stagflation" defined as rising inflation accompanied by recession.
Nixon Shock unleashed enormous speculation against the dollar. It forced Japan’s central bank to intervene significantly in the foreign exchange market to prevent the yen from increasing in value. Still, this large-scale intervention by Japan’s central bank could not prevent the depreciation of US dollar against the yen. France was willing to allow the dollar to depreciate against the franc, but not allow the franc to appreciate against gold. In 2011, Paul Volcker expressed regret over the abandonment of Bretton Woods: "Nobody's in charge," Volcker said. "The Europeans couldn't live with the uncertainty and made their own currency and now that's in trouble."
Unrestrained by trade concerns, and gold outflows, central banks could and let money supply growth run rampant.
Credit exploded, and a series of economic bubbles began, each with a bigger amplitude than the one that preceded it.
Bubbles of Increasing Amplitude
- Dotcom Bubble - 2000
- Housing Bubble - 2007
- Everything Bubble - 2018
Powell's Self-Serving Whitewash Warning
On May 8, Jerome Powell, chairman of the U.S. Federal Reserve, Warned Against Overstating Impact of Fed Policy on Global Financial Conditions.
Our subject is the relationship between "center country" monetary policy and global financial conditions, and the policy implications of that relationship both for the center country and for other countries affected.
The well-known Mundell-Fleming "trilemma" states that it is not possible to have all three of the following things: free capital mobility, a fixed exchange rate, and the ability to pursue an independent monetary policy. The trilemma does not say that a flexible exchange rate will always fully insulate domestic economic conditions from external shocks. And, indeed, that is not the case. We have seen that integration of global capital markets can make for difficult tradeoffs for some economies, whether they have fixed or floating exchange rate regimes.
In an attempt to absolve the Fed of wrongdoing, Powell cautioned: "The influence of U.S. monetary policy on global financial conditions should not be overstated. The Federal Reserve is not the only central bank whose actions affect global financial markets. In fact, the United States is the recipient as well as the originator of monetary policy spillovers."
Powell then posted a series of charts and comments allegedly exonerating the Fed. "Research at both the Fed and the IMF suggests that actions by major central banks account for only a relatively small fraction of global financial volatility and capital flow movements," said Powell.
"Market expectations for Fed policy seem well anchored with policymaker expectations." Jerome Powell
That statement is true now, but it was not at all true for years.
Powell also stated "The linkages among monetary policy, asset prices, and the mood of global financial markets are not fully understood."
Of course they are not "fully" understood, but it is also crystal clear that central banks have blown bubbles.
Emerging Market Time Bomb
On May 6, economist Daniel Lacalle discussed the emerging market time bomb in Behold The Sudden Stop. Risk of Emerging Markets Collapse.
The recent collapse of the Argentine Peso and other emerging currencies is more than a warning sign.
It could be the arrival of a “sudden stop”. As I explain in Escape from the Central Bank Trap (BEP, 2017), a sudden stop happens when the extraordinary and excessive flow of cheap US dollars into emerging markets suddenly reverses and funds return to the U.S. looking for safer assets. The central bank “carry trade” of low interest rates and abundant liquidity was used to buy “growth” and “inflation-linked” assets in emerging markets. As the evidence of a global slowdown adds to the rising rates in the U.S. and the Fed’s QT (quantitative tightening), emerging markets lose the tsunami of inflows and face massive outflows, because the bubble period was not used to strengthen those countries’ economies, but to perpetuate their imbalances.
The Argentine Peso, at the close of this article, lost 17% annualized is one of the most devalued currencies in 2018. More than the Lira of Turkey or the Ruble of Russia.
When the US dollar regains some strength, US rates rise due to an increase in inflation, the flow of cheap money to emerging markets is reversed. Synchronized indebted growth created the risk of synchronized collapse.
Massive money supply growth does not buy time or disguise structural problems. It simply destroys the purchasing power of the currency and reduces the country’s ability to attract investment and grow.
This is a warning, and administrations should take this episode as a serious signal before the scare turns into a widespread emerging market crisis.
Sudden Stop Irony
Compare that tiny strengthening blip to what happened in Argentina.
In case you missed it, Argentina Seeks IMF Financing Following Yesterday's Hike in Rates to 40%.
Don't Blame Me
Powell's speech was a "don't blame me for this" episode.
In a perverse way, Powell is correct. Every major central bank is doing the same stupid thing in foolish pursuit of 2% inflation.
Accidents are a given.
The Observer Affects The Observed
While it’s true the Fed typically only does what is expected, those expectations become distorted over time by observations of Fed actions.
I liken this to the Heisenberg’s Uncertainty Principle where observation of a subatomic particle changes the ability to measure it accurately.
The Fed, by its very existence, alters the economic horizon. Compounding the problem are all the eyes on the Fed attempting to game the system.
Fed Uncertainty Principle
I discussed Fed feedback loops in the Fed Uncertainty Principle.
The Fed, by its very existence, has completely distorted the market via self-reinforcing observer/participant feedback loops. Thus, it is fatally flawed logic to suggest the Fed is simply following the market, therefore the market is to blame for the Fed’s actions. There would not be a Fed in a free market, and by implication, there would not be observer/participant feedback loops either.
Please click on the link to see four corollaries.
No Economic Benefit to Inflation
My Challenge to Keynesians “Prove Rising Prices Provide an Overall Economic Benefit**”** has gone unanswered.
BIS Deflation Study
The BIS did a historical study and found routine price deflation was not any problem at all.
“Deflation may actually boost output. Lower prices increase real incomes and wealth. And they may also make export goods more competitive,” stated the study.
For a discussion of the BIS study, please see Historical Perspective on CPI Deflations: How Damaging are They?
Can We Please Try Capitalism? Just Once?
The major irony in this inane push for 2% inflation is central banks are guaranteed to produce extremely destructive asset bubble deflation in the process.
"If I were trying to create a deflationary bust, I would do exact exactly what the world’s central bankers have been doing the last six years," stated Stanley F. Stanley F. Druckenmiller in a Wall Street Journal Op-Ed last week.
That exactly matches what I have been saying for some time.
For discussion, and Druckenmiller's full speech, please see Can We Please Try Capitalism? Just Once?
Too Late For a Warning
Lacalle's warning cannot possibly be heard. It's too late.
Besides, and as explained in the Fed Uncertainty Principle, central bankers are deaf.
Mike "Mish" Shedlock