Gerard Jackson
BrookesNews.Com
Monday 1 March 2004

The threat of rising interest rates, falling currencies, growing trade deficits and capital flows has raised among some the spectre of the dreaded speculator. This is a remarkable economic creature with the power to bring currencies crashing to their knees and demolish even the most powerful economies.

Let's travel back in time a little. In Memo to Gurus: Honkers is not bonkers (Rupert Murdoch's Australian 24/11/1998), so read the title of Alan Wood's article defending Hong Kong's monetary authority's intervention in the equities and futures markets. Wood strongly defended the intervention, asserting that because it turned a profit this proved it was successful. (The shares the authority bought rose in price.)

Now Wood appeared to be supporting the argument that speculators, meaning the hedge funds, had launched an attack on Hong Kong's dollar, which was pegged to the US dollar, in October 1997 in the belief that the authorities would prefer to break the peg rather than raise interest rates to crippling levels.

However, the monetary authority allowed interest rates to reach 280 per cent, if even for half an hour, which burnt the hedge funds. Wood then described how the funds then changed tactics by acquiring Hong Kong dollars in advance while taking short positions in the stock index futures market.

Joseph Yam (who was chief executive of Hong Kong's monetary authority) explained that the funds object was to dump masses of Hong Kong dollars which would force up interest rates hence forcing down the stock market in which the funds now held short positions. (If by this time, readers are beginning to suss there was something dodgy with this line of reasoning — they are absolutely right.)

Wood argued, and he was not alone, that by exploiting the rules these fund made it necessary for Hong Kong's monetary authority to do likewise and intervene in the market place by shoring up stock prices. He justified this action on the grounds that "no country with a well-developed financial system can operate a currency board. As with the old gold standard*, the costs in economic and social dislocation are too high."

Basically a currency board is a pale reflection of a gold or silver standard. Instead of a country tying its currency to, for example, gold it to pegs it to a sound currency instead. In the case of Hong Kong that currency was US dollars. Theoretically this means that the supply of Hong Kong's dollars had to maintain a fixed ratio with its US dollar reserves in keeping with Hong Kong dollars purchasing power. In other words, the Hong Kong dollar was supposed to be neither undervalued nor overvalued at the pegged rate.

So one might ask how can speculators upset this monetary apple cart? They cannot, is the answer — but central banks can and do.

Hong Kong suffered massive capital inflows that greatly inflated the money supply and fueled a speculative boom. Needless to say, the monetary expansion was not matched by an increase in the supply of US dollars. In other words, Hong Kong's currency was overvalued relative to US dollars.

The Hedge funds merely moved to exploit the monetary situation. (This is precisely what Soros' hedge fund did in 1992 when it speculated against the overvalued British pound). If the funds had succeeded, they would have forced an early currency adjustment by forcing Hong Kong to devalue. By resisting the move, Hong Kong's monetary authority succeeded in maintaining an overvalued currency.

Now early on it was mentioned that speculators planned to dump masses of Hong Kong dollars and thus drive down their value. But how can this happen unless the currency is overvalued? A fact that escaped Wood's attention. To put it simply, the hedge funds were being accused of buying Hong Kong dollars in order to drive down the price of Hong Kong dollars in terms of US dollars. This is ridiculous reasoning.

Who in heavens name did Wood think printed the dollars in the first place? Hong Kong's equivalent of a central bank — that's who.

Hong Kong paid the price of its monetary authority's failure to do its duty: the money supply contracted and economic activity plummeted, unemployment rose and output dropped. Yet Wood claimed that not breaking the rules would have imposed even higher adjustment costs.

Utter rot. It was the breaking of these so-called rules by Hong Kong in the first place that created masses of unsound investments that caused its economic plight. But once again, the free market gets the blame, with a little help from it friends on the Australian right.

It's all too necessary to continually resort to economic history if mistaken economic policies are to be avoided. But in order to do this successfully policy makers, or at least their advisers, should have an understanding of the economic forces at work. Such understanding seems to be absent from the scene – and I don't just mean the media.

*It is absolute nonsense to claim that the gold standard caused "economic and social dislocation". This only happened when countries deviated from the gold standard, i.e., inflated their currencies. The true cost of the gold standard was the use of resources in mining, transporting and minting gold. A small price indeed to pay when one considers the depredations of the present monetary [dis]order that Lord Keynes and his disciples have imposed on the world.

Gerard Jackson is Brookes' economics editor