Currency Wars And The Philippine Peso

``One cause for hope of an early agreement is that many of the illusions concerning the advantage of drifting currencies and competitive depreciation have been dissolving under the test of experience. Great increases in export trade have not followed depreciation; the usual result of anchorless currencies has been a shrinkage of both export and import trade. Again, the fallacy is beginning to be apparent of the idea that a currency allowed to drift would finally "seek its own natural level." It is becoming clear that the "natural" level of a currency is precisely what governmental policies in the long run tend to make it. There is no more a "natural value" for an irredeemable currency than there is for a promissory note of a person of uncertain intentions to pay an undisclosed sum at an unspecified date. Finally, it has been learned that competitive depreciation, unlike competitive armaments, is a game that no Government is too poor or too weak to play, and that it can lead to nothing but general demoralization.” Henry Hazlitt, From Bretton Woods To World Inflation

The Federal Reserve’s prospective Quantitative Easing 2.0 has now triggered an impassioned debate among international policymakers over the risks of currency wars.

Today, policy divergences among developed and emerging markets, which have been spurring capital flows that has boosted asset markets of emerging markets, has prompted for such worries.

Brazil’s minister Guido Mantega fired the first salvo[1] to accuse advanced economies of adapting “beggar-thy-neighbour” policies that could harm international trade.

Currency wars or competitive devaluation simply implies inflationism applied by governments in order to “boost jobs by bolstering exports”. This has been a long held mercantilist-protectionist approach, which had been debunked[2] by classical economist as Adam Smith, but seemingly being adapted by today’s leading authorities, perhaps out of desperation.

As the Wall Street Journal editorial writes[3],

``The growing danger today is currency protectionism—what students of the 1930s will remember as competitive devaluation or "beggar-thy-neighbor" policies. As economic historian Charles Kindleberger describes in his classic "The World in Depression," nations under domestic political pressure sought economic advantage by devaluing their national currency to improve their terms of trade.

``But that advantage came at the expense of everyone else. "As with exchange depreciation to raise domestic prices, the gain for one country was a loss for all," Kindleberger writes. "With tariff retaliation and competitive depreciation, mutual losses were certain."

Here is my take on the currency episode:

First, I don’t see the Federal Reserve as attempting to attain “export competitiveness” by taking on the currency devaluation path.

The Federal Reserve’s action, as well as the Bank of England, seems to be more directed at surviving the balance sheets of their respective banking systems which has been buoyed by earlier dosages of QE.

Therefore, as said above, dodgy assets that are still held by the banks would need further infusion of credit to maintain their subsidized price levels.

Second, it is political season in the US with mid-term elections coming this November. Hence, political talking points have been directed against free trade to signify attempts to shore up votes by appealing to nationalism and to economic illiterates, following the growing unpopularity with Obama administration and the Democratic Party.

This has been underscored by the recent passage of the China currency sanction bill[4] at the US House. Yet this bill isn’t certain to be passed by the Senate, which will most likely be after elections.

Third, while the currency bill has been seen as directed towards “forcing” China to revalue what most don’t know is that technicalities matters. As lawyer Scott Lincicome writes[5],

``But none of that changes the fact that, if it became law, this particular legislation probably won't have a big effect on things, at least in the near term.”

Why?

Because, according to Mr. Lincicome, ``The change in language... gives the administration 'a way to say no' to U.S. industries and could signal to China that Washington isn't looking to declare a trade war over currency practices."

In politics, it is usually a smoke and mirrors game.

Lastly, global policymakers appear to be cognizant of the dangers of applying protectionism and the nonsensical approach by mercantilist policies.

The IMF has cautioned against currency friction and has volunteered to act as a “referee”[6] to settle trade disputes emerging from such strains.

Importantly, emerging market authorities have been quite sensitive into maintaining open trade channels.

Poland’s central bank governor Marek Belka in an interview with Wall Street Journal[7] delivers a jarring statement against mercantilism.

From Mr. Belka, (bold emphasis mine)

``All those wars produce a lack of stability, and the warring parties forget the basic point. The bottom line is devaluations and appreciations change your competitive position temporarily but they don’t change your competitive position for good. If you want to strengthen your competitiveness by devaluing your currency, this is a sign of despair, this isn’t a policy. I am worried because this destabilizes the global economy and it does not lead to rebalancing, something we all long for.”

We just hope that global policymakers remain steadfast in support of freer trade than engage in inflationism which is no less than veiled protectionism.

Nonetheless, as far as the subtle competitive devaluation has been an ongoing concern, we should expect the local currency, the Philippine Peso to benefit from a far larger scale of interventionism from advanced economies as United Kingdom and Japan, whom like the US, has been engaged in “quantitative easing”.

Figure 5: Yahoo Finance: Philippine Peso Versus Quantitative Easing Economies (ex-US)

This means that the Peso is likely to appreciate against the British Pound and could likely reverse its long term decline against the Japanese Yen as Japan expands her battle against alleged deflation, which for me is no more than promoting the nation’s export sector at the expense of the rest.

Relatively speaking, the Peso is in a far better position than both of the above and most especially against the US dollar given the current conditions.

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[1] BBC.co.uk Currency 'war' warning from Brazil's finance minister, September 28, 2010

[2] See Does Importation Drain The Wealth Of A Nation?, September 13, 2010

[3] Wall Street Journal, Beggar the World Monetary instability is a threat to the global recovery October 1, 2010.

[4] BBC.co.uk US House passes China currency sanctions bill, September 30, 2010

[5] Linicome Scott, House Passes Currency Legislation; Whoop-Dee-Freakin-Doo, September 29, 2010

[6] Marketwatch.com, IMF moves to referee currency debate, October 9, 2010

[7] Wall Street Journal, Poland’s Central Bank Governor Belka on Currency Wars, October 9, 2010

Where Is Deflation?

``In reality, Britain has the worst of all possible worlds: a stagnant economy, a crippling budget deficit and rising prices. The Keynesian consensus is that things would have been far worse without the stimulus provided by government. And if the economy isn’t pumped up with inflated demand, it will collapse back into recession. If it’s not working, that just proves the stimulus should be even larger. It is the argument quacks always push: If the medicine isn’t working, increase the dosage. And yet, reality has to intrude into this debate at some point. The deficit can’t get much bigger, interest rates can’t be cut much lower, and sterling can’t lose much more value. Stimulating the economy isn’t working. In fact, it’s only making it worse. Consumers and businesses don’t want rising taxes. A falling currency pushes up the cost of everything the U.K. imports, stoking inflation. Savers get decimated, and yet the banks remain reluctant to lend because they rightly believe the economy is in the doldrums.” Matthew Lynn, Deathbed of Keynesian Economics Will Be in U.K.

When deflation advocates point to charts of bank loan activities, the money multiplier or Treasury Inflated Protected Securities (TIPS) and proclaim “where is inflation?” - they seem to be asking the wrong question.

Figure 1 St. Louis Fed/Northern Trust: M1 Money Multiplier and Consumer US CPI

For instance, while it is true that the US M1 money multiplier[1] is down, (as shown in the left window in figure 1 and recently used by a popular analyst as example), there seems hardly a grain of truth that the falling money multiplier equates to sustained deflation in US consumer prices (right window).

In other words, if they are correct then obviously CPI should be adrift in the negative territory- to reflect on deflationary pressures until the present. Yet the CPI, both in the ALL items and ALL items LESS Food and Energy remains in the positive zone, in spite of, or even in the face of these ‘deflation pressure’ statistics; falling money aggregates, subdued TIPS and or lackluster bank activities.

And CPI turned negative only at the height of the crisis, which makes it more of an aberration than the norm. Of course, this counterpoint extends to the validity of the accuracy of the US government’s measure of inflation, which I am a skeptic of.

However, here are more of our counterarguments to the sarcastic question of “where is inflation?”:

1. Reading current performance into the future.

Deflation exponents insist that “deflationary pressures” ought to collapse the markets as they did in 2008. They’ve been doing so for the entire 2009. But this hasn’t been happening. That’s because the reality is, we haven’t been operating under the same ‘Lehman’ conditions of 2008!

The US government’s actions to effect a cumulative network of local and international market patches, as seen in the various ‘alphabet soup’ of emergency programs plus a raft of guarantees to the tune of over $10 trillion, swaps and direct expenditures (quantitative easing), seems to ensure of such non-repetition, as we have repeatedly discussed.

So more banks could indeed fail, the FDIC upgraded its watchlist from 552 to 702 banks in danger, but the liquidity gridlock of 2008 isn’t likely to happen. That’s because the Fed has a morbid fear of ‘deflation’ than warranted, and is likely to engage in a “whack a mole”; pouring liquidity on every account of the emergence of deflation.

Let me clarify that the US banking system is a solvency issue, but this is not the case for Asia or for major emerging markets. Ergo, the contagion from the Lehman collapse of October 2008 emanated from a liquidity shortfall as US banks seized up. Since today’s scenario is different, then predicting the same contagion seems unlikely, so any arguments calling for a 2008 scenario is like calling a banana an apple.

Besides, the Fed’s manipulation or “nationalization” of key markets such as the US mortgage markets seems to have been designed to stave off the odds of having a domino effect collapse in their banking industry. This, by keeping the banking system’s balance sheets afloat, through “elevated” or inflated prices. In spite of babbles for so-called exit strategies, this isn’t likely to change.

On the contrary, a broader view of markets appears to be suggesting that inflation looks likely a future or prospective phenomenon.

To consider, if any of these “deflationary” stats begin to recover then they are likely add to ‘inflation expectations’ and thus eventually reverse the current state of “deflation subdued” CPI .

2. Misleading Interpretation of Hyperinflations.

Hyperinflations have never been caused by excessive consumer borrowings, never in history. To paint of such an impression is to egregiously mislead.

Hyperinflations have basically been caused by insatiable government spending, whose exponential growth had been financed by the printing press. On the other hand, a credit boom from consumer borrowing is most likely to result in bubble (boom-bust) cycles and not hyperinflation.

The fundamental difference is that of the political goal; in boom bust cycles, government’s role to inflate the system is largely indirect-with mostly the goal to perpetuate ‘quasi’ economic boom conditions by inflating money supply and by skewing the public’s incentives through regulation or taxation to favoured political sectors, as in the case of the recent real estate-mortgage bubble.

Whereas, in hyperinflations, the government’s role is more direct, usually deliberate or represents an act of desperation to meet a political goal for the incumbent leadership, such as perpetuation of power (e.g. Zimbabwe), or the addiction to inflationism compounded by policy errors based on theoretical misunderstandings[2], as Germany’s Weimar hyperinflation experience, and not from war reparations as others have suggested[3].

Of course one may argue that there is always a possibility of first time. Perhaps.

3. Selective Perception And Misguided Expectations

Many deflation proponents tend to argue from the perspective of the private sector’s performance in the economy. Their propensity to “tunnel” or fixate into the private sector leads them to erroneously omit the impact of the rapidly bulging share of the US government’s contribution to the economy, which presently accounts for nearly a third.[4]

Ignoring government’s contribution and policy impacts to the economy renders a handicapped analysis.

Nevertheless, looking at the global scale, we seem to be seeing more incidences of a ‘quickening’ of consumer price inflation, as in Malaysia and in Brazil, aside from previous accounts in China, India, Vietnam, and even to the real estate bubble-banking crisis afflicted UK which saw consumer price inflation rise to its highest level since November 2008 (see figure 2)-where debt deflation has been the generally expected outcome by the mainstream.

Figure 2: Finfacts.ie/stockcharts.com: Surging UK Inflation, Devaluing UK Pound

Reporting on the surprising resilience on UK’s inflation (left window), according to Finfacts.ie. ``The ONS said the CPI fell by 0.2% between December and January. Although negative, this is the strongest ever CPI growth between these two months (prices typically fall at a faster rate between December and January). This record monthly movement is mainly due to the increase in January 2010 in the standard rate of Value Added Tax (VAT) to 17.5% from 15% and, to a lesser extent, the continued increase in the price of crude oil. In the year to January, the all items retail prices index (RPI) rose by 3.7% up from 2.4% in December. Over the same period, the all items RPI excluding mortgage interest payments index (RPIX) rose by 4.6%, up from 3.8% in December.” (bold highlights mine)

Why should oil prices rise if demand has been declining as the Fisherian and Keynesian deflationists experts allege? From a “money is neutral” perspective, wouldn’t that be a paradox?

Also, why should higher taxes become inflationary, when all it does is to distort the economic structure by shifting investments from private to the public, as well as, to decrease the incentives for the private sector to participate?

Murray Rothbard provides the answer[5], ``If inflation has been under way, this “excess purchas­ing power” is precisely the result of previous governmental in­flation. In short, the government is supposed to burden the pub­lic twice: once in appropriating the resources of society by in­flating the money supply, and again, by taxing back the new money from the public. Rather than “checking inflationary pres­sure,” then, a tax surplus in a boom will simply place an addi­tional burden upon the public. If the taxes are used for further government spending, or for repaying debts to the public, then there is not even a deflationary effect. If the taxes are used to redeem government debt held by the banks, the deflationary ef­fect will not be a credit contraction and therefore will not cor­rect maladjustments brought about by the previous inflation. It will, indeed, create further dislocations and distortions of its own.” (bold highlights mine)

In short, what could easily be seen is that the inflationary effects of bailouts, subsidies and its domestic version of quantitative easing programs have gradually been manifesting on her devaluing currency first (right window), and next, to consumer prices. And the newly increased VAT in the UK only adds to the existing distortions already in place.

Of course this account of emerging inflation seems to have befuddled the mainstream anew.

Yet, this dynamic is likely to emerge in the US too...perhaps soon.

For us, another reason why inflation is still quiescent in the US; aside from the slack in the banking system out of the reluctance to lend due to balance sheet concerns, is because of the natural belated response to the record steepness in the yield curve.

The uncertainty arising from the abrupt market cleansing adjustments and the rediscovery phase of where resources are needed, implications of new regulatory regime, prospects of higher taxes to pay for the slew of stimulus programs, risks of more government interventions, impaired and unsettled balance sheets of banks and financial institutions mired in the bubbles have all conspired to inhibit investors from taking advantage of the steepness in the yield curve.

Yet the past has shown that eventually zero interest rates and a steep yield curves will likely artificially impact the credit process to jumpstart a new boom-bust cycle. Although we aren’t likely to believe that a boom phase of a bubble cycle could happen in sectors recently affected by a bust, any seminal bubbles will most likely diffuse into other sectors untainted by the recent bubble (technology or materials and energy?) or percolate outside of the US.

This implies that the ramifications from policies are likely to gain traction with a time lag, as had been in the past.[6]

Hence, expectations for the immediacy of the markets’ response from policies have not been only myopic but also constitutes as wishful thinking-anchoring on a belief that people don’t respond to incentives.

4. The Folly Of Excluding The Role of the US dollar And Other External Forces

In addition to the lagged response, it is likely that the US dollar, as the world’s de facto seignorage provider, has the privilege to extend its inflationism outside her shores hence, inflation becomes a precursory tailwind (see figure 3)

Figure 3: St. Louis Fed: CPI (red) versus US Trade Balance (blue)

Recessionary forces around the world, as exhibited in gray shaded areas in both the 2000 and the present crisis, required diminished US dollar financing for global trade. This led to an improvement of the US trade balance (red line), which none the less, dampened US CPI inflation (blue line).

As the world recovered from the recession or the crisis, trade deficits surged anew to reflect on the revitalization of global trade. And the US CPI eventually followed suit. One could observe that the CPI trailed trade deficits by a short interval in both accounts.

And also given that today’s situation is vastly different from the 2000-2007, where the slack in private expenditures have been replaced by monstrous government spending, the impact from the surging “twin” deficits will likely have a more meaningful impact. First, this will be reflected externally, as in the account of emerging inflation ex-US, and possibly channelled via the US dollar relative to other currencies or if not through commodities. Next, this gets manifested on the US domestic consumer price indices.

Therefore the interstice, where CPI inflation seems subdued, should be known as inflation’s “sweet spot”, perhaps where we are today.

Hence the idea that slow inflation today equals slow inflation tomorrow predicated on the money multiplier and an impaired credit process, seems to grossly underestimate on the repercussions of inflationary policies because, aside from the lagged impact from yield curve and the blatant disregard of the expanding share of the US government in the economy, such analysis discounts on the effects of exogenous forces, particularly the US dollar’s role as chief financier of global trade, and the underlying transmission mechanism from external ‘inflation’, such as competitive devaluations, impact on nations with pegged currencies-a core to periphery phenomenon. This is, aside from, misconstruing money’s role as having neutral effect on the economy.

In other words, markets and economic trends will depend on the directions of ensuing policy actions, by major economies most especially the US, to ‘reflate’ the system.

And given that Fed Chairman Ben Bernanke was again shown as seemingly in a cautious stance about the “halting” pace of economic recovery for the US from which he reassured Congress of an extended regime of low interest rates and where in addition to the apparent mounting clamour of adopting a philosopher’s stone as mainstream policy, as discussed last week[7], more professional entities seem to be joining the chorus for extended inflationism, such as the latest joint project by Goldman Sachs [Economists Jan Hatzius] Deutsche Bank [Peter Hooper], Columbia University [Frederic Mishkin], New York University [Kermit Schoenholtz] and Princeton University [Mark Watson] who arrived at the conclusion that current conditions remain tight despite the Fed’s efforts.

We don’t need to actually wish for it, but evidently, the pronounced lobbying to justify more inflationism is likely to be music in the ears for the current crops of political and technocratic overseers.

So the question of “where is inflation?”, should be substituted with the opposite, given the limited and sporadic accounts of ‘deflation statistics’, the question should be “Where is Deflation?”

As markets haven’t been collapsing and as the world have elicited signs of rising incidences of inflation, the onus of proof, is on them.

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[1] coins, currency, checkable deposits demand deposits and travellers checks from wikipedia.org

[2] “The government and the Reichsbank both believe that monetary troubles arise from an unfavorable balance of payments, from speculation and from unpatriotic behavior of the capitalist class. They therefore attempt to fight the menace of depreciation of the Reichsmark by controlling dealings in foreign currency and by confiscating German holdings of foreign assets. They do not understand that the only safeguard against the fall of a currency's value is a policy of rigid restriction. But though the government and the professors have learned nothing, the people have. When the war inflation came nobody in Germany understood what a change in the value of the money unit meant. The business-man and the worker both believed that a rising income in Marks was a real rise of income. They continued to reckon in Marks without any regard to its falling value. The rise of commodity prices they attributed to the scarcity of goods due to the blockade. When the government issued additional notes it could buy with these notes commodities and pay salaries because there was a time lag between this issue and the corresponding rise of prices. The public was ready to accept notes and to keep them because they had not yet realized that they were constantly losing purchasing power.” Ludwig von Mises, The Great German Inflation, Money, Method, and the Market Process ch 7

Money, Method, and the Market Process

[3] See Wikipedia.org, Inflation in the Weimar Republic

[4] See previous post, It’s Not Deleveraging But Inflationism, Stupid!

[5] Murray N. Rothbard, Chapter 12—The Economics of Violent Intervention in the Market, Man Economy and the State

[6] See our previous discussion, What Has Pavlov’s Dogs And Posttraumatic Stress Got To Do With The Current Market Weakness?

[7] See Why The Hike In The Fed’s Discount Rate Is Another Policy Bluff