It’s Too Late For A Dollar Devaluation
International Perspective, by Marshall Auerback
December 9, 2003
The recipe for economic disaster over the last ten years has been the potent combination of three disequilibria: an asset bubble, a credit excess, and an exchange rate overvaluation. Extreme readings in any two are often enough to precipitate a financial and economic crisis; extreme readings in all three make crisis inevitable. Japan in the late 1980's had an extreme asset bubble and credit excess, but not an exchange rate disequilibrium. Mexico had an extreme exchange rate disequilibrium accompanied by something of an asset bubble and a selective domestic credit excess. Malaysia and Thailand had all three---asset bubbles, credit excesses and exchange rate overvaluations. Korea had the first two, but arguably its exchange rate was not overvalued by early 1997.
Increasingly, it appears that the US economy has become a candidate for crisis. It certainly has an asset bubble: all measures of valuation (Tobin's Q, market cap to GDP, P/E ratios) are again trading near March 2000 type levels. Judging from the recent anaemic performance of the dollar, it is becoming increasingly recognised that the US now has had a serious exchange rate overvaluation as well, which is in the process of resolving itself to the downside. The hope is that today’s controlled devaluation does not turn into a rout. The US trade account deficit has continued to haemorrhage, as the lagged impacts on trade from dollar strength of previous years begin to bite.
In early 1985, when the dollar peaked and a several year period of dollar crisis ensued, the US was still a net creditor nation with a current account deficit as a percent of GDP that was less than its current level. The US is now the world's largest net debtor nation, with a net debt equal to more than 18% of GDP. If the current dollar exchange rate persists, the US will soon have a current account deficit in excess of 6% of GDP. Then its net external indebtedness will be set to double in two to three years to levels deemed worrisome even for a fast growing emerging economy that can efficiently use external capital.
But the US is a mature economy at the technological frontier. On trend, at current inflation rates, the US can sustain nominal GDP growth of only 4% to 5% per annum. When one factors in the growing external interest rate burden that will accompany future increases in the US's net external indebtedness, it should be clear that the US economy is on an explosive debt path. This level of indebtedness in itself does raise questions about the efficacy of a dollar devaluation at this stage, especially since the currency is not declining against the leading source countries of its trade deficit.
To quote Larry Lindsey, former Fed governor and chief economic advisor to President Bush: “In terms of being overextended, we have never been that overextended before. The private sector is running a record deficit. We are in uncharted territory. We are borrowing increasing amounts from the rest of the world……Something has to give here”.
Well, that “something” appears to be the dollar. Just 18 months ago, the dollar index was 108, and the euro was struggling to reach parity against the greenback. Today, Europe’s monetary authorities have the luxury of dealing with an apparently overvalued currency (almost always an easier problem with which to deal), whilst the dollar index continues to plunge to fresh yearly lows, last Friday breaching the 90 level. As global strategist Chris Sanders notes,
“The dollar’s fall has by now become statistically significant, with the Fed’s broadest dollar index now closing in on its 38.2% Fibonacci retracement of the dollar bull market that began in 1995. This level is a logical place for the dollar to stabilise for a little while against a broad basket of currencies, which ought to mean that it should recover somewhat against the yen, euro and other trans-Atlantic currencies. Against the currencies of America’s major trading partners, is within less than 11% of its 1995 lows having retraced more than 73% of the rally that began in 1995. It should easily revisit those levels in 2004.”
We largely share this assessment, although we would qualify this endorsement by stating that any dollar recovery against the euro, yen and other trans-Atlantic currencies is likely to be feeble at best, a purely technical bounce to work off an extremely oversold position amidst rampant bearish sentiment on the greenback.
Why does this not mark the end of the dollar decline? Quite simply, the conditions which triggered the decline in the first place – a huge and growing current account deficit, rampant debt creation, etc. – show no signs of alleviation. In an International Perspective written last year, “Helicopter Money or the Road to Weimar”, we argued that Fed Governor Ben Bernanke’s paper last November on possible radical monetization by the Fed was a double edged sword. In all probability, Governor Bernanke believed that, by indicating a willingness to monetize treasury debt without limit and even private assets, he was providing encouragement to investors and that this encouragement would support private asset prices. We maintained, however, that this edge of the sword would most likely prove to be blunt: most investors would not comprehend his words of encouragement and those who did were already over positioned in equities and corporate bonds.
Unfortunately for Governor Bernanke, his shocking speech extolling the “virtues of the electronic printing press” have proved to be a profoundly dangerous double-edged sword that has afflicted the dollar with ample wounds in its aftermath. By expressing a willingness on the part of the Fed to deliberately monetize to the point of currency debasement, he has clearly discomfited holders of treasury bonds and foreign holders of all U.S. dollar assets. Both of these classes of market participants were very long these assets and very vulnerable. Their discomfort has placed selling pressures on the US currency that has more than offset any buying support from the official sector, which clearly sees no virtue to a rapidly plunging dollar.
Normally, we ought to be celebrating the onset of dollar devaluation, particularly given its controlled nature (thus far), which in theory should go some way toward alleviating these profound external imbalances. But the major problem has been that the decline in the US currency has largely taken place against the euro, whilst China, (whose bilateral trade surplus against the dollar is expanding rapidly), continues to peg the renminbi against the dollar. By the same token, the other nations of emerging Asia, fearing a relapse in a negative balance of payments position (as they all experienced in 1997), have managed their currencies closely against the US dollar, in effect reaping massive competitive gains in the process.
This is now manifesting itself in the latest ISM report, which raised the market’s spirits so considerably last week. Neglected within last week’s report was a surge in the import component to an all time survey high. Recall we have previously used this series to forecast import growth in the monthly merchandise trade report. On generous assumptions for US merchandise export growth (not entirely supported by the decline in the export component of the ISM survey yesterday) a $50b deterioration in the trailing 12 month cumulative merchandise trade balance in Q4 would not be an unreasonable assumption, even though this is currently three times the market consensus estimates.
Also confirming the ISM data is the level of inbound container traffic, now at an all time high, just like the ISM import index. And the Asian export data, notably China’s reported in last Friday’s Dow Jones Business newswire, tends to confirm this underlying pattern. Exports of Chinese made electronic and information technology products are expected to rise 41.2% year on year to $130 billion in 2003, the state-run Xinhua News Agency reported last Friday, citing official figures. Manufacturing of electronic appliances for export markets has been a key driver of industrial output in China this year, helping to lift overall economic growth.
Electronic and IT goods accounted for 31.5% of China's total exports in the first 10 months of this year, the report said. Just imagine what the import picture will look like if China's administered credit crunch trips up their domestic demand growth, so they must train all their excess capacity on flooding the rest of the world with tradable goods in 2004.
The parallels with the US and Japan abound. Former Treasury Secretary Laurence Summers has said: “This (US) expansion has been more like pre-war cycles, or like that in Japan in the late 1980’s, driven by credit”. The asset bubble of Japan in the 1980's created a very conspicuous excess in the real economy---a rise in the ratio of business investment to GDP that was unprecedented for a mature economy. In this departure from the norm one was able to identify the possible source of a severe future economic contraction when the asset bubble burst. And in fact the unwinding of this excess of fixed investment has contributed to the stagnation of Japan's economy for almost a decade
Despite a decline in Japanese interest rates to zero and massive government deficits, the Japanese economy has stagnated for a decade. More and more people are identifying Japan’s crushing debt burden as the cause of this stagnation and there are increasing calls in Japan for a bailout inflation, an inflationary confiscation of debt.
Mainstream economic thinkers, faced with the severe adjustments required by the prevailing debt excess, are beginning to fear a bailout reflation in the US as well. Last year, Stephen Roach, Morgan Stanley Global Economist, argued: “The FED, in my opinion, is now doing everything in its power to avoid a purging of those excesses by reinflating the equity bubble. In the end, this could be a serious mistake”.
And this persistent reluctance to allow post-bubble adjustments to be made is THE crucial distinction today between the US and Japan. Stagnation in the Japanese economy has widely been attributed to the burden of private debt built up in the 1980’s. Faced with greatly reduced collateral, private firms and households reduced expenditures and sold assets to reduce their debt burden. This in turn reduced aggregate demand.
Like Japan in the 1980s, the U.S. experienced in the 1990’s an asset bubble, and it was accompanied by a private debt bubble. However, when U.S. equity prices collapsed, private economic agents did not all respond by paring expenditures and selling all assets to reduce debt levels. Corporations did move to reduce expenditures on investment goods and labour, but never to the point of significant debt reduction. By contrast, U.S. households continued to increase their expenditures on consumption goods. Though they liquidated equities, they in turn bid up home prices. To do this they took on more and more debt. And they did so with the full housekeeping seal of approval of the Federal Reserve.
There is no precedent for such profligate behaviour by U.S. households. In all prior recessions households paid down debt and home price inflation abated. That it is unsustainable is clearly now being recognised by foreign private sector creditors, although their “credit revulsion” is largely being offset by persistent official sector US dollar accumulation.
One wonders how much further the official sector can resist this broadly negative trend for the US dollar. The recent breach of $400 gold in this respect is highly significant. What is the message its strength is conveying today? The US has a massive net external debt and an unsustainable current account deficit. Why has the dollar not crashed? The usual answer is that the world’s other major currencies – the relatively new and untested euro and yen- have their own very serious drawbacks. The anaemic state of the eurozone’s recovery thus far is the obvious explanation as to why France and Germany felt impelled to jettison the Stability Pact, and Japan’s longstanding deflationary pressures (the ultimate response which may well be a radical monetisation that would take the yen substantially lower) hardly makes the yen an attractive alternative.
Many have remarked that, if all of the world’s currencies are unattractive, gold might regain some lustre as a reserve currency and a store of value. That appears to be a dynamic which continues to be operating favourably for the gold market; there is a persistent “bid” in the market, which has curbed the downward drafts one normally associates with spec long liquidations. It also helps that nominal interest rates everywhere are negligible. It also helps that, in a world of ubiquitous excessive debt, gold is the one asset that is no one’s liability. But it might also be the case that gold’s strength is conveying speculative or investment buying because of concern about central bank “monetization” in the future. Certainly, it seems to be reflective of a profound vote of “no-confidence” in the central banking community, a substantial shift from a few years ago, when “official sector omniscience” was in a profoundly bullish phase.
But most of all, gold’s rise does seem to indicate that the long reign of King Dollar is rapidly drawing to a close. The Bush Administration has clearly accelerated this process by using the political cover from September 11 to damage the US economy more directly. By showering Republican industrial interests with subsidies and protectionist favours, the President has broken with a free market philosophy of
economic management that has served America well. By procrastinating in response to the Wall Street accounting scandals, he has undermined confidence in US business practices.
There certainly was a strongly Keynesian case for short term front-loaded tax cuts to offset the inevitable adjustment as US private sector agents worked to reduce their bloated, debt-laden balance sheets; the excess of private expenditure over income implied a build up of private debts had become too onerous for the private sector to bear alone. But the long-term tax cuts which were in fact introduced, along with the huge defence programmes, threaten an uncontrollable expansion of the budget deficit that will become a burden on the economy for decades to come, whilst furnishing little in the way of economic multiplier effect. Moreover, the abandonment of free trade and the corresponding introduction of a veritable grab bag of inefficient, pork-laden fiscal measures under the guise of serious domestic policy initiatives, have investors everywhere beginning to wondering whether the American economic model really works, and indeed whether the spectacular economic statistics of the 1990s might have been as fictitious as the accounts of Enron. To many, it evokes the “crony capitalism” supposedly so characteristic of Asia during the 1990s.
Over time, such questions corrode US self-confidence, undermine financial markets, damage investment and productivity, and threaten to set off a vicious circle that quite plausibly could drag America back into a 1970s-type period of economic malaise. All of this seems to be signalled, albeit tentatively, by the recent actions in the dollar and gold markets. But we appear to have passed the point of no return, during which a simple dollar devaluation could remedy today’s external imbalances. Indeed, at this stage, a rapidly falling dollar could exacerbate the problem: eventually disappointed expectations of future returns lower warranted asset valuations. This begets selling which lowers asset prices, which leads to yet lower expectations and so forth. Could this be the process underway right now? And how much longer will Asia be prepared to hold the fort, as more and more private investors come to the same conclusion? We may very well be at the stage where the dollar’s controlled decline turns into a rout.
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