Foreign Governments Are Broken, Too

Many investors either fear investing outside of their own country’s markets or simply don’t understand how to do it. Tax, regulatory, legal and other costs tend to discourage foreign investment. The so-called “home bias” leaves many investors over-exposed to domestic markets. The home bias sometimes applies in reverse to a bearish investor, as I was in late 2007.

When the real estate market began to crater, I bailed out of the domestic market to commodities and the so-called BRIC markets (Brazil, Russia, India, China). I expected the Federal Reserve to crank on the printing presses as the market crashed, weakening the dollar and strengthening other currencies (including the BRICs).

The Fed’s reaction was incredible, even to me. The Fed printed enough money to triple the number of U.S. dollars in circulation in just over three years:

St. Louis Adjusted Monetary Base, January 1, 2007 to Present

St. Louis Fed Adjusted Monetary Base, January 1, 2007 to Present

Yet, my foreign investments haven’t made me much money. In fact, I closed a few of my foreign-market positions at a loss.

Why? Competitive devaluation. I had assumed other countries would let their currencies rise as the dollar sank. That would make travel (and U.S. exports) cheaper to their citizens, essentially making Americans poorer. That didn’t happen.

It turns out exporters in, China, Brazil, and to some extent India, make a great deal of money from their countries’ weak currencies. Exports were 35% of GDP in China and 24% in India, and most of those exports went to the United States. So, the governments of China, Brazil and India printed Yuan, Reals and Rupees; traded them in for dollars; and bought U.S. Treasuries, keeping their exchange rates relatively stable and their exports cheap:

Exchange Rates, January 1, 2007 to Present

The dollar-buying spree of the BRICs kept most of the money the Fed printed out of domestic circulation, keeping U.S. inflation down. However, if you’re trying to keep your currency weak against a country that’s adding that quickly to money supply, you are going to have to print a ton of money. Printing lots of money (unless you have an economy with the collective weight of the BRICs sopping it up) pushes up prices. Prices in the BRIC economies rose much faster than in the United States, as the Fed effectively outsourced its inflation:

CPI for Brazil, Russia, India, China, and U.S., Indexed to January 1, 2007

CPI for Brazil, Russia, India, China, and U.S., Indexed to January 1, 2007

The Fed was trying to cheapen U.S. goods by making our wages worth less. Foreign central bankers, fearing the collapse of their own export-based economies, did the same in contest. The result: everyone except the bankers is poorer, and the economies of all five locales are sputtering as prices rise.

Worse, the central banks of the BRICs reacted by tightening domestic money supply, rather than letting their tightly-controlled dollar exchange rates rise. They’ve hiked interest rates on borrowing, raised bank reserve requirements, and pushed tougher lending standards, all the while printing piles of new money. This punishes domestic consumers to save exporters. Consumers purchase fewer U.S. exports, which slows U.S. demand for BRIC exports, ad infinitum. The BRICs’ currencies haven’t strengthened as much as they could have (some have even lost ground, like the rupee), and tight money has fueled an exit from stocks and bonds, restraining the growth trajectory for the principal on my investments.

For a time, I forgot that the failings of central bureaucracies and bankers are inherent, not localized. I paid for it, dearly. The lesson of this affair is simple: government intervention always favors the status quo, good of the people notwithstanding. That’s true no matter where you invest. Bet on the government doing its best to entrench the existing power structure, and you’ll make a lot of money. “Independent” central banks are no exception.


About Matt Murphy

I'm a software engineer with a certain company you've probably heard of. In my free time, I'm an advocate for individual liberty and free markets.
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