Intervention With a new twist


With a new twist

By Martin A. Armstrong

Copyright August 14, 1998

Princeton Economic Institute

Friday’s price action in Hong Kong brought with it more than a mere short-cover rally of 9%. For perhaps the first time in history a government has directly intervened in a share market using the futures to do so. The Hong Kong exchange fund (front for the HK government) bought the index futures (not the stock) in an effort to attack those who have been betting on a HK$ devaluation. The Hang Seng futures jumped 9% in a single day. The government intervention was indeed sparked by a widespread rumor that the hedge funds were positioning themselves for a big attack on Hong Kong come Monday the 17th when the HK market is scheduled to be closed.

Those interested in trading the HK$ usually buy the forward and short the Hang Seng index. This strategy is typically used in belief that as interest rates are raised sharply higher in an effort to defend the HK$ peg, the real victim is always the Hang Seng index. Based upon this trading strategy, the government intervened in the Hang Seng index futures trying to squeeze the hedge funds out of the market and thus avoid a HK$ devaluation. While this strategy may have proved to a successful for one day, it is unlikely to save China or Hong Kong from an inevitable devaluation. Holding the HK$ has indeed caused severe damage to the economy. Property prices have collapsed putting pressure on bank loans. While the HK$ is being defended for a political face saving effort, there is no regard as to its impact upon the economy as a whole.

Japan has spent billions of dollars in a vain attempt to support its currency for political reasons as well. In the case of Japan, the government intervened immediately following an announcement of one its its latest stimulus packages in an futile attempt to try to pretend that the market rejoiced over the political decisions in Japan. Of course the yen immediately retreated and often made new lows thereafter within less than a week or two. Still, the Japanese politicians tried to create the false image that the world approved of their policies by using intervention. We also saw the same attempt throughout Southeast Asia and in Korea as politicians stood their ground trying to intervene instead of addressing the issues that had caused a decline in confidence in the first place. Now the intervention crowd has also been joined by Canada, which is trying the very same approach to support its currency while refusing to review its political-economic policies of high taxes. And of course no list of the intervention crowd would be complete without the Clinton/China intervention against the dollar yen made back in June. The problem we now face is that this crowd of official market manipulators are being also joined by the nightmare in Russia as the IMF continues to squander the taxpayer’s money of the world in defense of another hopeless cause.

We must face the facts. Whenever a government is forced for political reasons to intervene within the currency markets, or now even share markets, this very action proves beyond a shadow of doubt that their current political policies are a complete failure. In the case of Hong Kong, the government wrongfully believes that if the peg goes then foreign investment will no longer trust HK and in fact it will leave. In reality, capital will leave anyway when it perceives that the government policies are wrong and that the currency is overvalued relative to its economy. Politicians view currency values as a scorecard. Therefore, instead of reversing their political-economic policies or at least taking an objective view, they claim that the marketplace is wrong and try to intervene.

Like Britain being forced out of the ERM, the turmoil exists prior to the collapse – not afterwards. The pound was established in the ERM at the highest possible rate for political prestige purposes. That overvaluation from the start was not supported by the underlying economic conditions on a sustainable basis and the pound was eventually forced back out of the ERM. While politicians scream loudly whenever the markets force a currency devaluation, in reality the adjustment is typically followed by a reversal in economic conditions when the devaluation is fair. The pound departure from the ERM marked the precise low in the British economy. Following a devaluation, foreign capital normally surges into the effect economy looking for bargains. However, IF the devaluation is viewed to be not enough, then foreign capital still stays away.

In the case of Hong Kong, the politicians are in fact sealing their own fate by intervening in the HK share market. If investors now have to worry about political intervention in the price of shares, then you are better off staying away from those shares entirely. This latest round of intervention may in fact cause more damage than good if capital now has to worry about overvalued shares with prices established by politicians in the same manner as its currency. Hong Kong should simply get on with its devaluation and focus upon restoring economic growth. The current policy may lead to widespread bankruptcies and bank insolvencies the longer the HK$ remains overvalued for political reasons. The devaluation pressures building in HK have had no basis relative to its reserves. The entire case for a devaluation is simply that the HK$ is overvalued for the region. This war by the government to hold the HK$ at all costs have in fact undermined its own economy while exposing itself to far greater weakness. Thus, the entire issue of holding the peg has in fact been a political disaster that has now given capital just cause to sell Hong Kong due to a future that appears quite uncertain.

In the case of Canada, the government here too cannot raise interest rates without destroying jobs. The issue in Canada remains the burden of socialism that has caused its government to overtax its citizens and drive capital investment from its shores. The government here too will be unsuccessful in supporting the C$ long-term. In the end, either the government will collapse despite its majority position or it must reverse its policies on taxes. As the economy implodes due to high socialistic tax policies in Canada, the majority will fracture due to public pressure and it will be this trend that has always undermined even the strongest majority as we are seeing in Germany and Japan. The longer Canada refuses to admit that Reagan and Thatcher’s policies of lower taxation attracts more business thus creating jobs, the steeper the fall in the C$ in the months ahead. In the end, we may see a 59-60 cent level in the C$ against the US before the government begins to come to its senses.

In the case of China, devaluation is again inevitable. While we may not fear wholesale defaults or a banking collapse since the government still owns the big industries and the banks, nonetheless the economic pressures demand a devaluation of the currency. Devaluations are NOT merely for trade considerations. A devaluation is also a means through which an economy writes down its internal debt. Unfortunately, debts that have been borrowed in terms of any foreign currency increase in direct proportion to the devaluation in local currency terms causing defaults internationally. For this reason, we have been critical of the IMF and its policies of lending in dollars while demanding that a currency must not be devalued. If the IMF took the risk of the local currency, there would be no international default on the books of the IMF merely a currency depreciation due to the forces of inflation.

When we look at Russia, how anyone can possibly image that there is an investment opportunity in this nation may be grounds for a case of insanity. While assets may appear cheap by international standards, Russia lacks far more than mere infrastructure. Russia is effectively devoid of any rule of law. Individuals refuse to pay taxes and the government has yet to pay its own workers for months on end. While assets may appear cheap, there is no economic structure within the Russian economy through which the potential productivity can be brought into focus. The Mafia rules the nation and keeps Yeltsin in power against all odds. This is why Yeltsin can sack his entire cabinet while at the same time the majority of political power still rests in the hands of the communists under various political names. The IMF makes matters worse by lending to Russia in dollars and then demanding that it must not devalue or else the IMF will lose. The IMF also demands that Russia must make interest payments on all loans even before it pays its workers. This is a plan designed to create revolution – not economic stability. Once the loans from the West stop, Yeltsin has served his purpose and will be deposed. From the domestic political perspective, it can be argued that the IMF is pillaging the resources of Russia by extracting interest payments it cannot possibly afford. If the West intended to help Russia, it should have called the IMF loans aid. At least if we looked at Russia with open eyes, perhaps we would have seen that taking a communist state and transforming it into a capitalistic functioning economy will take far more than a single generation.

In the case of the Euro, again we see politicians trying to establish currency values based upon political prestige instead of reality. No one is asking the important questions about what happens if an individual economy within EMU diverts, as was the case with the UK several years ago. If the individual currencies cannot float to reflect the divergences within European economic conditions due to fixed rates prescribed by LAW, then there is no possibility for a devaluation. However, fixing rates by LAW between EMU currencies over the next 4 years will in effect shift the burden of defending all individual economies to the ECB (European Central Bank) which would then be forced to pump in cash from the rest of Europe. In effect, one only needs to look at the turmoil in Asia and particularly Hong Kong to see what happens when the value of a currency is fixed at an unrealistic level. A decline within the southern European economies could cause a drain upon the economies of the north as the ECB by decree is forced to intervene thus squandering its reserves in support of yet another unrealistic political ideal.

In the case of Japan, again we see a political agenda that has refused until recently to even admit that Japan has been in a recession. This policy of political denial has forced the LDP into a hopeless action of intervention to support the yen at all costs. Japanese politicians want a higher yen because they too view the weakness in the yen as a vote against the policies of the LDP. Despite a devastating loss for the LDP in the Upper House Elections, the policies toward tax reduction and the reduction in burdensome regulation have not changed. The government refuses to relinquish its iron grip control over virtually every aspect of its economy that has led to the myth many refer to as “Japan Inc.” The Japanese government in the face of adversity still refuses to consider that it may be the cause of the problem. Tax cuts are proposed in a begrudging manner and of course they would not dare consider them to be permanent since it might reduce the government’s revenue. Therefore, once again we see the yen sliding against the dollar during press conferences that proclaim that the trend has changed while no change in the political agenda can be found.

While all these issues are clearly causing havoc within the global FX markets driving the dollar even higher and sending the world into a deflationary tailspin, at some point we must ask ourselves should political motives be allowed to continue to fix currencies at rates that are economically unsupported? Should government investigations be permitted to take place without also an investigation into the possible role of government itself? We must realize that Bretton Woods collapsed along with the gold standard for the very same reasons we are experiencing today. Money supply was allowed to expand along with political social programs without a realistic view as to the value of gold and its peg to currencies. Eventually, money supply growth grew far beyond the amount of gold when fixed at $35 per ounce causing the gold standard to collapse. Politicians refused to readjust gold’s value due to the fact that this would have reflected the degree of money supply growth sparked by socialism during the postwar period. Had the peg between gold and the value of a currency been flexible, the gold standard would have automatically adjusted the value of gold in direct proportion to the money supply. However, this would have revealed the degree of inflation that was honestly being created instead of masking the issue by expanding public debt. While many in government who enjoyed being able to promise anything argued that national debts were really a borrowing from ourselves, the underlying economics of the transaction were never looked at in detail. Was it truly less inflationary to borrow than monetize? If you look at any national debt over the past 20 years, one will find that 70% is due to rolling the debt to pay for accumulative interest payments. This is why both China and Russia will devalue. Both currencies are being fixed within the world marketplace while internal debts rise. Thus, the very same trends that caused the collapse of Bretton Woods has now made the outcome inevitable. Therefore, it was the inflexibility of the system created by political agendas that eventually undermined Bretton Woods itself and will now further undermine the world economy once again. In the case of Bretton Woods, we simply let it go and the world survived. In the current atmosphere, governments around the globe are conducting a desperate war to hold off the inevitable by means of intervention.

In the final conclusion, we must realize that it has ALWAYS, and without exception, been the very forces of government that have undermined both its own economy as well as the value of its currency. The root cause of this historical trend has always been the relentless desire for government to spend more than it has and to control more than it should. While during previous centuries government spent recklessly in pursuit of its own power and empires, the postwar period has been marked by the same relentless spending but for an empire of social programs. With the advent of socialism, government has contributed greatly to the undermining of the family structure. Where the family unit took care of its own, the government replaced the role of the family. Now, when someone is in trouble, they turn to government rather than their own family. This power in the hands of the politicians has been destructive when taken to excess. The social structures of government moved beyond taking moral responsibility for those who were in need to instead trying to provide structures for everyone thus replacing the strong family sense of responsibility that dominated social structure during previous centuries. While these policies have been popular among the people and given great support to socialistic political parties, they are in reality an unsustainable long-term goal. Where business is always in pursuit of trying to reduce its transaction costs in hopes of increasing profits, government ignores transaction costs (tax rates) thus insuring its own demise. The costs of political promises are never considered as a percent of the total economy. Politicians only look at what would be popular in order to retain power. However, like any parent who refuses to discipline his child, in the end one creates a spoil dependent that often demands unrealistic benefits.

Indeed perhaps the most interesting challenge that socialism has yet to face is the coming debacle over inheritance taxes. Where people are worried about Y2K problems, no one seems to be interested in considering the implications of an excessively high inheritance tax and the potential to wipe out more than 40% of all small businesses in many countries over the next 5 years. In Japan, this is rising to the crisis level when inheritance taxes stand at 70% and several generations live in the same house due to the high cost of real estate. The inheritance tax rate in Japan not merely threatens the core of its small business community; it also poses the risk of forcing families into a homeless situation. Likewise, inheritance taxes threaten much of Europe. While the US has addressed this issue by increasing the amount of wealth that is tax-free to $1 million, it still leaves a fair number of small family business operations at risk in the years ahead. Can we imagine what would happen to the world economy if every generation were forced to sell off its assets for taxes and start over? Would any major company exist in the future if 70% of its assets were confiscated each time wealth passed from one generation to the next?

The chaos we are now witnessing is emerging from those economies where the political goals are the most out of synch with its economy. Whether or not we could ever design a form of government that was sufficiently restrained to prevent such grave mistakes of fiscal mismanagement in the future remains perhaps only a utopian dream. Government, no matter what form its takes, tries so hard to ignore its own contribution to world financial chaos. Like Britain who blamed Soros for the demise of the pound or Malaysia who called for a total ban on foreign exchange markets, neither admitted for a single moment that perhaps politics interfered with sound economics. While history never repeats in the same identical manner, it does repeat in the sense of cause and effect. Government enjoys the power and in that sense it loathes the thought of giving up that power no matter how noble the cause. Nonetheless, government must learn that its duty is to provide the basic rule of law, legal structures within which disputes are addressed while insuring public safety both in products sold and crime. While government may provide the moral conscience of society by insuring that no one starves and that the people must be provided with training and education, it must not be allowed to move into a position where it provides for the welfare of society as a whole. Once a blanket-wide social system is unleashed, then the costs will never match the benefits. Perhaps the nations of the West should look well at the lessons emerging from this chaos before it too strikes deep within the hearts of our own political-economic systems. Intervention will not save the world – only honest reflection upon the inefficientcies within each economy even if government itself is partly responsible. It is time that government stops blaming the free markets for their failures – some self reflection has become a matter of the utmost urgency.