Greenspan between a rock and a a hard place.
Is The Declining Dollar "Checkmate" For Mr. Greenspan?
June 04, 2002
I have always maintained that so long as Mr. Greenspan could keep "printing" dollars at will, the
economic checkmate from the burst 1990s' stock market bubble could be delayed. And, as the
chart below shows, Mr. Greenspan did indeed print a lot of dollars last year. On a
year-over-year basis, M2 growth went from about 6% at the end of 2000 to about 9% just
before September 11, 2001. The spike right after September 11 was due to a lot of bank credit
extended to cover overdrafts resulting from disruptions in the payments system. Even though
M2 growth has slowed this year, the latest reading of 8% still implies a lot of overtime printing
activity at the Fed.
But if the US dollar continues to depreciate, which I think it will with only minor countertrend
rallies, then Mr. Greenspan is going to lose the policy latitude to keep printing greenbacks at
will. Ironically, though, until Greenspan takes action to slow the dollar's decline, he will be forced
to print even more dollars. Here's how that works. Once the forex sharks smell the blood in the
water, they will start to borrow dollars in order to sell them for euros, yen or gold. Currently,
they can borrow dollars for three months at a ridiculously low annual rate of less than 2%. As
the demand for short-term "shorting" US dollar credit increases, short-term U.S. interest rates
would "want" to rise. But by maintaining its fed funds target at 1.75%, the Fed is signaling that it
doesn't want short-term rates to rise. The way the Fed prevents rates from rising is to create
more credit - i.e., print more dollars.
But how does this limit Mr. Greenspan's latitude to keep on printing? Inflation. The cheaper
dollar is, all else the same, going to temporarily make US exports more competitive in world
markets. Why do you think that the National Association of Manufacturers has been lobbying for
a weaker dollar policy from the Bush administration, what ever that policy might be? So, foreign
demand for US goods and services will start to augment domestic demand. Unless aggregate
supply curves are infinitely elastic, which only "new era" types and Keynesians believe, then an
increase in aggregate demand is going to lead to an increase in prices, i.e., higher inflation.
Moreover, domestic producers will now have some "cover" to raise their prices inasmuch as the
dollar prices of their foreign competitors will have risen.
As of April, the year-over-year percent change in the US CPI was 1.6%. Thus, the fed funds
rate is only 15 basis points over the inflation rate. Unless Greenspan hikes the funds rate soon,
which he has shown no inclination to want to do, then, in the second half of this year, the CPI
inflation rate is likely to rise above the funds rate, in part due to the depreciating dollar. A
negative inflation-adjusted return on short-term US money will drive global investors out of the
dollar all the more. It's a Sid-vicious cycle.
Why doesn't Greenspan want to raise the funds rate now? For starters, have you looked at what
the stock market has done this year? If it keeps on its present downward course, 2002 will mark
the third consecutive calendar year in which the stock market has fallen. This hasn't happened
since the 1930s. Despite all of the bravado about housing being more important than the stock
market when it comes to augmenting consumer spending, Greenspan is frightened as to what a
continued bear market in stocks will do to aggregate demand. And speaking of housing, would a
Fed hike in interest rates be a plus for the residential real estate market and home-equity
borrowing? As Bill Gross has pointed out, Corporate America has borrowing in the bond market
and swapping this obligation for floating-rate exposure. If Greenspan hikes the funds rate,
Corporate America's interest costs will rise significantly, perhaps precipitating even more
bankruptcies. And, oh yes. Congressional elections are scheduled for November 5. If Greenspan
raises rate now and the Republicans lose control of the House, he might incur the wrath of the
Bush-family "enforcer" - Babs!
So, Alan, old buddy, it's beginning to look like checkmate. If you raise rates now to defend the
dollar, you run the risk of aborting the expansion. If you hold off, the dollar continues to
weaken, inflation continues to worsen, and you have to raise rates a lot more later this year or
early next. The expansion gains speed this year only to hit a brick wall next year. If you can
manage to avoid this checkmate, then Big Green(span) will have topped Big Blue.
Paul Kasriel
Director of Economic Research
Northern Trust |
