WEEKLY COMMENTARY: ARMAGEDDON? -->
By James R. Cook, August 21, 2001
About the only thing Wall Street hasn't been able to put a positive spin on these days is falling corporate profits. Sooner or
later some analyst will try to make this into something good. The latest positive twist, however, concerns the falling dollar.
Supposedly that will be a big plus for multinationals. This optimistic outlook ignores the far more serious implications of a
dollar decline, which is, after all, a devaluation of the currency. For one thing, more expensive imports cause inflation. (It
used to be that 30% of what we consumed came from overseas. It's probably higher now.) Rising prices for imports would
also give domestic industries more flexibility in raising their prices.
Since foreigners own a lot of American securities, a falling dollar and falling markets would hit them with a double whammy.
They would be sellers. This would drive down the stock market and in the bond market would push up interest rates. What
would higher rates do to a moribund economy?
The best analysis of the situation comes from the superb economist, Kurt Richebacher. Here's the last page of his August
letter:
EURO AND DOLLAR:
"The central focus of our attention in the global financial markets is not the Dow or the Nasdaq. It is the euro-dollar
exchange rate. It is by far the single most important price in the global financial universe involving many trillions of dollars.
Consider that foreign gross holdings of dollars amount to almost $10 trillion, as against American holdings of foreign assets
amounting to approximately $8 trillion. The United States is a net debtor by about $2 trillion to the rest of the world, of
which more than half has accrued during the last three years. For the first trillion, it took about 15 years.
Formerly, the movements of exchange rates were primarily influenced by changes in the trade balances. Weakness in the
current account used to mean a weak currency. But in the 1980s, ballooning capital flows became the more powerful market
force. Despite a rapidly rising trade deficit, in the first half of the decade the dollar was riding high on the back of soaring
capital inflows. This was an utterly new experience for the currency markets.
The great surprise that shocked markets and policymakers occurred in late 1984 - early 1985 when the dollar inexplicably
accelerated its surge against the backdrop of slowing economic growth and falling interest rates in the United States. In late
January and early February 1985, the United States joined in concerted interventions against the dollar. Yet the market
boosted it further from DM 3.17 to DM 3.47 in late February.
We have done this little excursion into history in order to show the present experience is by no means unique. Still, it's most
important to see, on the other hand, that some big differences exist between then and today.
It begins with the tremendous difference between the German Bundesbank and the European Central Bank. The
Bundesbank never permitted the slightest doubt that it regarded the D-Marks' weakness as both undesirable and unjustified,
and it had no qualms whatsoever to demonstrate its opinion with unilateral interventions. Nevertheless, its determination and
credibility didn't stop the superdollar. As to the European Central Bank and its president, Mr. Wim Duisenberg, we find it
impossible to say one single positive word about them. Perhaps the dollar was unstoppable, but Mr. Duisenberg, in
particular, has rightly earned the contempt of the markets with repeated careless remarks, among them his complete
disinterest in the euro's weakness. Quite fitting to this is his apparent inability to grasp the dangers in the world economic
situation.
Having said this, we hasten to follow up with the question: What about Mr. Greenspan and Mr. Paul O'Neill, the U.S.
treasury secretary. In contrast to Mr. Duisenberg, they exercise enormous influence in the market. But we regard this as evil
and extremely negative. A mere comparison between Mr. Greenspan with former Fed Chairman Paul Volcker may elucidate
what we mean by this remark. Mr. Volcker pursued his monetary policy with the focus on money and credit as the primary
targets of his policies. Mr. Greenspan, on the other hand, has distinguished himself as the most prominent cheerleader of the
American "new paradigm" economy, importantly contributing to the collective, manic euphoria that developed and grossly
imbalanced the U.S. economy. Certainly, Mr. Greenspan is far more dangerous than Mr. Duisenberg.
We come to another difference between 1985 and 2001 that we regard as the most important one. It concerns the relative
weight of manufacturing interests versus Wall Street interests in American policy decisions. In 1985, with Jim Baker at the
helm of the U.S. Treasury, the Reagan government, worrying about the damage that the overvalued dollar was doing to the
manufacturing sector, took the initiative for concerted G5 action against the strong dollar. The rest was the Plaza Agreement
of Sept. 22, 1985. Its secret provisions featured up to six weeks of intervention to initially knock 10-12% off the dollar. In
the event, the Plaza "announcement effect" was much more powerful than the G5 had expected. After barely a week with
very small interventions, the dollar was down 12%, causing fears of an uncontrolled collapse.
There will be no Plaza Agreement this time. Wall Street interests have become absolutely predominant in Washington. In
fact, both the U.S. economy and its financial markets have become so inordinately dependent on persistent, huge capital
inflows that policymaking has no choice anymore. While a falling dollar would help the manufacturing sector, these beneficial
effects would be vastly outweighted by the devastating effects that sharply slower capital inflows would do via a plunging
currency to inflation, stock prices and long-term interest rates. Considering the potential sums involved, it could easily turn
into Armageddon.
CONCLUSIONS:
Economic conditions around the world are worsening dramatically. In the past few years, large parts of the world economy
became highly dependent on the bubble-related surge in U.S. import demand. The bursting of Japan's bubble was a problem
for Japan; the bursting of the U.S. bubble is a global problem.
There is a striking dichotomy in the U.S. economy and the markets between great optimism talked and pessimism practiced.
It's called confidence building. Mr. Greenspan, in particular, is engaged in the exercise to temper the slowdown by talking up
the economy's long-term prospects. But when consumers and businesses are overextended, no amount of talk will prevent a
painful reckoning.
An endless stream of very bad news from corporations themselves leaves no doubt that economic conditions continue to
deteriorate. But in the public discussion, head-in-the-sand optimism prevails.
The greatest secret worry of all is that bad news about the U.S. economy may set off a free fall of the dollar. All it may need
for that to happen is doubt in the dollar's stability inducing foreign holders of dollar assets to hedge the associated exchange
risk. U.S. economic and financial prospects have effectively become hostage to the perception of an invulnerable dollar.
Considering the atrocious imbalances in the U.S. economy, the dollar's free fall is unavoidable." |
