May 5, 2015

The Bloomberg article posted HERE reports that after a decade-long 5-times increase, the worldwide stash of foreign currency reserves held by central banks has begun to shrink. Is this good, bad, or irrelevant?

The answer is no — it’s not good, it’s not bad, and it’s not irrelevant. To be more accurate, it would be good if it indicated a new long-term trend, but it almost certainly doesn’t indicate this. Instead, it is just part and parcel of the way the current monetary system works.

The key to understanding the implications of global reserve changes is knowing that these changes are mostly driven by attempts to manipulate exchange rates.

During the first stage of a two-stage cycle, many central banks and governments perceive that their economies can gain an advantage by weakening their currency on the foreign exchange market. Although it is based on bad theory, this perception is a real-world fact and often guides the actions of policy-makers. It prompts central bankers to buy-up the main international trading currency (the US$) using newly-printed local currency, resulting in the build-up of foreign currency reserves, growth in the local currency supply, and an unsustainable monetary-inflation-fueled boom in the local economy.

The build-up of foreign currency reserves during the first part of the cycle is therefore not a sign of strength; it is a sign of a future “price inflation” problem and a warning that the superficial economic strength is a smokescreen hiding widespread malinvestment.

During the second stage of the cycle the bad effects of creating a flood of new money to purchase foreign currency reserves and manipulate the exchange rate become apparent. These bad effects include economic weakness as investing mistakes become apparent, as well as uncomfortably-rapid “price inflation”. Pretty soon, policy-makers in the ‘reserve-rich’ country find themselves in the position of having to sell reserves in an effort to arrest a downward trend in their currency’s exchange rate — a downward trend that is exacerbating the local “price inflation” problem. This is the situation in which many high-profile “emerging” economies have found themselves over the past two years, with Brazil being one of the best examples.

In other words, the world is now immersed in the stage of the global inflation cycle — a cycle that’s a natural consequence of today’s monetary system — in which reserves get disgorged by central banks as part of efforts to address blatant “inflation” problems. This would be a good thing if it indicated that the right lessons had been learned from past mistakes, leading to a permanent change in strategy. However, that’s almost certainly NOT what it indicates.

The disturbing reality is that at some point — perhaps as soon as this year — a large new injection of money will be seen as the solution, because bad theory still dominates. As evidence, I cite two comments from the above-linked article. The first is by the author of the piece, who implies in the third paragraph that emerging-market countries need to boost their money supplies to shore-up faltering economic growth. The second is from a former International Monetary Fund economist and current hedge-fund manager, who claims via a quote in the fourth paragraph that emerging markets now need more stimulus.

So, emerging-market economies have severe problems that can be traced back to earlier monetary stimulus, but the solution supposedly involves a new bout of monetary stimulus. Let the idiocy continue.

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