Two Lessons in the Mercantilist Mindset

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.


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.


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.


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.


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.

January11, 2007

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

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