Exchange Controls and Deflation

by: David Goldman

Treasuries and gold tanked together on Friday, evidently in response to news reports that Asian countries may impose exchange controls to hold back the septic tide of dollars bubbling out of the Fed’s printing press. Never before has the world displayed the sort of public contempt for American policy that Germany, China and others expressed last week. Wolfgang Schaueble’s Spiegel interview last week describing quantitative easing as “clueless,” followed by Federal Chancellor Angela Merkel’s open attack on it during the G20 meetings, is entirely new, as is the Chinese and other Asian threat to simply keep dollars out.

The rest of the world is right and the Fed is wrong. QE2 is turning into TItanic I. The Fed has been exporting inflation through excess money creation; holders of dollars buy foreign currency, which forces foreign central banks to intervene on foreign exchange markets by selling their own currency. The foreign central banks create new local currency in order to buy the unwanted dollars and stabilize their exchange rates, which adds to inflationary pressures in their countries. They use the dollars they have bought to buy Treasuries.

If the Asians do impose exchange controls, they will have to print less of their own currency and buy fewer Treasuries. The global float of currency grows at a slower pace, which is deflationary, and of course the bid for Treasuries diminishes. Foreign central banks have been buying Treasuries at a $900 billion pace this year, more than the proposed $600 billion quantitative easing by the Fed.

We have never been in a mess like this before, and it is difficult to forecast market reactions. In some ways the collapse of American policy should favor gold, although the near-term deflationary effect works in the opposite direction. I have stop-losses on my gold futures positions in case the market shakes out violently. On the other hand, if central banks distrust the Fed, they may simply buy more gold.

The only historical analogy would be to October 1980, when Fed Chairman Paul Volcker returned from the Belgrade annual meeting of the International Monetary Fund and pushed the fed funds rate up to mid-double-digits. Treasuries, gold, and the economy crashed. A generalized run out of the dollar forced his hand and finished off the presidency of Jimmy Carter. This is extremely unlikely today for one obvious reason: measured inflation is extremely low, as opposed to double digits when the Fed acted in 1980. No one wants the Fed to take such drastic action, surely not the Asians, for the US economy would seize up and their exports to the US would crash.

This sort of situation is bad for ALL asset classes: stocks, bonds, and commodities. The prudent thing is to increase cash positions.