With countries like Japan, China, the US, and Europe fighting deflating bubbles in major market sectors, it’s important to understand how overinvestment in certain sectors becomes an intractable problem when currency markets are too manipulated. As the graphic shows, falling prices cause ripple effects throughout the economy that create serious unemployment problems as demand drops. This cycle becomes self-reinforcing since prices drop even more if demand continues to fall. One way that this cycle can be broken is by allowing the currency to float upward, making all the goods and services in the economy more expensive. As prices rise, it restores some equilibrium to markets that allows economic growth to resume.
Countries like China have seen historic interventions by central banks in an effort to boost demand by providing cheap cash. In 2008, China introduced a stimulus package worth about 14 percent of GDP with the idea that boosting demand was key to preventing crisis. China’s intervention kept Chinese currency from adjusting according to market prices, and as a result, the popping Chinese bubbles are now causing a large slow down in Chinese manufacturing, housing, and exports. If China allows its currency to adjust, perhaps they can break the vicious cycle.