For today’s piece, I’m going to do something I rarely do. I’m going to defend the Federal Reserve on something.
I am not defending the institution or its policies. But I do believe it is taking the blame for something that isn’t its fault.
In the last few weeks, we have seen currency crises occurring around the world. The two biggest stories are out of Turkey and Argentina.
In both countries, interest rates jumped significantly as a result of both central planning and market forces. Both currencies are not only falling, but they’re falling against other fiat currencies such as the U.S. dollar.
In addition, there are major currency problems in other countries such as India, South Africa, Brazil, and Russia. Even China is showing signs of problems. These countries account for a huge portion of the world’s population.
It is interesting just how much of a role monetary policy and a relatively stable currency play in the economic growth of a country. It really goes hand in hand with property rights in general.
Countries such as India are very poor because of an overbearing government. The regulations are so burdensome that they stifle economic growth. Property rights are not as strong as most of the developed countries in the world, and in addition, currencies used in third-world countries tend to be very unstable.
The governments and central banks in these countries have a habit of paying their bills through inflation, even more so than in developed countries. These nations are poor to begin with, and inflation tends to be the easiest form of taxation.
In most third-world countries, you are likely to see other forms of money used, even if on the black market. Many foreigners will use the U.S. dollar or another relatively stable currency instead of holding the currency of their home country, which quickly loses purchasing power.
It’s sad that so many people desire U.S. dollars when the dollar has lost over 95% of its purchasing power over the last hundred years. But the dollar is still that much better than so many other fiat currencies.
Don’t Blame the Fed
I have seen a few people pinning the blame on the Fed for the currency troubles that have popped up. The Fed has certainly engaged in unprecedented monetary inflation over the last six years, more than quadrupling the adjusted monetary base.
It is also true that dollars do find their way to other countries, but this is in the form of actual dollars (physical currency). The digits are all part of the banking system.
However, the Fed is simply not to blame — at least not directly — for the currency problems in other countries. It’s the governments and central banks of those countries that are guilty.
The main reason the lira (Turkey) and the peso (Argentina) are falling is because they are fiat currencies. The central banks are creating too many of them.
If it were the Fed’s fault, then why aren’t we also seeing major currency problems in Switzerland with the Swiss franc?
Mercantilism to the Rescue?
It is true that some governments and central banks around the world are engaging in massive monetary inflation because of the Fed’s policies. They think they have to devalue their own currencies so they don’t rise against the dollar and harm their exporting sector.
This is mercantilism. China is the best example of this. The Chinese central bank continues to debase the yuan in order to subsidize its export sector. It wants to keep shipping cheap products to Americans.
And while this does help the export sector in China, it comes at the expense of the average Chinese resident, who has to pay more for its own nation’s products and services.
It is bad economic policy, and it subsidizes the American consumer. It is not the fault of the Fed that other central banks feel the need to compete with the Fed in monetary inflation.
Foreign countries could simply let their currencies appreciate against the dollar by refusing to inflate or at least inflating at a much slower pace. This might hurt the exporters in the short run, but it would mean an overall higher standard of living for the people living there.
It would also lead to better long-term economic growth, as resources are allocated more in accordance with actual consumer demand.
Kicking the Can
I think the best lesson we can learn from these currency crises is that you can only kick the can down the road for so long. Did government “leaders” in Argentina think they could just keep interest rates artificially low forever? Did they think they could continue to just print money to pay their bills and never see the consequences of it?
When push came to shove, even these troubled countries eventually gave in and allowed interest rates to go up, likely halting or severely slowing their pace of monetary inflation. The day of reckoning is here for them.
At some point, even Keynesians and socialists must relent and slam on the monetary brakes. If they don’t, hyperinflation will result.
Officials in Argentina and Turkey realized they were losing control of their currencies. We will see if they can regain enough confidence to avoid runaway inflation.
But Americans also need to realize you can only kick the can down the road for so long. Because the U.S. is very wealthy in comparison to many of these countries, and because the U.S. dollar still serves as the world’s reserve currency, the road is a little longer for the U.S. government. However, at some point, even the day of reckoning will hit for the U.S. government and the Fed.
It’s easy to forget the U.S. faced something similar in the 1970s with double-digit interest rates and double-digit price inflation. At that time, the Fed was losing control of the dollar. Confidence was way down, and the money velocity was high. People were getting rid of their dollars in anticipation that they would continue to lose purchasing power.
It wasn’t until Paul Volcker took over at the Fed and slammed on the monetary brakes that people regained their confidence in the U.S. dollar. Stopping the monetary inflation and allowing interest rates to rise even more were the necessary steps to restoring the currency.
It also resulted in a severe recession.
The Day of Reckoning
We really have no idea when the Fed will face its day of reckoning. It is trying to taper right now, and the economy and stock market are showing signs of a correction. Will Janet Yellen’s Fed continue to taper and allow a deep recession, or will the Fed reverse course and try to kick the can down the road again in order to avoid short-term pain?
If the Fed continues its path of quantitative easing, there will be a day when the Fed will have to decide between hyperinflation and a severe correction. I think it will ultimately choose the latter.
From an investing standpoint, it is impossible to know when this will happen. It might be a year from now, or it might be five years from now.
My guess is the Fed will not allow a full shakeout or correction this time around. If anything, Yellen will likely push her foot on the monetary accelerator to avoid the pain. It will just make the future pain that much worse.
In the meantime, you want to have some exposure to hard assets such as gold to protect yourself against continued monetary inflation. Betting on foreign currencies is probably not the answer, as it seems to be a race to the bottom.
Until next time,
Geoffrey Pike for Wealth Daily
