Armageddon is coming to the FX market

Central banks are like generals: they tend to fight the last war.

The Great Financial meltdown of 2008 force the central banks and treasuries of the major economies “did whatever it took” to save the private banking sector from insolvency and collapse. In effect, central banks launched a multi-pronged bailout of banks and other financial heavyweights (such as AIG).

The problem with preparing to fight the last war is that crises arise not from what is visible to all but from what is largely invisible to the mainstream.

The other factor is what’s within the power of central banks to fix and what’s beyond their power to fix. It’s widely assumed that virtually any problem can be fixed by printing a trillion dollars (or multiple trillions) and throwing it at the problem. Yes, the looming student-loan debacle can be fixed by printing a trillion dollars and paying down a majority of the existing student debt. But lots of other problems are not fixed by printing a trillion dollars.

So what else is beyond the easy fix of a quick $1 trillion printing/bailout? How about the foreign exchange (FX) market? Many a government and central bank has attempted to fix the foreign exchange market, but they fail for the simple reason that the FX market is too large to control for long. $1 trillion just isn’t that much in a market that trades $3 or $4 trillion per day.

It’s not that difficult to predict that the next global financial crisis will arise not in the banking sector but in a market that’s beyond the reach of central banks. That is, printing $1 trillion and promising to “do whatever it takes” won’t fix what’s broken.

One sign is on focus on the potential of the U.S. dollar (USD).
Everybody can already see the consequences of a strengthening USD: since the USD started strengthening against other currencies late last summer, capital flows have reversed globally, fleeing China and the emerging markets. Commodities and global trade have crashed.

The other sign crises arise is policies designed to solve one problem end up triggering another even more uncontrollable problem. Trying to control FX markets is intrinsically loaded with paradoxes and unresolvable conflicts, as whatever a central bank or treasury does to effect global FX markets has another set of consequences within the domestic economy that issues the currency. Conversely, if the central bank/treasury set policies to control a crisis in their domestic economy, those policies have uncontrollable consequences in global FX markets.
For example: if a central bank raises interest rates to defend its currency, those higher rates strangle the domestic economy. In effect, the central bank has only bad options: either accept a domestic recession to defend the currency, or let the currency devalue and watch the domestic economy implode as import costs soar and capital flees the devaluing currency.

It seems increasingly likely the next Global Financial Meltdown will arise in the FX/currency markets. The core paradox–that central banks can’t control both domestic and global FX markets with the same set of policies–cannot be resolved by printing $1 trillion, or even $5 trillion.