Dollar bubble about to burst?
Larry Elliott
Monday May 21, 2001
The Guardian
Apart from John Prescott's bit of argy-bargy, not a lot happened in the the election last week. Labour will win by
a country mile because real incomes are rising, public spending is increasing and the Tories cannot come up with a
credible answer when asked how they would pay for their tax cuts.
You know that and I know that. At some point over the next couple of weeks, it may be worth returning to
British domestic politics, but for the time being let's turn our attention to something that presents a rather more
difficult intellectual challenge: explaining what is going on with the US economy.
The fact is that last week's really important events - and events that may impinge on Britain before too long - took
place on the other side of the Atlantic. On Tuesday the Federal Reserve cut interest rates by 50 basis points for
the fifth time in as many months, expressing concern about the health of the US corporate sector where
investment spending is falling rapidly and stocks are run down in an attempt to boost profitability.
On Friday, the US trade figures were released showing an increase in the deficit from $26.86bn (£18.66bn) in
February to $31.17bn in March. Put another way, that's $1bn a day.
Good news
Now, call me old fashioned if you like, but I was always told that running a trade deficit of this size was a sign of
economic weakness, and would result in a depreciation of the currency in order to make imports dearer and
exports cheaper. Apparently not. According to the Reuters news wire, dealers on Wall Street see the increase in
the trade deficit as rattling good news because it shows that the cuts in interest rates are stimulating consumer
demand.
"While the trade report suggested the economy was weaker than earlier thought at the start of the year,
economists said it augured better times ahead, with the import number indicating consumers have not been scared
into snapping their pocketbooks shut."
So, because the trade figures were so "good", the dollar rose against the euro on the foreign exchanges, making
life for the US corporate sector even more difficult. Dell, the world's biggest producer of computers warned that
earnings in the second quarter were likely to disappoint, and no wonder.
Don't worry if you're baffled by this, because a lot of clever people in the world of economics are baffled by it as
well. "The rise in the dollar since February has been puzzling", the Bank of England said in its inflation report last
week, "as it has been associated with falls in US growth forecasts and short-term interest rate expectations
relative to some of its major trading partners". Loose translation: all our models say the dollar should be falling like
a stone but for some reason it is going up.
The International Monetary Fund cannot explain it either. It devoted a special section in last month's world
economic outlook (WEO) to the factors driving the weakness of the euro and the strength of the dollar, which it
said seemed "to defy explanations from conventional exchange rate models". Conventional exchange rate models
treat the value of a currency as just another price that will fluctuate in order to bring a market into equilibrium.
If you are running a big trade deficit, the price of your currency will fall; if you are running a trade surplus it will
rise. Economics text books say that this is what happens under floating exchange rate regimes, but in the real
world the big three currencies - the dollar, the euro and the yen - are grotesquely misaligned.
The IMF has looked at all the possible explanations for the strength of the dollar against the euro and concluded
that the likeliest cause is the flow of hot money out of Europe and into the US, encouraged by the perception that
America offers better prospects for growth and profits. This is amply borne out by the data. Net portfolio flows
into US assets, according to the IMF, have increased from $25bn a year in the early 1990s to $500bn a year in
2000. What's more, the composition of these flows has changed over time, with foreign investors spurning the
safety of US treasury bonds in favour of equities, where net flows have risen 12 fold over the past decade.
So, let's recap. Here we have an economy that is running a current account deficit of 4% a year. It is one that has
an overvalued currency and one where the corporate sector is showing all the classic signs of distress; falling
profitability, cutting investment and laying off staff. It is an economy dependent on constant flows of hot money
but which also gives investors the absolute right to leave with their money whenever they want. Faced with a
similar set of circumstances in Thailand, dealers could not get out fast enough.
The US is not Thailand and the dollar is not the baht. Even so, you would be forgiven for wondering whether it is
true that all the really smart people are working in the City these days rather than in the civil service, the media or
education. Nick Parsons, currency strategist for Commerzbank and a man who understands the psychology of
markets as well as anybody, says there are two rational explanations and one irrational one.
The two rational ones are; first, that whatever the problems of the US economy it has a central bank that is
proactive. Unlike the European Central Bank, which appears to delight in stuffing the markets, the Fed has done
what dealers have expected; cut often and cut big. There is something in this: the ECB has the William Hague
problem; it lacks credibility.
Second, while Europe may have stronger growth than the US this year, it will still be affected by a slowdown on
the other side of the Atlantic. Germany is already struggling as a result of a one-size-fits-all monetary policy and
will struggle even more as exports to the US dry up.
And the irrational explanation? Simple: the only reward for being right six months before everybody else is a P45,
so the safe bet is to do what everybody else does. The herd mentality is powerful and, at the moment, the herd
believes that Alan Greenspan has the situation under control, or at least pretends that it does.
Dangerous
It doesn't take a genius to deduce that this is a situation fraught with danger. The dollar has appreciated by 65%
against the euro over the past six years, well in excess of any conceivable improvement in US productivity relative
to Europe, and at some point will fall. If it were to fall slowly and steadily there would be a gradual readjustment,
but the chances of this happening recede with every week that the currency remains absurdly high.
The bubble in the dollar will eventually become as obvious as the bubble in hi-tech shares, and the market
reaction will be the equivalent of someone shouting "fire" in a crowded cinema.
Can Greenspan save the day? I doubt it, because he is now part of the problem. The feeling that Greenspan is
God has encouraged the belief that the US economy will snap back as a result of easier monetary policy,
boosting corporate earnings and thereby justifying faith in both equities and the dollar.
In the short term this may work, but only at the expense of yet another consumer binge and a further burgeoning
of the trade deficit. Far from being the "maestro", as Bob Woodward called him in his book last year, Greenspan
is more like a quack doctor dispensing happy pills to the gullible.
The IMF is aware of the dangers. In the WEO it said that there must be "a proportion of the euro area outflows
that would be repatriated if returns abroad turn out to be disappointing". Another way of putting it would be that
the dollar is an accident waiting to happen.
It is already the case that the number of financial crises in the modern post-1973 era has been double that of the
Bretton Woods and pre-great war gold standard eras and before many months are out the world's finance
ministries could have another really big one on their hands.
Or rather two, for as figures out in the UK will show, Britain's trade deficit is not looking too clever either and
sterling is also defying gravity against the euro. There is trouble ahead.
larry.elliott@guardian.co.uk |
