Currency Manipulators Created $7 Trillion, Causing the Global Economic Bubble

The single most important development affecting the global economy over the past decade has been the creation of $7 trillion worth of paper money by central banks in developing countries. This explosion of money creation drove up the price of stocks, bonds and commodities – and drove down yields – all around the planet. It caused the Fed to lose control over interest rates and over the economy. In short, this new money (along with the US trade deficit which played a role in its creation) caused the global economic bubble that imploded in 2008.

It is mindboggling that Washington, Wall Street and the financial press all failed to identify the source of the money inundating the world. Thousands of economists and financial journalists from dozens of nations watch the Fed’s every move. Yet, somehow, they entirely missed the paper money revolution being carried out by other central banks. This failure is all the more incredible given that the IMF publishes the relevant information each month in its International Financial Statistics database, under the heading of Total Foreign Exchange Reserves.

Foreign Exchange (FX) Reserves are owned by central banks. Central banks acquire FX Reserves in the same way that they acquire any other asset, they create paper money from thin air and buy them. Therefore, the increase in Total FX Reserves from $2 trillion in 2000 to $9 trillion in 2010 shows that central banks conjured up $7 trillion worth of new paper money during those years. To put $7 trillion into perspective, the entire amount of US government debt held by the public was less than $7 trillion when this crisis began.

It is important to understand exactly how this process of Reserve accumulation works. Consider how China accumulates Reserves. China’s central bank, the People’s Bank of China (PBOC), holds nearly $3 trillion in FX Reserves, much more than any other central bank. Last year, China’s trade surplus with the United States was $270 billion. When Chinese exporters sell their goods in the US, they are paid in dollars. They take those dollars back to China and convert them into the Chinese currency, the Renminbi (RMB). Were this done in a free market, the conversion of $270 billion into RMB would put extreme upward pressure on the value of the RMB; and the appreciation of the currency would reduce China’s trade competitiveness and cause China’s export growth and economic growth to slow. In order to prevent that from happening, the Chinese government instructs the Chinese central bank to buy all those incoming dollars at a fixed exchange rate. So, the PBOC “prints” $270 billion worth of RMB and buys the $270 billion from the exporters at a rate decided by the central bank.

The exporters accept RMB from the PBOC in exchange for dollars and they deposit their RMB into the Chinese banking system. These very large deposits cause rapid deposit growth in China, which, in turn, necessitates very rapid loan growth. The rapid loan growth fuels very rapid economic growth. The central bank, meanwhile, has accumulated, in one year, an extra $270 billion in FX Reserves with no greater effort or expense than that involved in waving their central bank, money-making, magic wand.

That is how China’s central bank accumulated $3 trillion in FX Reserves. The central banks of many other countries – primarily those in developing countries with a trade surplus with the United States – have accumulate Reserves in the same way, by printing money and buying dollars. Like China, they have done this to hold down the value of their currencies in order to perpetuate their low-wage trade advantage. That explains how (and why) Total FX Reserves increased from $2 trillion to $9 trillion over the last 10 years.

There have been numerous undesirable side effects to Reserve accumulation. All the countries that have experienced a rapid build up in Foreign Exchange Reserves – Japan in the 1980s, the Asia Crisis countries in the 1990s and China more recently – have been blown into economic bubbles as the result of too much exogenous money pouring into their banking systems and causing excessive credit growth. And every economic bubble pops sooner or later, leaving a great deal of damage behind.

Moreover, not only has this widespread practice of currency manipulation destabilized the economies of its practitioners, it has destabilized the US economy as well. When central banks print money and buy dollars, they must then reinvest those dollars in US dollar-denominated assets in order to earn a return on them. Central banks prefer to invest their dollars in US government bonds. During the 12 years leading up to 2008, however, the amount of dollars being accumulated by central banks outside the US each year exceeded the amount of new bonds sold by the US Treasury Department. With an insufficient supply of new government bonds to absorb them, the dollar inflows went elsewhere and created a bubble in the United States.

Every year from 1996 to 2008, the US trade deficit was larger than the US budget deficit. In other words, the central banks of the surplus countries accumulated more dollars than the Treasury Department needed to fund the US government’s budget deficit. In 2006, for instance, the US trade deficit reached $800 billion. That is roughly the amount of dollars that the central banks in the surplus countries accumulated as FX Reserves. Those central banks would have liked to acquire $800 billion worth of US government bonds that year. However, the US government’s budget deficit was only $160 billion in 2006; so the Treasury Department only sold $160 billion worth of new government bonds. Even if foreign central banks had bought every new government bond the Treasury sold that year, they still would have had $640 billion to invest in other US dollar-denominated assets.

This left those central banks with two options. They could buy old government bonds (in other words, those the government had sold in earlier years) or they could buy other kinds of US dollar-denominated assets – such as the bonds sold by Fannie Mae and Freddie Mac. They did some of both.

When they bought old Treasury bonds they pushed up the price and drove down the yield of those bonds. That caused the Fed to lose control over interest rates. Recall that between mid-2004 and mid-2005, the Fed had increased the Federal Funds rate numerous times, but the yield on 10-year government bonds kept falling. When a Senator asked Fed Chairman Greenspan why that was, Greenspan said it was a “conundrum.” It wasn’t really, however. Foreign central banks were buying enormous amounts of US government bonds and pushing down their yields, leaving the Fed powerless to rein in the out-of-control property bubble inflating in the United States.

In addition to buying old Treasury bonds, foreign central banks also bought new bonds issued by Fannie and Freddie, since those bonds were understood to have the implicit guarantee of the government. Between 1998 and 2003, Fannie and Freddie (with the help of foreign central banks) issued nearly $3 trillion worth of bonds. As they expanded their debt, all that was required in order for their managers to earn multi-million dollar bonuses was for them to grow their assets, or, in other words, to buy up mortgages. And that is what they did, blowing the US housing market into a bubble in the process.

To summarize, the US trade deficit, which peaked at $800 billion in 2006, threw dollars off into the global economy. The central banks of the trade surplus countries printed the equivalent amount of their own currencies and bought all the dollars entering their economies in order to perpetuate their low-wage trade advantage. Those central banks then reinvested their dollars into US dollar-denominated assets, causing the United States to bubble. Rapidly inflating house prices allowed Americans to extract equity from their homes and to spend more. Increasing consumer spending pulled in imports from abroad. Other countries expanded their industrial capacity to meet the inflating US demand.

It was all good while it lasted. But eventually every bubble pops. When the US bubble popped, it left the world in a crisis characterized by excess capacity and insolvent banks. As a result, governments around the world have been forced to run enormous budget deficits and to create yet more paper money in order to absorb the excess capacity, bail out insolvent banking systems and stave off a new great depression.

In retrospect, it is obvious that the creation of $7 trillion dollars worth of paper money in ten years could only end in economic catastrophe. Had the US government taken steps to prevent its trading partners from manipulating their currencies in this manner, the global economic bubble could have been prevented. Now, the bubble has popped, but little else has changed. Currency manipulation remains as widespread as ever and the US government continues to tolerate it. The ultimate cost of the failure of the US government to stop this abuse of the international monetary system is certain to be very high.


Richard Duncan
for The Daily Reckoning

P.S. For more perspective from Richard Duncan you can visit his blog on economics in the age of paper money at