International Perspective, by Marshall Auerback
A Growing Weak Dollar Constituency…As Long As There’s No Collapse
January 27, 2004
prudentbear.com
(dated, so will disappear in several days)
From the early 1970's onward, American industrialists have been concerned about competitive inroads from lower wage countries on a rapid path toward modernization. In the 1980's the focus was on Japan and its successful takeover of a long succession of consumer durable goods markets (autos, TV's, etc.) and some high tech markets (semiconductors) that were developed initially by US firms. By the 1990's concerns were rife that imports of an ever widening range of goods from lower wage countries, particularly in the Far East, would "hollow out" America's industrial base.
Throughout most of the post-war period, a number of Treasury Secretaries conducted economic policy with an eye toward preventing a loss of US competitiveness. Faced with calls for protectionism from firms and workers whose industries and jobs were at risk, these former Treasury regimes were biased toward a low dollar exchange rate which would enhance the position of US industries in world trade without running the risk of trade wars posed by protectionist solutions. Most of these Treasury Secretaries remembered an earlier era when the US ran current account surpluses and was the world's largest creditor nation. They also had the experiences of the so-called Third World debt crisis of the 1980s in mind and the corresponding fear of debt trap dynamics. In other words, dollar devaluation was grounded in sound economic theory, rather than desperation. It was pro-active, rather than reactive.
Under Treasury Secretary Rubin, all of this changed. Secretary Rubin differed in his focus: trade competitiveness was seldom cited as an issue; instead, he emphasized the support a strong dollar gives to domestic financial markets. We see this clearly in an interview Mr. Rubin granted to the New York Times, September 29th, 1996.
Mexico was still boiling when Rubin faced his second potential political disaster, the fall of the dollar to below 80 yen. For Rubin, this was more familiar territory: he had supervised the currency traders at Goldman, and he knew both the fiscal and political risks. "These kinds of occurrences are not without consequences," Rubin said. A declining dollar tends to drive investors out of American stocks, bonds and Treasury debt, putting pressure on the federal government to raise interest rates. "It would take a while to show up, but I'm certain it would have happened," he said.
From Rubin’s perspective, a strong dollar was always desirable to the extent that it encouraged short run speculative trend following capital inflows which buoyed domestic stock and bond markets and kept domestic interest rates low. The corollary of was that a weak dollar from any level was dangerous in that it would reverse such capital flows which could, to use Rubin's words, “drive investors out of American stocks, bonds and Treasury debt”. A loss of competitiveness, a rising current account deficit, and a growing net debtor position, all associated with a very strong dollar, were, in Rubin’s eyes, always be outweighed by any potential risks from destabilizing capital flows out of US stocks and bonds.
Rubin’s “strong dollar” policy became too successful. Notwithstanding mounting external imbalances in the US economy, a significant rise in foreign holdings of US debt, the dollar rose inexorably throughout the latter part of the 1990s and the early part of the new century. The mantra “a strong dollar is always in the interests of the US economy” took on status in the forex markets akin to the Catholic catechism, but the ultimate effect was to encourage yet greater reliance on short term speculative capital, thereby propagating greater potential financial fragility in the US economy. As the bubble grew bigger, and the external imbalances mounted, the need for a weaker dollar became manifest. However, Rubin’s successors generally eschewed the notion of pursuing a policy of devaluation on the grounds that an Asian-type financial crisis might lurk behind any sign of that the US was abandoning its ostensible commitment to a strong currency.
There were other unhealthy side-effects from this policy. Rubin's policy of encouraging a strong dollar for financial market reasons had the dangerous effect of undermining political support for free-trade initiatives. Previously, the soft-dollar approach, notably under James Baker’s tenure, had provided some grease for the wheels of progress toward consistent reductions in trade barriers, by soothing the worries of US industrialists that this would lead to rapid erosion of domestic market shares and making them lick their chops for opportunities to export into previously blocked markets with the low dollar as an inducement. Having the CEOs on board helped mitigate or offset the consistent opposition of the trade unions. By 2000-2001, the lofty dollar and recessionary business conditions had caused the business community from top to bottom to align more in favor of stopping or rolling back the free-trade tide which, unsurprisingly, has led to a rapid increase in global protectionism, even as the dollar began its gentle decline in 2002.
If anything, the surprise of the past 2 years has been the absence of a long anticipated Asian-style financial crisis, in spite of persistent dollar weakness, a vicious bear market, and a significant increase in American financial profligacy. Indeed, since the recovery in the US stock market last March, Treasury Secretary Snow, the ostensible “custodian” of the strong dollar policy, has abandoned even the pretence of being interested in it. Similarly Fed Governor Ben Bernanke has gone as far as celebrating the American central bank’s ability to print endless dollars to ward off any incipient deflationary threats. The current environment, therefore, seems to be the Washington’s economic equivalent of having its cake and eating it too. Stock markets have recovered robustly since last March and the ten year bond yield is now hovering around 4 per cent (back to pre-“Bernanke put” levels in fact).
It is true that, but for the massive support of the Asian central banking community, we would not be experiencing this benign set of circumstances. Fed Foreign (“Custody”) Holdings of Treasury, Agency Debt have increased $102.85 billion in 10 weeks, or better than 50 per cent annualized. Over the 52 weeks, custody holdings were up an astonishing $247 billion, or 29 per cent, year-over-year.
But the dirty little secret in today’s markets is that the Asians have grown to love a weaker dollar as well. Whilst the dollar has lost one-third of its value against the euro and the Australian dollar, 20 per cent against the yen and sterling and 18 per cent against the Canadian dollar, against the most important of emerging market currencies, China's renminbi, the dollar has moved not at all. The Hong Kong dollar and Malaysian ringgit are also fixed. But even the Indian rupee, Korean won, Taiwanese and Singaporean dollars and Russian ruble have barely moved since tumbling during the 1997/98 financial crisis, which implies that emerging Asia is also reaping substantial competitive gains from the dollar’s decline at the primary expense of Europe. These countries can pursue a devaluationist policy on the quiet, with little of the political pressures that greeted such moves when adopted in the 1980s or 1990s.
And the US does appear to be deriving some benefits from its pursuit of a weaker dollar on the external side (although in the broader context of economic history, it hardly seems appropriate to call last November’s “mere” $38bn trade deficit substantial progress). In a recent piece, we noted the gap between accelerating US consumer cyclical demand and a sluggish US consumer goods production response, which suggested an impending surge in US imports. Based on the ISM monthly survey data, which is a diffusion index that by its very construction acts as a leading indicator for the Commerce Department import data, we anticipated a 15-20% pace of import growth as Q4 2003 data was released, which in turn led us to forecast a rapidly accelerating trade deficit.
With the recent release of November’s trade data, we have confirmation of the expected import surge. The shocker was an unanticipated surge in exports. The Sept/Nov. export data now displays a point to point surge of 47 per cent growth at an annualized rate, and a 3 month trailing average growth rate of 19 per cent.
Of course, before one gets too carried away with the current state of affairs, it is important to note that even with the marginally improving American trade picture, US imports are now nearly twice the size of US exports. If US import growth settles down in the 5-10 per cent range, US export growth will have to run in the 10-20 per cent range to simply keep the trade balance stable at Q4 2003 levels. Given the slack pace of final demand outside China and the US, this means an awful lot of pressure on foreign firms trying to preserve global market share against firms based in a country with a 16 per cent depreciation on a broad currency basis (Fed definition), and a 33 per cent depreciation on a major currency basis.
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. |
