Section 2. The Runaway U. S. Trade Deficit and Currency Manipulation Plots (Revised, February 9, 2013)

The Vigilante Mechanism of a Free Currency Market

The third hidden pillar of allowing currency market manipulations has been pointed out in Section 1 (the introduction) to be the essential element of supporting the "Globalization Process of Yesterday". The "Globalization Process of Yesterday" was clearly designed to let The U. S. run huge trade deficits. Why the designers of the "Globalization Process of Yesterday" want The U. S. to run huge trade deficit will be discussed in the next section, Section 3. The aim of currency manipulation plots is to nullify the vigilante mechanism of a free currency market so that the currencies of the exporting countries can be kept under valued vs. U. S. Dollar. Under valued currencies of those exporting countries will allow them to continue the export spree into The U. S. to let them to rake in huge trade surpluses on one hand and causes huge trade deficit of The U. S. on the other hand. Therefore, we start from the discussion about the free currency market and its vigilante mechanism in this section. Various currency manipulation plots, then, will be discussed one by one in succession.

The Free Currency Market and Its Vigilante Mechanism

Let us consider two countries A and B with currencies A$ and B$ respectively. Countries A and B trade manufactured goods freely without any tariff. Traditionally B$ is used for settling the trade. There is a free currency market to trade A$ and B$. At the beginning the trade between A and B is balanced, and A$ and B$ are traded at par, that is, A$1.00 = B$1.00. Suppose at certain point Country A has experienced a productivity surge based on new inovation so that the exports from A to B has increased, whereas the export from B to A has not changed. This means that Country A has started to have a trade surplus vs. Country B. Let us see how the free currency market will handle such a situation.

Exporters of Country A receive B$ for their exports. Since B$ is not the legal tender in Country A, those exporters must sell received B$ for A$ in the free currency market so they can pay the expenses and continue their operation. On the other hand importers of Country A must sell A$ at hand for B$ in the free currency market so they can use the B$ to buy things from Country B. At the time when the trade betwee A and B was balanced, the supply of B$ from the exporters of A and the demand of B$ from the importers of A are balance, so the exchange rate of A$ and B$ is stable. Now Country A is running trade surplus against Country B. This means the exporters of A are taking in more B$ than the demand from the importers of A. Thus B$ will depreciate against A$. The depreciation of B$ against A$ makes made-in-A goods more expensive in terms of B$, so the exports from A will fall. Whereas the prices of made-in-B goods when converted to A$ will drop so the imports of A from B will increase. The depreciation of B$ vs. A$ will continue until the trade between A and B becomes balanced again. This re-balancing of trade between A and B takes time. The trade surpluses accumulated by A during this re-balancing period becomes the reward of A for its inovation and productivity gain. This ability of a free market to force the re-balancing of trade is called "the vigilante mechanism" of a free currency market.

Let us consider another example to further illustrate the vigilante mechanism of a free currency market. We still consider two countries, A and B. However, A is a developing country with lower labor cost than B. Country A also has an iresponsible government that allows wanton environmental pollution. There were tariffs on goods trade, and barriers for the movement of capitals. Those two factors restrained the trade between two countries so the trade between A and B was balanced. Now suppose suddenly the tariff and the restriction on capital flow are lifted. Capital and knowhow from B will move into Country A to produce goods with lower cost, and then are exported back to Country B. Thus A runs trade surplus against B. According to the supply and demand of B$ in the currency market as discussed in the above examle, A$ will be pushed to appreciate against B$ until the advantage of production in A disappears. Then the trade between A and B becomes balanced again. Of course, the accumulated trade surplus of A in terms of B$ until the trade is re-balanced is the reward of Country A. Also a portion of under employed workers in A now have jobs of manufacturing goods to be exported to Country B. But those small rewards of Country A is obtained by sacrifizing its environment. Meanwhile some workers in Country B will lose their jobs due to the out sourcing, but some businesses of Country B become slightly richer due to the outsourcing.

The above two examples show how the vigilante mechanism of a free currency market works to re-balance the temporary trade imbalances. Without such a vigilante mechanism, the trade imbalance can just escalate into a disaster as we will discuss later.

If Country A in the above two examples want to keep running trade surplus against Country B, the vigilante mechanism of free currency market must be defeated. Various measures designed to nullify the vigilante mechanism of free currency market are called "curency market manipulation plots". The policy wanting to have perpetual trade surplus is called "mercantilism". However, there is still no official name for the policy adopted by The U. S. to let herself run huge trade deficit; we can only call it the "economic suicide". Now let us see what kinds of currency manipultion plots are currently employed around the world.

The Currency Market Manipulation Plot of the First Kind

This kind of currency manipulation is straightforward and easy to understand. When a country has trade surplus against The U. S., there will be surplus U. S. dollars wanted to be sold for the local currency in the currency market. If nothing is done, the local currency will appreciate vs. U. S. Dollar, and the trade surplus of the country will be reduced. This is the so called vigilante mechanism of the free currency market as discussed before. To counter this vigilante mechanism, the government of the trade surplus country will come into the currency market and buy up all those unwanted dollars to keep the local currency undervalued vs. U. S. Dollar so that the country can continue to export and enjoy the trade surplus. Japan, China and other smaller countries engage in this kind of currency market manipulation. In case of Japan, the usage of this type of manipulation has been limited to the time when her currency appreciates vs. U. S. Dollar very rapidly. When the government of a country buys up unwanted dollars, it must release a matching amount of local currency into the society. When Japan engages in the first kind of currency manipulation, Japanese central bank promptly takes measure to drain those added liquidity. Such drainage of the added liquidity is called the action of "sterilization". When "sterilization" is done, the effect of preventing the appreciation of the local currency will be short lived.

China and other Asian trade surplus countries routinely perform the currency market manipulation of the first kind, but usually do not perform sterilization action. For the case of China, the Yuan liquidity created by the central bank of China through the Dollar buying operation accounts for more than 90% of Yuan ever created. This vast amount of Yuan liquidity then has prompted local Chinese governments, some times alone and some times in conjunction with private parties like Hong Kong and Taiwan merchants, to undertake massive infrastructure constructions. That has been the reason of China's phenomenal growth in nominal GDP for many years. Though we have quoted China as an example here, China is not the first to engage in this route of development, totally legitimate according to the design of the Globalization Scheme. We call this type of development model by combining low labor cost, loose pollution control and the first kind of currency manipulation as "Taiwan Model" since Taiwan was the first to use the model to climb up the ladder of "quick rich". Taiwan Model in Taiwan was terminated by the early 1990s when the wage level in Taiwan rose substantially, and the dawn of democracy has allowed people to speak out against pollution. Also The U. S. Government had put enormous pressure to force Taiwan's currency to appreciate against U. S. Dollar. This pressure against Taiwan had worked temporarily since Taiwan is small and so heavily depend on The U. S. for its security. Around the time that Taiwan Model ended in Taiwan, China has started to engage in Taiwan Model and devalued Chinese Yuan massively. Those Taiwan merchants that had grown along with Taiwan Model in Taiwan have rushed into the mainland China to continue their Taiwan Model experience there and thus has turned China into "the factory of the world".

Some crude oil producing countries seem to continue rake in huge trade surplus and thus looks like violating the vigilante mechanism of free currency market. Actually it is not so. In those crude oil producing countries oil companies are nationally owned, so the government can withhold some of the revenue of oil companies, that is, dollars, and send those dollars directly to oversea markets to be invested without going through the currency market. What those governments are doing is just the same as the government itself buys those dollars from the nationally owned oil companies, pay them with local currency, and then take away those local currencies from the oil companies since they are owned by the government anyway. Therefore, in essence those crude oil producing countries are doing the first kind of currency manipulation to prevent the appreciation of the local currency vs. U. S. Dollar. If the oil companies are private ones, the local currency will appreciate against U. S. Dollar when those companies sell oil revenue dollars for the local currency. As the local currency appreciates against U. S. Dollar, the cost of producing crude oil rises, the demand of crude oil drops and eventually the trade surplus of the oil producing country will disappear as crude oil consumers switch to alternative source of oil or to alternative fuels. If the government want to keep the local currency under valued vs. U. S. Dollar, then the government must do the first kind of currency manipulation to prevent the appreciation of the local currency.

We should note that the first kind of currency manipulation without sterlization is most effective to depress the value of the local currency against U. S. Dollar since the foreign government can create unlimited amount of its own currency to buy up unwanted dollars in the market. However, this kind of action will most likely ignite high inflation.

If a foreign government wants to use the first kind of currency market manipulation to boost its own currency vs. U. S. Dollar, it must dump U. S. Dollar on the market to buy up its own currency. This will require the foreign government to have a huge dollar reserve, otherwise the foreign government needs to beg U. S. Federal Reserve to let it borrow Dollar to be used for that purpose.

Currency Market Manipulation of the Second Kind

The second kind of currency market manipulation is to create an interest gap between U. S. Dollar and the foreign currency of concern. The best example is Japan's near-zero interest rate policy of 19951. Very low interest rate of Yen compared to the interest rate of U. S. Dollar had prompted the explosion of Yen carry trades. In the Yen carry trade, speculators borrow Yen at near-zero interest rate, sell those borrowed Yen for Dollar, and then use those dollars to buy higher yielding Dollar denominated assets. The Yen rich Japanese private entities joined the game to sell Yen for Dollar. By that near-zero interest rate manipulation of 1995, Dollar was boosted from about 80 Yen/Dollar, to 170 Yen/Dollar within three years. The manipulation bestowed the continued huge trade surplus to Japan for many years. However, when the interest rate of U. S. also drops to near-zero, then the advantage of Japan's near-zero interest rate disappears, and Yen will start to rise rapidly vs. Dollar to the degree promting Japanese Government to undertake the currency market manipulation of the first kind to hold down the galloping Yen. The details of Japan's near-zero interest rate policy, that was fully supported by Clinton Administration, and the consequence will be the center piece of the discussion in Section 8.

Currency Market Manipulation of the Third Kind

The third kind of currency market manipulation results from the forming of currency unions, like Euro2, 3. Let us consider a simple example to show why forming a currecncy union is a currency market manipulation and destined to pull the participants into disaster.

Again we consider two countries A and B with currencies A$ and B$ respectively. Country A is more industrialized than Country B. The trade balances of both A and B versus the whole world are balanced. The exchange rates of A$ and B$ vs. US$ are stabilized at A$1.00 = US$1.00 and B$1.00 = US$0.20 respectively. The size of the economy of Country A is 3 times of the size of Country B. Countries A and B agreed to form a currency union with the new currency called E$. What should be the exchange rate of E$ vs. US$? The obvious answer is to use the sizes of the two economies as the weight to calculate the exchange rate of E$ vs. US$. The formula is:

      E$1.00 = (3/4)*US$1.00 + (1/4)*US$0.20 = US$0.80,

where "/" means division and "*" means multiplication. Once the exchange rate of E$ vs. US$ is known, it becomes easy to calculate the exchange rates between A$ vs. E$ and B$ vs. E$ respectively. They are,

      A$1.00 = (US$1.00/US$0.80)*E$1.00 = E$1.25,


      B$1.00 = (US$0.20/US$0.80)*E$1.00 = E$0.25.

The newly established central bank for E$ then issues just enough E$ to give Country A so that the holders of A$ can exchange their A$ with E$ at the exchange rate of A$1.00 = E$1.25. Similarily just enough E$ is issued to let the holders of B$ to exchange for E$ at the rate of B$1.00 = E$0.25. After that both old A$ and B$ are retired and only E$ is use in both countries A and B. Now let us see what is going to happen to Country A and Country B next.

Let us consider an export product of Country A that cost A$100 = US$100 before the currency union. After the currency union, it costs E$125 that is still US$100. Thus the exports from Country A will not change. Same thing can be said about the imports of Country A, and the exports and imports of Country B. This means that both A and B will keep their trades balanced. Thus the situation looks to be in an equilibrium inspite of the currency union. However, in every discipline, an equilibrium can be stable or unstable, and an equilibrium in economics is no different. If disturbed, a stable equilibrium returns to the original equilibrium situation quickly, but an unstable equilibrium cannot return to the original equilibrium situation any more once disturbed. Unfortunately the equilibrium under the currency union is an unstable equilibrium. Let us see why it is so.

Suppose Country A has a surge in inovation and productivity so that the production cost of that export item is lowered to E$100 per item from E$125 per item. Thus the made-in-A product beats its competitors around the world. This event causes the export of A to increase and Country A starts to have a trade surplus. Since the trade of Country B is still balanced, the currency union of A and B starts to have a trade surplus as the whole. The vigilante mechanism of the free currency market, then, will push up the value of E$ vs. US$ to rebalance the trade of the currency union. As E$ appreciates, imports to A and B will increase, whereas the exports of Country B will decline. This means that Country B will have a trade deficit. The appreciation of E$ will continue until the amount of the trade surplus of Country A becomes equal to the amount of the trade deficit of Country B. At that point the trade of the currency union as a whole becomes balanced again, and the vigilante mechanism of the free currency market ceases to operate after achieving its goal. Thus the currency union has entered a new equilibrium but a poisonous one as we will see next.

When the currency union is formed, the central bank in charge of E$ has given a fixed amount of E$ to Country B. When Country B runs trade deficit, it must pay with US$. How can Country B get US$ to pay for its trade deficit? Country B must sell its E$ at hand for US$ and uses the US$ to pay for its trade deficit. This means that E$ in the hands of Country B will be reduced. Since E$ is the currency in circulation in Country B, reduced E$ at hand means reduced economic activity. However, Country B is forced to run trade deficit every year under the new equilibrium, so the economy of Country B will spiral down to nothing. In order to counter such an unacceptable consquence, Country B must borrow E$ from the market to replenish its lost E$. That means that both the private parties and the government of Country B must issue E$ denominated IOUs to borrow E$ back. As time proceeds, the E$ denominated debt load of Country B increases steadily until Country B comes to the brink of default. What can be done? There are three solutions as will be outlined below.

Solution 1: Country A is running trade surplus every year under the new equilibrium. This means that A is accumulating a lot of US$. Country A can sell its US$ for E$ and gives those E$ to Country B free in order to keep the new equilibrium going forever. However, how will the people of Country A think? Will they regard Country B as a permanent parasite living on their back?

Solution 2: The central bank issues unlimited amount of E$ to buy up E$ denominated bonds issued by Country B. In doing so E$ will be depreciated vs. US$, and the living standard of every one in the currency union area decreases in perpetuation. The problem is how long the people of Country A will be blindsided and tolerate such water-torture like treatment?

Solution 3. To force Country B to tighten the belt and reduce the living standard, waiting for a fantacy that one day Country B will suddenly have an inovation and productivity surge to wipe out its trade deficit. Then the vigilante mechanism of the free currency market will come in again to push up E$ to the level that both trades of A and B are balanced. At that time the original unstable equilibrium will be restored and every one lives happily everafter?

Neither solution 1, 2 or 3, or any combination of the three will save the final collapse and the disolvement of the currency union. Both people of A and B have been deceived by the sweet talks of the designers of the wicked and foolish currency union without careful thnking. Once the currency union is adopted, it will certainly be very painful to get out of it.

Looking back at the three currency manipulation plots, the third one is most foolish and short lived. Euro has lasted less than ten years before Euro crisis has popped up. Many believe the ultimate fate of Euro is doomed. Even the currency market manipulation of the first kind has its sever down side, but it is not in the scope of this review, that centers on The U. S. side, to discuss this issue. In the next section we will start to discuss why the designers of the "Globalization Process of Yesterday" want to let The U. S. to run huge trade deficit and eventually brought an ongoing disaster on the whole world.



Comment 83: The Cause of European Crisis is Euro, the “Currency Manipulation Plot of the Third Kind” (October 1, 2011)

3. Comment 84: Euro Winners and Losers (November 27, 2011)

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