Thursday, November 11, 2010

The Currency Wars and the Free Flow of Capital

The foundation for the economic health of the world for the last fifty years has been the relatively free flow of capital begun in the 1960s. That consensus is being threatened now.

The extent of the problem is captured in the New York Times article by Landon Thomas, “Countries See Hazards in Free Flow of Capital.” (

“In China and Taiwan, regulators are imposing fresh restrictions on stock market investments by foreigners. In Brazil, officials have twice raised taxes on foreign investors. Even South Korea…pressure is building on the government to take similar steps.

As the leaders of the 20 major economic powers gather in Seoul, an increasing number of them have either imposed curbs or are in the process of doing so to slow the torrent of hot money into their markets…

Once a core policy commandment of the so-called Washing consensus and held dear by the United States Treasury, the International Monetary Fund, and global investment banks, the belief that unfettered capital flows are a boon for everyone—including the country on the receiving end—has been dealt a major blow.”

The culprit that has brought us to this situation is another one of the legs of what is called the “Trilemma” of international monetary relations. The “Trilemma” basically states that only two of the following three conditions can hold: free capital mobility; fixed exchange rates; and a country’s independent economic policy. The leg that is now causing all the trouble is the leg that allows a country to pursue an independent economic policy.

More specifically, in terms of the situation that the world is now facing, is the ability of the United States to “go-it-alone” and follow an economic policy that is independent of the rest of the world.

Whereas most other countries in the world, especially in western Europe, that have tried to conduct economic policies independent of the rest of the world, ultimately paid a price for this independence. The United States, because of its size and the fact that the United States dollar is the world's reserve currency, has never had to face the reality created by its independent economic policies.

The bill is now coming due.

The United States government, since 1946, has had one major economic goal and one minor economic goal. The major goal: to achieve low levels of unemployment within the United States economy. The minor goal: to achieve homeownership for most Americans.

For more on this assertion see the Financial Times award winning book by Rajan Raghuram, titled “Fault Lines.” (

Given these goals, the United States, in the past fifty years, has persistently followed an economic policy of credit inflation. This policy has resulted in a decline in the value of the dollar by more than 40 percent during this time even though there were two periods when the value of the dollar actually rose. The decline in the value of the United States dollar since January 20, 2001 has again been dramatic.

The value of the United States dollar has been able to decline as it has because in August 1971 President Nixon floated the value of the dollar due to increasing capital mobility internationally and due to the fact that he wanted to retain the independence of United States policy making.

It is very interesting that Thomas, in his article, brings up one of the conditions of the Post- World War II monetary system agreed upon in Bretton Woods, New Hampshire in 1945. A crucial part of this agreement was the presence of controls on the international flow of capital. As quoted in the article by Thomas, “Just as John Maynard Keynes said in 1945—capital controls are now orthodox.” In the 1930s and 1940s, Keynes was a major proponent of restricted capital flows. Nixon “broke” the Bretton Woods system.

Running an independent economic policy based upon credit inflation does have consequences. The value of the currency of the country running such a policy may decline. And, as we have seen, the credit inflation created by this country, especially if it is the largest economy of the world, can export its inflation to all of the rest of the world!

And, this is precisely what the United States has been doing, regardless of what is going on any place else in the world. And, this is precisely what the rest of the world is rising up against.

There have been other consequences of the United States economic policies, regardless of whether the party in power has been the Republicans or the Democrats. I have presented these consequences in many other blog posts and will just state them here. First, the credit inflation policies of the government have tended to keep unemployment lower…in the short run…but, in the long run these policies have resulted in about one in four workers of employment age being under-employed. Second, capacity utilization in the industrial sector has continuously declined since the middle of the 1960s. It is now around 75 percent. Third, the inflationary policies of the federal government have resulted in a substantial skewing of the income distribution, with the wealthier, who can hedge and protect themselves against inflation, receiving more and more of the income generated within the United States.

Still, the leaders in the United States government use an economic model that prescribes more of the same: more spending and more monetary expansion to further stimulate the United States economy. Whereas the Congress will not provide further stimulus from the fiscal side, Bubble Ben at the Federal Reserve has entered into a desperation commitment, a “hail-Mary” pass if you will, in order to try and save the game.

The problem is that a “hail-Mary” pass at this time in the game cannot do much if your team is down by 35 points!

However, this “hail-Mary” pass can do a lot of damage to the rest of the world because the international flow of capital is so open and fluid. But, the rest of the world does not seem like it will bend over and just accept what the United States has to give it.

Two final points: First, I do not believe that we will go back to an age in which world capital flows are highly restricted. For one thing, I believe very strongly in the advancement of information technology and the increased flow of information throughout the world. Regulations and controls are going to have less and less impact over restricting international capital flows in this world. Restrictions of any kind will be “gone around” if there is an incentive to do so. This is why I believe the Frank-Dodd financial reform legislation is relatively useless. Fluid international capital flows, to me, are a given for investment analysis in the future.

Second, the United States is not going to prevail in its efforts to keep inflating the world. There are three reasons for this. One, other countries will band together and more aggressively confront the United States and work against it. And, I don’t believe the United States really wants a world of controls and protectionism. Two, by following this inflationary policy the United States is handing over its assets to the rest of the world. (See my “China Buys the World”: Finally, the United States must ultimately stop hurting its own people through its macroeconomic policies.

No comments: