The Emerging Markets Story: a repeat of the 1830s?
I’d like to present a rather eccentric comparison of two market environments; the emerging market boom of the 21st Century and the US boom of the 1830s.
During the 1830s, gold, silver and copper circulated as money throughout most of the world. In the US, both gold and silver were the legal tenders, but silver was practically the only one in use. This was the result of the misguided policies of bimetallism. Simply put, the US government decreed that silver should trade with gold at a rate of 15 to 1, whereas the world market rate stood at ~15.75 to 1. This put silver at an overvalued status and gold at an undervalued status; so the process described by Gresham’s law ensued. Silver rushed into circulation whereas gold disappeared into hoards and flowed abroad.
Over the border in Mexico, the Santa Anna Regime were also playing god with their own currency; their central-planning tool of choice was to repeatedly debase Mexican copper coin. They did this while still retaining the exchange ratio between copper and silver before the debasement. This pretender policy severely overvalued copper, and severely undervalued silver. Gresham’s law kicked into gear once more; copper coins were flung around in exchange while silver was hoarded and exported.
Perhaps you can see where I’m going with this; if there is a strong profit-motive for Mexican entrepreneurs to export silver, where is it going to go? Naturally, it flowed to the US. The stock of silver metal in the US more than doubled between 1833 and 1837.
But that is not all. The metal that flowed into the US was – by and large – deposited into US banks, which engaged in fractional-reserve practices. Consequently, the supply of money in the US exploded (sound familiar?). This period would have been great for virtually all businessmen and debtors. Virtually all people who owned things and owed money would have gained, and a lot of other people must have capitulated into that trade.
The central insight of Ludwig von Mises’ work on socialism was that all central planning must fail. The misguided policies of the Santa Anna regime were no exception; they were forced to embrace the reality of markets and ceased their policy of copper coin debasement. Thus the profit-motive that compelled Mexican entrepreneurs to export silver vanished.
Over in the US, the ‘short money long things’ trade – all of a sudden – wasn’t looking so hot. The mass of market participants rushed to sell things and buy money (all at once), precipitating the panic of 1837.
To summarize, the boom of the 1830s was not the result of human inspiration, superior business practices, demographic change or whatever other rationalization that might have been used at the time. Rather, the unintended effects of a debauched monetary policy in Mexico implied a boom in the US. To me, all of this sounds rather familiar. My question is; can we substitute the West for Mexico and emerging markets for the US?
The 21st Century Emerging Market Story:
Today, however, the money supplies of the world consist of central bank notes (federal reserve notes, sterling notes, …) and demand deposits. The central bank notes are themselves centrally planned in their composition. Meaning, the ‘backing’ for (say) a dollar is decided by the Fed. That is, elected officials decide what central bank notes will consist of, and then force them upon us (to the degree that we accept them). The demand deposits components of modern money supplies are also partly socialized in the sense that bankers have special privileges (eg. bailouts). Furthermore, the exchange ratios between central bank notes and deposits are tweaked by central planning authorities via manipulation of short-term rates.
That’s a lot to stomach! It is no wonder that the discipline of understanding money is so confused!
The policies of western governments are now persistently overvaluing demand deposits with respect to central bank notes. As a crude indicator, I include some charts of real interbank rates below:
Now, we mustn’t confuse the usage of Gresham’s law and say that deposits will invariably drive out central bank notes. Rather, we should note that a process of hoarding central bank notes tends to extinguish demand deposits (withdrawals). In an economy where the overvaluation and undervaluation are large, widespread withdrawals are inevitable unless there exists a viable outlet for capital via the carry trade (implicit exporting of central bank notes). It is my contention that the emerging markets have been that outlet for western capital in recent years, and the result has been the emerging markets boom.
The potential for a severe ‘scarcity of money’:
If my reasoning is correct, then we should be fearful of a world in which the real rates of return on emerging market deposits are sinking. A fall in the real rates of return on emerging market deposits could set up a situation where a great portion of western capital is repatriated at once. Upon being repatriated, there may be tendencies for the extinguishment of credit and other IOUs, as the overvalued status of deposits gets ironed out.
This is why I believe that recent commodity price spikes are cyclical twists, designed to get people positioned in the worst place at the worst time.
In the 1830s, the policies of Mexico created a boom and bust in the US. In the 21st century, the policies of the west may be creating a boom and bust in the Emerging Markets. Should this occur, the implications could be a profound scarcity of money in the west.
Recommended: Charting the Federal Reserve's Assets - 1915 to 2012