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"No gold-digging for me… I take diamonds! We may be off the gold standard someday."

                              Mae West

Commentary & Analysis

Currency Warriors had it wrong. And now EMs may be lurching into crisis.

The emerging (developing) market [EM]) currencies are getting clobbered. It seems the idea of EM growth as far as the eye can see, as once heralded by the BRIC lovers, is fading fast.

Source: Financial Times

The realization that EMs lack enough internal demand and depth of capital markets is coming home to roost. They have not been able to sever their dependence (remember how we have been sold on the bill of goods called "decoupling" by many EM sponsors) on those dead old industrialized economy consumers. And the demand from their new leader — China, where much of its growth depends on those dead old industrialized economies — is adding to EM woes.

Interesting that not long ago all of those armchair currency warrior analysts were so worried about all that money pushing those EM currencies to the moon. Now, EMs are doing all they can to prop up the value of their currencies. Shouldn’t that be considered war against the United States dollar and other industrialized world currencies now? Oh where have you gone currency warriors (sung to the tune of "Mrs. Robinson") …

I wonder if Jim Rickards’ book, Currency Wars, has hit the give-away bin at Barnes and Noble yet. Jim seemed to tell us a lot about his resume in that book, and not much about currencies, in my humble opinion.

Here is what I wrote about the fake currency wars back on February 8th, 2013…

Of course adding to the "Currency War" scare pieces of late you have probably seen the invocation of…wait for it….wait…be ready to be scared…"The 1930’s all over again!" Sorry Yogi.

Oh really. "The 1930’s again?" I like what Niall Ferguson wrote about the phony "Currency Wars" a couple of weeks ago in the Financial Times:

"Back in the 1930’s it was obvious who was waging a currency war. Before the Depression, most countries had been on the gold standard, which had fixed exchange rates in terms of the yellow metal. When Britain abandoned gold in September 1931, it unleashed a wave of competitive devaluations. As economist Barry Eichengreen argues, going off gold was the essential first step towards recovery in the Depression. Floating the pound not only cheapened British exports; more importantly, it allowed the Bank of England to pursue a monetary policy focused on domestic needs. Lower interest rates helped generate recovery via the housing market.

"Today, however, we live in a world of fiat money and mostly floating rates. The last vestige of the gold standard was swept away in August 1971, when Richard Nixon suspended the convertibility of the dollar into gold. For one country to accuse another of waging a currency war in 2013 is therefore absurd. The war has been going on for more than 40 years and it is a war against all of us."

Central banks (CBs) are delusional in their belief that they can wonder off into a fantasy land of monetary madness and it not lead to some type of blowback.

The crush out of EM currencies on the back of a relatively small increase in market yields shows just how hooked on credit these countries must be and how desperate for more they must be in a world of tepid aggregate demand. This has boom-bust written all over it. We have seen it many times before. Here is how George Soros defined it in Alchemy of Finance, circa 1987:

The connection between lending and economic activity is far from straightforward (that is, in fact, the best justification for the monetarists’ preoccupation with money supply, to the neglect of credit). The major difficulty is that credit need not be involved in the physical production or consumption of goods and services; it may be used for purely financial purposes. In this case, its influence on economic activity becomes problematic. For purposes of this discussion it may be helpful to distinguish between a ‘real’ economy and a ‘financial’ economy. Economic activity takes place in the real economy, while the extension and repayment of credit occur in the financial economy. The reflexive interaction between the act of lending and the value of the collateral may then connect the ‘real’ and the ‘financial’ economy or it may be confined to the ‘financial’ economy. Here we shall focus on the first case.

A strong economy tends to enhance the asset values and income streams that serve to determine creditworthiness. In the early stages of a reflexive process of credit expansion the amount of credit involved is relatively small so that its impact on collateral values is negligible. That is why the expansionary phase is slow to start with and credit remains soundly based at first. But as the amount of debt accumulates, total lending increases in importance and begins to have an appreciable effect on collateral values. The process continues until a point is reached where total credit cannot increase fast enough to continue stimulating the economy [this may be precisely where the EM markets are now in this process as evidenced by the chart above showing the number of units of credit to produce a unit of gdp growth]. By the that time, collateral values have become greatly dependent on the stimulative effect of new lending and, as new lending fails to accelerate, collateral values begin to decline. The erosion of collateral values has a depressing effect on economic activity, which in turn reinforces the erosion of collateral values. Since the collateral has been pretty fully utilized at that point, a decline may precipitate the liquidation of loans, which in turn may make the decline more precipitous. That is the anatomy of typical boom and bust.

To taper or not to taper, that is the question. [My apologies to Bill…]