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It appears only a matter of time before the ECB cracks and begins to join the game of global competitive currency devaluations, which would likely upset this delicate balance, a state of affairs that has enabled US and Asian capital markets to levitate in spite of the persistent weak dollar trend (which has taken currencies such as the renminbi down in its wake). For whilst the weak dollar constituency is growing in Asia, there are signs of a backlash elsewhere: The Bank of Canada just eased and has signaled the possibility of further cuts reflecting concerns about the strong Canadian dollar on its economy. The Norwegian monetary authorities have signaled likewise for months. Late last week, all currencies fluctuated widely as Reuters cited an unidentified European diplomatic source saying that a further strengthening of the euro could lead to a looser monetary policy, in spite of ECB President Trichet’s stern rejoinders to the contrary. Trichet himself has recently noted falling inflationary pressures, which implies a bias toward imminent easing.
Of course, it is important to note that however much the Asian central banks have grown to love a gently declining dollar, they have no interest in witnessing a collapse. The Asian official sector has in effect acted as a buffer between private speculative capital (which continues to wash its collective hands of the dollar), and the Asian and American industrialists, which are deriving benefits from a slowly declining currency, but who would be the first casualties of a dollar collapse (given the deflationary impact of the latter through the sharply higher long rates it would ultimately produce). The massive dollar support operations of the Asian central banks have preserved low long term US rates, and helped to sustain an ongoing market for Asian exporters, but at a cost of perpetuating growing American financial profligacy (to a degree that even President Bush is beginning to pay attention to it) Since global final demand remains quite sloppy outside of the US and China, it must be the case that US and emerging Asian exporters are stealing global market share away from European firms especially, and Japanese firms to a lesser extent, which may be reflected in the increasingly anxious tones of German and French industrialists, fretting about the euro’s ongoing surge against the dollar.
Moreover, the pervasive Asian central banks’ purchases of dollars to hold down their local currencies have had the mechanistic effect of boosting domestic money supply, and in effect engendering a series of mini-domestic credit bubbles throughout Asia, especially China. So we now have a new kind of “Goldilocks” scenario: a gently declining dollar, whose “not too hot, not too cold” descent enables US monetary authorities to perpetuate lower interest rates/higher bond prices, in turn creating a broad Asian-American constituency for ongoing US dollar weakness.
This appears to run counter to all economic theory, but in the context of a rapidly spreading global credit bubble, one can see the short term attractions. However, whilst the monetary consequences of a weaker dollar have turned out to be surprisingly expansionary in Asia, such expansion appears thus far insufficient to reduce the US current account deficit. All that is happening is that we are seeing faster global economic expansion on the back of a still overextended US consumer, rapidly rising commodity prices, significant increases in global capital expenditure, all of which will probably end in worldwide overheating and a dollar collapse as the indebted US economy finally reaps the consequences of the higher rates brought about by such an inherently unstable policy.
Indeed, should the very recent spate of dollar strength continue, it might begin to unravel this “happy” state of affairs insofar as it removes the incentive for foreign central banks to continue to buy US dollar bonds, as the need for dollar support operations diminish. We use the word “happy” guardedly, since it is clear that even if the dollar resumes its decline, the underlying problem of indebtedness remains. The expansion of credit is an increase in debt. When debt levels are low a credit expansion which increases debt does not leave a legacy which later suffocates demand, since the resulting still low level of debt is not yet a problem. But when debt levels are very high the increases in debt created by credit expansion soon act as a burden on demand. It follows from the above that, as the level of debt relative to income rises, it should take larger expansions of credit to achieve any given percentage increase in demand, since the now high and climbing debt burden acts as a countervailing force to depress demand.
Arguably, it is the US mortgage rate which is the key price in the world economy, as keeping the US consumer happy and liquid has been the key to keeping the global economy afloat amid all the excess capacity in the world. That means US long-term rates cannot be permitted to rise for now, but instead must work gradually lower, and the way that happens with so much government debt being issued is for the rest of the world to absorb it, which means the dollar must stay weak enough to encourage all those purchases from the foreign official sector. But this process simply puts off the inevitable denouement for the US economy, whilst simultaneously introducing an element of monetary instability into Asia. The efforts of U.S. policy makers to avoid a full unwinding of the 1990’s stock market bubble through the encouragement of a credit bubble and a housing bubble has, despite something of a recovery, made both conditions worse. Today private debt is higher relative to income than it was two or three years ago and core inflation has fallen to only 1 per cent. China’s capital expenditure is way above trend and authorities there are voicing concerns.
The embrace of a weak dollar has in effect placed both countries today closer to the Fisherian debt deflation dynamics which created prolonged stagnation and repeated recession in Japan. Therefore, the real risk is that today’s global credit blow-off ultimately places everybody closer to debt deflation dynamics and greater currency instability, hardly a conducive backdrop to perpetuate the current sanguine state of affairs in today’s capital markets. |
