Here's The Real Reason Markets Are Diving

Stocks are falling because of brewing troubles in emerging markets. And those troubles are the result of economic ignorance: too many central bankers don't know how to defend their currencies, which are under attack. If they don't get their act together, we could have another big financial crisis like that which hit in Asia in 1997-98. The danger is that the Fed, the IMF, the European Central Bank, the Bank of England and the Bank of Japan are just as clueless as their developing country counterparts on how to quickly put a stop to a potentially devastating currency crisis that will hit banks hard everywhere.

Putting out these flames before they become a conflagration is easy; emerging countries just need to know how to keep their currencies afloat.

Here's what they need to do. An important first step involves public relations : announce that keeping your currency stable is paramount and the government will do everything it can to defend it. That means defining a benchmark, which could be a narrow range vis-a-vis the dollar or Euro or some other major currency; or a basket of currencies that encompass most of your trading partners. (We're still a few years away before gold resumes its historic place as the global measure of currency value.)

Then raise interest rates. It doesn't have to be a lot, just enough to let markets know you are serious.

These two steps are foreplay for the biggest, most important move by far: Central banks must be willing to aggressively buy their currencies in foreign exchange markets. They can use their foreign reserves; most countries have ample amounts for the immediate task at hand. A slumping currency means that at the moment there is too much of it out there. Thus the need to temporarily reduce the supply until the crisis abates.

Simple? Yes. But here we get to something that is so astonishing as to defy belief, on a level with doctors suddenly proclaiming that germ theory is bunk: When central banks buy their currency to fight speculators, they all too often turn around and re-issue that money back into their domestic economies via open market operations! What they take with one hand, they give back with the other. In other words, the money supply–or more precisely, the monetary base, which central banks can control directly–remains the same!

Top 5 Safest Companies To Buy For 2015

The exercise is thus fruitless. (Economists call this self-destructive nonsense sterilization.) But it's even worse: countries run down their reserves to no effect.

Sadly, countless examples abound of this self-defeating exercise. Thailand in 1997 had reserves several times the monetary base. Yet the country engaged in sterilization, running down reserves and then throwing in the towel and letting its currency, the baht, fall to pieces. Thailand's folly was then immediately replicated by Indonesia, South Korea and others. Mexico did the same thing in 1994 and Brazil several years later.

Occasionally countries get it right. The Russian ruble was assaulted by speculators in 2008-09. The country's central bank, after absorbing the advice of noted monetary expert Nathan Lewis in an op-ed he had written, reduced its monetary base by buying rubles and keeping them out of circulation, instead of reissuing them via domestic open market operations. The ruble was saved. Hong Kong, whose dollar has been fixed to the US dollar for many years, beat back a fierce attack during the so-called Asian Contagion that felled Thailand and other countries.

If countries don't wish to use their foreign exchange reserves, they can achieve the same result domestically by having their central banks sell assets–primarily government bonds–thereby reducing their monetary base. What is exasperating is that there is virtually no learning curve: Russia now wants to "gently" devalue the ruble against the dollar to gin up its sluggish economy.

Sadly Russia is not the only state enticed by the toxic siren of easy money. The Australian government, whose dollar is already down 15% against the US dollar, wants its currency to slump even more to boost weakening activity in the wake of the downturn in mining. Japan is determined to have the yen fall further against the greenback. And, of course, new Fed head Janet Yellen would, if she had her way (which thankfully she does not), gleefully debase the dollar to oblivion.

One thing nations should not get caught up in is obsessing about their current accounts. Conventional unwisdom has it that the current account is a critical factor in evaluating a currency's worth. This leads to counter-productive acts like trade and currency restrictions. In gauging a country's actual economic health, the current account is useless.

We got a foretaste of this emerging market crisis several months ago when outgoing Fed boss Ben Bernanke hinted at tapering. The currencies of Brazil, India, Indonesia , Turkey, South Africa and others came under pressure. Global trouble was averted after the Fed temporarily backed down on tapering.

What now? We will see which countries reduce their monetary bases and avoid a currency collapse. We will also see which countries rev up internal economic reforms. Brazil and India, for example, are ripe for restructurings to lessen smothering rules and restrictions.

For the moment, expect turbulence. Brace yourselves for an unnecessary stomach-turning experience and hope that enough nations stumble on to the monetary base cure to make this storm short-lived.