God is a Capitalist

Tuesday, February 11, 2014

ABCT Extends to Emerging Markets

Trouble in emerging markets has provided the rationale for at least part of the recent correction in the stock market. Emerging markets, such as, Brazil, Russia, India, Turkey, Thailand and China, are suffering largely because of the withdrawal of US dollar investments from them and this confirms the effects of monetary policy as described by the ABCT, the Austrian business cycle theory. Here is a chart showing the performance of emerging market stocks relative to the rest of the world:

To refresh your memory, the ABCT states that inflationary monetary policies such as those of the Fed for the past five years will cause an unsustainable boom as new money pours into the economy and stimulates demand for consumer goods and for investment. Usually we think of the ABCT in terms of a single nation, but the EM problems demonstrate that it has international implications, especially in a world of increasing trade integration and a currency that other countries use for trade and their banks for reserves.

 Mises wrote that trade deficits happen when the banks create more credit money than the domestic population wants to hold:
“The role money plays in international trade is not different from that which it plays in domestic trade. Money is no less a medium of exchange in foreign trade than it is in domestic trade. Both in domestic trade and in international trade purchases and sales result in a more than passing change in the cash holdings of individuals and firms only if people are purposely intent upon increasing or restricting the size of their cash holdings. A surplus of money flows into a country only when its residents are more eager to increase their cash holdings than are the foreigners. An outflow of money occurs only if the residents arc more eager to reduce their cash holdings than are the foreigners. A transfer of money from one country into another country which is not compensated by a transfer in the opposite direction is never the unintended result of international trade transactions. It is always the outcome of intended changes in the cash holdings of the residents. Just as wheat is exported only if a country's residents want to export a surplus of wheat, so money is exported only if the residents want to export a sum of money which they consider as a surplus.”[1]
I know. What Mises wrote is backwards to what mainstream economics and the financial media have taught you: trade in goods happen first then money follows to square the balances. But give Mises’ explanation a chance. Much of Austrian economics contradicts mainstream theory.
Mises wrote about international trade. I’m concerned here with international investing, but the same principle applies. Just as consumers will buy imported goods if they Fed creates more money than US citizens want to hold, investors will “import” investments (export money) if they can’t find opportunities in the US as profitable as those in other countries. As a result, the Fed exports its unsustainable boom, often to emerging market countries, one reason that Fed monetary pump has not generated the higher inflation in the US that the Fed would like.  
The export of US investment dollars to emerging market countries caused the boom in their economies but merely the threat of reduced credit expansion by the Fed has brought turmoil. Of course, the Fed has done nothing but nipped at the massive bond purchases by cutting back ten of $80 billion in purchases per month. The Fed advertises that it will keep interest rates near zero indefinitely. That means that money flowing to emerging markets will not increase in the future, which would not be a bad thing until you remember that in order to keep an economy growing on newly minted money the banks have to increase the rate of money creation. Therefore, a leveling off of money creation is as hard on the unsustainable boom as an increase in interest rates. Emerging market countries enjoyed the boom fostered by Fed profligacy; now they are paying the price in terms of reduced funds flowing to them. As Mises wrote:
“One of the main objectives of currency devaluation-whether large-scale or small-scale-is...to rearrange foreign trade conditions. These effects upon foreign trade make it impossible for a small nation to take its own course in currency manipulation irrespective of what those countries are doing with whom its trade relations are closest. Such nations are forced to follow in the wake of a foreign country's monetary policies. As far as monetary policy is concerned they voluntarily become satellites of a foreign power. By keeping their own country's currency rigidly at par against the currency of a monetary "suzerain-country," they follow all the alterations which the "suzerain" brings about in its own currency's parity against... the other nation's currencies.”
The emerging market situation reflects another aspect of the ABCT: most emerging market nations export commodities such as metals, food, coal and oil. In the Austrian taxonomy, they produce higher order goods, consumer goods being the lower order. In another analogy, commodities are at the headwaters in the production process and flow downstream through many transformations before becoming consumer goods. Commodities are much more sensitive to changes in the money supply because producing them is such a capital intensive process. As a result, commodity production is much more volatile than consumer goods production.
So emerging markets are facing two problems: 1) the withdrawal of investment funds from the US, which will cause higher interest rates in those countries and 2) a collapse in the demand for commodities as the boom ages and turns into a bust.
If only the Fed could see the damage it causes.

[1] Ludwig von Mises, Human Action: A Treatise on Economics, Scholars Edition, 1998, 446.

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