Manipulated Markets Can Cause Ruin

Saturday, 9 October 2010 at 13:52, By Ron Robins, Founder & Analyst - Investing for the Soul


Market manipulations eventually led to Soviet economic collapse. Though not as overt as the Soviets, it is the manipulation of currencies and interest rates by major economic powers that has mostly led to massive misalignments in investment and consumption that pose extraordinary dangers to global economic health.



Ask anyone if they believe that the Chinese currency, the renminbi, is manipulated. Almost everyone agrees that it is. Are US interest rates manipulated? Again, everyone knows they are. (Not too long ago it was only the short term rates that were controlled. Now the US Federal Reserve [the Fed] is buying longer dated US treasury bonds to bring their rates down too.) Countries all over the world are manipulating their currencies lower to gain export advantages and maintaining near zero interest rates to spur domestic demand and cheap government borrowing.



It is basic economics that where markets are manipulated, supply and demand are distorted. And one distortion creates the need for a further distortion, and so on. The longer the distortions continue the greater the possibility of total market failure. We are near that point today with currencies and interest rates.



The Chinese have scored a major mercantile advantage by pegging their currency, the renminbi, at a relatively set and undervalued rate to the U.S. dollar. Not only have US exports suffered, but the exports of many other countries have suffered as well. Under US law, the Chinese should probably have been labelled a ‘currency manipulator.’ However, by bowing to Chinese demands that they not be labelled a currency manipulator, President Obama’s administration is losing credibility everywhere.



So, Americans are waking up to find that not only does China dictate U.S foreign exchange policy, but China indirectly influences its domestic economic agenda as well. Everything from employment policies (export expansion) to government funding needs (requiring Chinese funding) are all partly defined by the present exchange rate policies.



Increasingly, Americans realize that on the foreign exchange front they have been ‘checkmated’—as in the game of chess—by China. Should difficult economic times continue, or worsen, increasing American anger is likely at this arrangement. It could pass the breaking point and encourage America to act unilaterally against China. Currency turmoil might then embrace the globe.



However, one never discussed but possible reason why the US government has been afraid to label China (and Japan previously) as currency manipulators may be because the US itself may be acting covertly to manage the dollar exchange rate.



According to the US government’s own legislation, it can act secretly in currency exchange markets to affect the dollar’s exchange rate using the Treasury’s Exchange Stabilization Fund (ESF). The US Treasury says that the ESF, “with the approval of the President, may deal in gold, foreign exchange, and other instruments of credit and securities." The ESF was established by the Gold Reserve Act of 1934 and then amended in the late 1970s.



Also, the Fed engages in opaque currency ‘swaps’ with other nations, and there is significant evidence of U.S Treasury and Fed engagement in gold price suppression. Gold is the ‘anti-dollar’ and barometer of confidence in the dollar. (See my August 24 column, “The Ethics of Gold,” at http://english.alrroya.com/node/54671 and gata.org)



Another manipulation of the Fed is its control of short term rates—and now possibly long term ones as well—to smooth out the booms and busts of the economy. However, we see the falsity of this argument. After almost two years at a near zero per cent federal funds rate the US economic quagmire continues—or worsens.



Induced low rates over the past ten years or so created a massive real estate boom and bust, discouraged savings, led to inordinate financial risk taking and moral hazard, unsustainable consumer debt, and now excessive, possibly uncontrollable government deficits and debt.



In their seminal work, “Growth in a Time of Debt,” published January 2010, Professors Carmen M. Reinhart and Kenneth S. Rogoff found that when government debt/GDP ratios exceed 90 per cent, economic growth rates fall considerably. According to the BIS, U.S. government debt/GDP will be 92 per cent by the end of 2010 and 100 per cent in 2011.



Furthermore, on September 1, the International Monetary Fund said, “general government debt in the G-20 advanced economies surged from 78 per cent of GDP in 2007 to 97 per cent of GDP in 2009 and is projected to rise to 115 per cent of GDP in 2015.”



Unfortunately, the present and future private deleveraging of debt in the U.S. and some other developed countries means potentially continued high—or higher—government deficits as economic growth is retarded or declines further. The Fed has said that to counter any renewed softness in US economic activity it will significantly expand its purchases of US government bonds and possibly other assets. This has the potential for fuelling a huge expansion of the money supply and creating high or even hyperinflation.



The U.S. and some other countries are following a path whereby every manipulation begets further manipulation, and which then begets even further manipulation. With China, perhaps Japan again soon, and other countries controlling their currency values, the U.S. may be forced overtly or covertly to counter their currency manipulations. And with continuing economic difficulties, with interest rate policy having created a debt nightmare and becoming increasingly ineffective, the Fed may institute money proliferation policies that have the possibility of leading to high or even hyperinflation.



If a vicious circle of manipulations by US authorities and other countries occurs, given time, it might rival some aspects of the Soviet command economy—and with a possibly similar tragic outcome. Hopefully, Americans and others will wake up before it is too late and realise that manipulated markets can eventually cause ruin.



E-mail the writer: r.robins@alrroya.com