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Free Market Pricing


...central bank intervention has interrupted the free market pricing mechanism.

Editor's Note: This letter is in response to this article, "Foreign Trade Angst" written by Walter E. Williams, an economics professor at George Mason University.

Dear Mr. Williams,

You are pragmatic and an advocate for free markets as the best mechanism by which risk and assets are priced. I agree fully. Your sanguine attitude toward the trade deficit, however, has us in disagreement.

The main reason is that central bank intervention has interrupted the free market pricing mechanism.

At some point the grocer starts to worry and stops lending to the buyer of groceries when debt gets too high. At least the grocer begins to demand different terms, for example higher interest rates. If it were left up to free markets, this would have happened long ago to the U.S. consumer.

As the Fed provides cheap credit through repos or coupon passes (or lower margin requirements), that excess credit in the system begins to weigh on the dollar (credit equals "printing" of dollars). Japanese business receiving dollars as U.S. consumers access this cheap credit go to their banks to exchange dollars for yen. Normally those dollars are sold in the market for yen and the dollar weakens and/or U.S. interest rates rise.

However, in the current case those dollars are being sterilized. The BOJ (or central bank of China) steps in and buys the dollars, prints their local currency to exchange to businesses, and then buys U.S. securities with those dollars. This keeps U.S. rates from rising and the dollar from falling (further than the already 50% it has fallen versus other currencies/gold over the last twenty years).

I agree that if it were private investors, business, investing those dollars back in U.S. securities, the free market would be saying all is balanced. But it is not: in reality, foreign central banks are doing the investment with credit of their own. As an advocate of small government this should appall you. The tick data is flawed as studies by Harvard economists show: when a foreign central bank buys U.S. securities through a "broker," it shows up as private investment. My firm's work shows that it is overwhelmingly foreign central banks that are providing the inflows into the capital account of the U.S. Our central bank creates credit for the U.S. consumer and foreign central banks create the credit to fund that.

The world now is riding on a sea of credit created by central banks. We are now seeing for the first time the net interest component of the trade deficit turn negative as the amount of debt is growing to a point that U.S. investors are now earning less than foreign investors on the balances (U.S. investors enjoy higher returns overseas than the paltry returns earned on our treasury debt by foreign central banks, but the amount of debt now is sufficient to overtake that). This will grow worse as our debt increases and foreign central banks begin to demand higher rates of return.

Total debt in the U.S. is now 3.6 times GDP, much higher than it was in 1929. If GDP falls the situation is untenable.

John Succo
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