Two Lessons in the Mercantilist Mindset

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The
Wealth of Nations

was published in 1776. The book was mainly a critique of mercantilism:
the idea that politicians and bureaucrats can establish coercive
policies that interfere with the free market, thereby increasing
the wealth of a nation. Smith explained the wealth of nations as
the product of voluntary exchange.

Over the next
century, the book’s influence grew. Then, with the rise of the various
European empires, mercantilism was resurrected. Politicians and
hired economists found supposed exceptions to Smith’s principle
of non-intervention. A defense of the intervention of empire in
international affairs was matched by a defense of intervention into
the domestic economy. Under certain conditions, tax-funded academic
experts insisted, wise management by government officials can make
the free market more efficient, more just, more stable, and less
harsh.

Today, this
idea is alive and well in academia. It is also alive and well at
The Economist, the weekly magazine.

THE SUPPOSED
LIQUIDITY GLUT

On January
4, The Economist published an article: “The global gusher” It began with a subhead: Thailand’s bungled
attempt to stem capital inflows is just one symptom of the worldwide
liquidity glut
.

WHEN
Thailand’s introduction of capital controls sent its stockmarket
plunging a few days before Christmas, you could have been forgiven
for thinking, “Here we go again”. It is almost ten years since the
start of the Asian financial crisis, when capital flight on a huge
scale caused financial markets and economies in the region to collapse.
The problem that Thailand and other Asian countries face today,
however, is the exact opposite: how to stop capital flowing in.

The 1998 crisis
was a flight of capital out of Asian markets. This time, it is a
flight of capital in. Why is this a threat? Why should it bother
any politician in Asia? I can think of only one reason: Governments
distrust the free market
. This fact should not bother journalists
at The Economist. But it does.

The author
does not define “glut.” I will. “Glut: The oversupply of an artificially
overpriced item in relation to an artificially underpriced item.”
A glut is the result of a government-imposed price control of some
kind. No one with any knowledge of economics should ever use the
words “glut” or “shortage” without adding “at a government-controlled
price.”

If there is
a “glut of liquidity” flowing into Thai markets, then the Thai baht
is underpriced by government fiat. Apart from such a fiat price,
how could a glut exist? The international currency markets are the
most sophisticated on earth. The mere hint of undervaluation causes
a rise in price. Then demand is reduced. This is what pricing is
all about: reducing gluts and shortages.

What the writer
is talking about is an undervalued equities market. It has
nothing to do with “too abundant liquidity.”

Worldwide,
an abundance of liquidity has lured investors into riskier assets
in search of higher returns. Though there is no agreement on how
to measure liquidity, using the global supply of dollars as a proxy,
The Economist estimates that in the past four years it has
risen by an annual average of 18%, probably the fastest pace ever.

First, he admits
that the experts don’t know how to measure liquidity. Then he ties
this undefined something in an undefined way to the dollar. Then
he says there is a glut of it: 18% per annum.

This entire
procedure is nutty. But it makes for a snappy headline. He even
supplies a chart.

Last
year it washed through emerging economies in record amounts, pushing
up their currencies. Between the start of 2006 and mid-December
the Thai baht rose by 16% against the dollar — more than most
other currencies tracked by The Economist.

“It washed
through.” What washed through? How did it wash through?
What does “washing through” mean?

This poor soul
cannot follow the logic of the basic economic principle of supply
and demand. He says that capital is flowing into Asian capital markets.
This means these markets’ prices for capital are perceived as too
low by profit-seeking foreign investors. But if Asian central banks
are inflating — and China says it is, and has been — then
Asian currencies should fall in price in relation to American and
European currencies. If they are not falling, then this needs an
explanation. Are there Asian government controls on buying and selling
their domestic currencies?

Not once does
the author discuss the international value of Asian currencies in
a supposed world glut of liquidity — a glut domestically produced
by Asian central banks.

He needs to
write about currency values, not capital markets. But he
never once mentions currency values.

Obviously,
he doesn’t understand economics.

Neither do
Asian politicians.

MERCANTILISM
LIVES!

The author
continues.

When
capital inflows accelerated in December, the Bank of Thailand panicked
and slapped a tax on inward portfolio investment (similar to that
used in Chile). After share prices fell by 15% in a day, the controls
were hastily removed from equities. They remain on debt investments.

This was a
stupid law. It hurt capitalists in Thailand. They could not legally
absorb all of the capital that Western investors were offering them.
Now the government has placed a similar restriction on credit.

Because foreign
investors purchase Thai securities with bahts, the rising price
of the Thai stock market has nothing to do with foreign liquidity,
only domestic liquidity: a bubble market. Liquidity is a monetary
phenomenon. Rising liquidity at home — too much Thai money-creation
— should force down the price of that baht across the boards.
If this isn’t happening, this deserves an explanation. The author
doesn’t even mention this, let alone attempt to explain it.

Conclusion:
The writer doesn’t understand the basics of economic theory,
let alone monetary theory
. Yet this article was published in
the premier economics magazine on earth.

This
clumsy flip-flop has severely undermined the credibility of Thailand’s
economic policymakers. Yet the drastic measures highlight the seriousness
of a dilemma faced elsewhere in Asia: how to curb domestic liquidity
when foreign capital is flooding in. Thailand could have allowed
the baht to rise further, but it had already gained against all
other Asian currencies last year, raising concerns about exporters’
competitiveness.

Domestic liquidity
— national money — is controlled by a nation’s central
bank. It the central bank is inflating, then there is a rise in
domestic liquidity. If it is not inflating, then there is no change
in domestic liquidity, unless the foreign currency (such as U.S.
dollars) is actually circulating as a black market currency. This
is the case in high-tax, highly inflationary Third World countries.
But these countries are not marked by foreign capital flowing in.
Capital (from their own citizens) flows out. The domestic currency’s
value is falling.

Some
economists argue that Thailand should simply have cut interest rates
to stem capital inflows, making bonds less attractive to foreign
investors. But this is to misunderstand the nature of the problem.
David Carbon, an economist at DBS, a Singapore bank, argues that
the baht’s strength is not the real issue, because Thailand’s exports
have continued to grow strongly. Instead, the Bank of Thailand is
more worried about excessive domestic liquidity. Lower interest
rates would simply add to the problem, generating higher credit
growth, inflation and asset prices. Similarly, central-bank intervention
to hold the baht down by buying dollars would also boost the money
supply.

If the Bank
of Thailand — meaning the country’s central bankers —
is “worried about excessive domestic liquidity,” the bank can solve
this problem, beginning today. It can stop buying assets that serve
as a reserve for the baht. The way to stop price inflation is
to stop inflating the currency. As for lowering interest rates,
that’s what central bank inflation does: it lowers rates.

How can these
people speak of “the baht’s strength” if the central bank is inflating?
Don’t these economists understand anything?

It’s hard to
say. The author of the article surely doesn’t.

Moreover,
as Brad Setser of Roubini Global Economics points out, Asian central
banks are having to buy dollars not just because of their current-account
surpluses, but also because foreign investors are moving money into
the region.

The central
banks do not have to buy dollars or anything else. If they
are buying dollars, it is because they are following mercantilism’s
policies: trying to hold down the price of their own currencies
as a way to stimulate the export sector. This lowers the value of
their currencies compared to what they would have been without the
monetary inflation. That’s why Asian central banks inflate.

If dollars
are “flooding in,” that’s because the terms of trade favor the Asians.
Dollars should flood in. People should (and do) take advantage of
bargains.

So, if Asians
are inflating their currencies, they are doing it to keep dollars
from raising the value of their currencies.

The Federal
Reserve is in tight-money mode. The dollars flowing in have to do
with low prices in Asia. Liquidity gluts produce high prices in
domestic currency units. If they don’t these days, then this demands
an explanation. We do not get one.

CAPITAL
CONTROLS

The author
moves to the next policy of Asian mercantilism: capital controls.

Capital
controls are a way around what economists call the “impossible trinity”:
an economy cannot simultaneously control domestic liquidity, manage
its exchange rate and have an open capital account. Only two of
the three are possible. Controls on short-term capital inflows,
if (a big if) they are implemented in a well-thought-out and transparent
way, can offer a viable compromise, curbing capital inflows and
excessive money growth, while taking pressure off the currency.

As with all
price controls, government-imposed capital controls always produce
effects opposite to what the regulators promise. They always distort
reality. They are the product of anti-economic thought. Capital
controls are never “implemented in a well-thought-out and transparent
way,” nor can they “offer a viable compromise.” That was Adam Smith’s
message in 1776. It still has not fully penetrated the editorial
offices at The Economist.

The
deluge of spare cash has two main sources. First, average real interest
rates in the developed world are still below their long-term average.

This is nonsense,
pure and simple. Average real interest rates in the developed world
may or may not be above or below their long-term average. Nobody
in a central bank knows. That is why there are currency markets
where speculators make guesses backed up by money that can be lost
if they guess wrong. That is where there are futures markets for
interest rates. But if it is true that real interest rates are below
the average, then this is because of domestic inflation by Western
central banks.

Money (the
adjusted monetary base) is tight in the #1 market: the United States.
So, where is the threat of the liquidity glut?

Second,
America’s huge current-account deficit and the consequent build-up
of foreign-exchange reserves by countries with external surpluses
has also pumped vast quantities of dollars into the financial system.

He has it backwards.
The domestic inflationary policymakers of Asian central banks have
pumped in domestic reserves to buy American government-issued debt.
These central banks could buy their nation’s T-bills. Instead, they
buy U.S. T-bills. The author knows this.

A
large chunk of Asia’s reserves and oil exporters’ petrodollars have
been used to buy American Treasury securities, thereby reducing
bond yields. In turn, low bond-market returns have encouraged bigger
inflows into higher yielding emerging-market bonds, equities and
property, especially in Asia. Liquidity has been further boosted
by the use of derivatives, and by carry trades (borrowing in currencies
with low interest rates, such as yen, to buy higher-yielding currencies).

This guy is
hopeless. He saying that bond speculators are buying foreign bonds
because of their high yields in relation to the U.S. dollar’s bond
yields. Yet the dollar’s bond yields are today lower than T-bill
rates: an inverted yield curve. This signals recession. Recessions
push bond yields even lower — an opportunity to make money
in today’s U.S. T-bonds. Meanwhile, monetary inflation (“glut of
liquidity”) is hitting Asia, which raises domestic prices (i.e.,
lowers the value of the currency), which hurts foreign investors
— a falling return on their investment.

Why would anyone
buy Asian bonds? Because he thinks that a recession will raise the
value of Asian bonds (falling rates), and will also raise the value
of Asian currencies. This strategy makes sense to me!

Then why is
there also a flood of Western investment into Asian stock markets?
For the same reason that there is money going into the U.S. stock
market. Stock market investors do not believe the Austrian theory
of the business cycle
. They do not believe that domestic monetary
inflation produces domestic capital bubble markets.

There are stock
market bubbles building in Asia. They are driven by Asian central
bank inflation. These bubbles are a prelude to recession in these
export-driven economies, because the United States — the main
buyer of their goods — is heading toward recession. Yet the
author denies there is a bubble. Such talk is “premature.”

The
spread on emerging-market bond yields over American Treasury bonds
fell to another record low last week. Share prices in emerging economies
have risen by 243% on average from their trough in 2003. That still
leaves the average price/earnings ratio below its historical average
and less than that in developed countries, so for most markets it
is premature to talk about bubbles. But if asset prices continue
to climb at their recent pace, central bankers will become increasingly
nervous.

If you want
to avoid losing your stock market investment when a bubble pops,
you had better start talking about its existence “prematurely.”
The Asian bubble will pop when (1) inflation fears cause the central
banks to stop inflating their currencies; (2) the artificially stimulated
demand for exports falls. In short, it will fall when the U.S. gets
a recession.

The Asian economic
boom will die sooner or later. Don’t be in Asian stocks when it
does.

CONCLUSION

The Economist
article would not be worth commenting on except as an example of
the survival of the mercantilist mindset. The anonymous author does
not understand monetary cause and effect. The result is a jumble.
The article is incoherent.

That is not
a big problem. But his methodological peers in Asian central banks
and legislatures are distorting their nations’ economies. This is
a huge and escalating problem. They are providing the fiat money
that creates economic booms. Then, when this policy produces price
inflation, and the central bank slows the rate of monetary inflation,
the result is a recession.

The
two lessons seldom register: (1) If you want to avoid recessions,
do not inflate the money supply. (2) If you want increased national
wealth, do not pursue mercantilistic policies.

The politicians
never seem to learn. Neither do financial journalists.

January
11, 2007

Gary
North [send him mail] is the
author of Mises
on Money
. Visit http://www.garynorth.com.
He is also the author of a free 19-volume series, An
Economic Commentary on the Bible
.

Gary
North Archives

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