Manipulated Markets Can Cause Ruin

By Ron Robins, Founder & Analyst, Investing for the Soul

Blog Enlightened Economics; twitter

First published October 9, 2010, in his weekly economics and finance column at
alrroya.com

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.
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