Memo To: Website browsers, fans and clients
From: Jude Wanniski
Re: Origins of the Asian Flu
Almost every day there is a new hypothesis on why the economies of southeast Asia suddenly collapsed this year after so many years of stability and expansion. Most of them help explain why problems compounded once the slide began. None trace it to its source — the dollar deflation in 1997 that emerged from the Federal Reserve's worries about economic growth.
For the last year, the dollar price of gold has been falling from its three-year plateau of $385 while the Fed has allowed dollar liquidity to become scarce. Because gold is the most monetary of all commodities, it is always the first to react to a surplus or scarcity of dollar liquidity — cash and bank reserves. It is the only proven test: Surplus produces inflation, scarcity produces deflation.
Because the dollar is so dominant as the world's key currency, all other central banks in the world must take note of its value in order to stay within the bounds of global commerce and finance. The Japanese yen and the German mark are satellite currencies, important in their realms, but still guided by the dollar.
One might suppose the currencies of southeast Asia would look first to the yen for guidance, but because of patterns of trade that have developed in the past 50 years, they have keyed on the dollar. The currency relationship proved beneficial to the region in the last 15 years as the Fed managed to stabilize the dollar within a range of $350 to $400 -- at least until November 1996.
The problem began for the region two years ago when Thailand imposed capital controls in an attempt to guard against the movement of equity or "hot" capital out of the country. Other countries were getting the same advice from western economists following the experience in Mexico, but only Thailand responded. Predictably, its stock market slowed to a crawl, then began a retreat.
At the same time, Thailand was experiencing a mild inflation as the dollar price of gold climbed to a $385 level from the $350 plateau where it had seemed to settle since 1985. The Fed had permitted this to happen when the 1993 Clinton tax increase took effect, diminishing the domestic demand for dollar liquidity. If the Fed were in a position to mop up the surplus by selling bonds from its portfolio, it could have kept gold at $350. Fed Chairman Alan Greenspan has no mandate to do so, however. All he could do was raise interest rates, which slowed the economy instead of making dollars scarce relative to gold.
In order to keep its currency, the baht, tied to the dollar during this 10% surge in the dollar's gold price, the Bank of Thailand had to inject liquidity into its banking system in the form of surplus reserves. If it did not, the baht would have appreciated against the dollar. The banks, having no first line borrowers with up-front collateral, pushed the reserves to the second tier of borrowers who would put it into bricks and mortar, hoping the market would keep expanding.
This, of course, was the practice throughout the region, as the other central banks followed suit, adding bank reserves to prevent their currencies from appreciating against the dollar or the baht. All was well and good until November of 1996, when the U.S. elections produced a re-elected Democratic President and a Republican Congress committed to bipartisanship. As the market began to sense a cut in the capital gains tax as part of a budget deal, the demand for dollar liquidity rose.
The Fed, though, did not supply new liquidity, which it could do by buying bonds from the banks, or indirectly by lowering the fed funds rate from 5.5%, which would lead to the selling of bonds according to the Fed's operating procedures. There was no sentiment at the Fed for these procedures, as there have gradually developed a fresh concern for the inflationary impulses which followed gold's rise to $385 from $350.
Without fresh liquidity, gold's dollar price began to decline, and by January, it had retraced its steps to $350 and continued in a gradual slide to $325 by July. In these seven months, the Bank of Thailand found that in order to keep from depreciating against the dollar, it had to drain baht reserves from its banking system. Alas, strapped for reserves, the banks could not lend to the enterprises that would have occupied the bricks and mortar built in the previous three years. The debtors had no choice but to turn their projects over to the banks and walk away.
All the while, the market players saw the deflationary ditch Thailand had been dragged into, speculating that the Bank of Thailand would have no choice but devalue. Devalue it did in early July. Having gambled and won in Bangkok, the speculators moved against the Malaysian ringgit and the Indonesian rupiah. Now, the weakened Thai currency meant Thailand's exporters would be dumping goods in the world market at distress prices.
The ringgit and rupiah might have hung on, but the dollar price of gold continued its decline, to $310, which meant the Malaysian and Indonesian central banks had to starve their economy of liquidity. They were doomed. Manila threw in the towel on the peso and Taiwan saw it was pointless defending its dollar and caved in as well. Only mainland China and Hong Kong were big enough and determined enough to scare off the speculators.
At first glance, this process may seem complex with so many tax and monetary variables involved, but it really is a simple mechanism understood by Fed Chairman Alan Greenspan, an advocate of a dollar/gold standard for most of his adult life. After the Mexican peso devaluation pulverized that economy, Mr. Greenspan told the Senate Banking Committee that had we been on a gold standard, the problems in Mexico would not have developed.
There's little point, though, in directly blaming the Fed chairman for the monetary policies of the southeast Asian economies. The Federal Reserve Act limits his responsibilities to the 12 Federal Reserve districts within our borders. Jack Kemp told Fox News on December 28 that the Asian crisis would not have occurred if the dollar/gold price had been pegged at $350 — which is the monetary policy he urged on this page on June 18, 1996. He is, of course, absolutely right, as Mr. Greenspan was about Mexico.
Mr. Kemp also urged the replacement of the top people at the International Monetary Fund, who rushed into the crisis situation as they usually do, offering loans of taxpayer money in exchange for promises of tax increases and further devaluations. If the IMF did not exist — a suggestion former Treasury Secretary William Simon made on this page in October -- it would not have been able to pour gasoline on the southeast Asian fire and would not now be rushing to our Congress for help.
The entire episode is a reminder that the world will continue to find it most uncomfortable living with the key currency of the only superpower if every country is forced in ways large and small to import our domestic economic policies, the bad and the good. Only if the dollar is anchored to a centerpole of gold will every other country find it comfortable inside our tent. If we don't fix our dollar, the rest of the world will be forced to defend against it with their own gold blocs.