Why The US Dollar Will Not Weaken (yet)

Barry Eichengreen, the reliably even-handed Berkeley prof, has written an article arguing that the future of the US dollar is not nearly as grim as some would have you believe:

"The blogosphere is abuzz with reports of the dollar’s looming demise."

With posts like this one, Barry? Onwards:

"The first thing to say about this is that one should be sceptical about economists’ predictions, especially those concerning the near term. Our models are, to put it bluntly, useless for predicting currency movements over a few weeks or months.... Over periods of several years, our models do better. Over those time horizons, the emphasis on the need for the US to export more and on the greater difficulty the economy will have in attracting foreign capital are on the mark. These factors give good grounds for expecting further dollar weakness. The question is, Weakness against what?"

This is precisely the point that one of our readers brought up when I discussed this issue a couple of weeks ago (see? we read your comments). The argument goes like this: the dollar is weakening, but so are the currencies of all other major economies due to stimulus packages and mounting government debt. If you are going to abandon the dollar, you need to switch to something else. Barry dismisses the likelihood of the USD being replaced by the euro or yen, and points out that China will not be ready to introduce the remnibi as a viable alternative for quite some time.

Nor is inflation a plausible threat right now, either: despite what some shrill voices may be saying, the Federal Reserve is still determined (and credible) in its fight against inflation.

So without an alternative currency to the dollar, there's nowhere to go. Aha! that is where gold comes in, right? Not so fast, says Nouriel Roubini in a recent interview:

"I don’t believe in gold. Gold can go up for only two reasons. [One is] inflation, and we are in a world where there are massive amounts of deflation because of a glut of capacity, and demand is weak, and there’s slack in the labor markets with unemployment peeking above 10 percent in all the advanced economies.... The only other case in which gold can go higher with deflation is if you have Armageddon, if you have another depression. But we’ve avoided that tail risk as well. So all the gold bugs who say gold is going to go to $1,500, $2,000, they’re just speaking nonsense."

I think that these are all important counter-arguments to those inclined to write the dollar's obituary. My earlier post suggested that the evidence pointed to a long-run decline in the dollar - and that argument still holds. But for the short term? I leave the last word to Prof. Eichengreen:

"For the moment, the patient is stable, external symptoms notwithstanding. But there will be grounds for worry if he doesn’t commit to a healthier lifestyle."

Why the US Dollar Will Weaken

Predicting the future value of currencies is a tricky business.

For instance, about one year ago, as the US economy started heading down the toilet and investors of all stripes began to panic, one would have thought that the impending collapse of the US economy would be bad for the dollar. But not so. In fact it was the opposite: as the crisis spread, US dollar assets became a safe haven from all the other collapsing world economies. Why? Because the US economy is still the biggest, most open, and most liquid in the world.

Nevertheless, without being too specific, I would argue that we are likely to see a long-run weakening of the US dollar. Here are at least two big reasons why:


Changes in the US Economy
It took having to be beaten over the head with a rather large recessionary stick, but US policy makers have realized that the economic conditions that prevailed in the last decade or so should not be repeated going forward. I'm talking in particular about 1) low domestic US savings, and 2) the US's reliance on everyone else to make stuff, sell that stuff to America on the cheap, and invest the money earned from selling that stuff in US assets with a low rate of return. American financial institutions would then take that money and invest it in riskier assets, earning greater return, and making everyone rich.

That's an oversimplification, but you get the idea. Recognizing that there's a big downside to this state of affairs, Obama's top policy advisors have been advocating a shift in the US economic strategy. Larry Summers has been the most explicit, according to two authors from the Peterson Institute:

"The US, [Summers] said, must become an export-oriented rather than a consumption-based economy and must rely on real engineering rather than financial wizardry. Tim Geithner, the US Treasury secretary, and other top officials have spoken similarly of rebalancing US growth.... Redirecting resources away from finance and consumption towards exports and investment will require relative price shifts, for which the dollar has to move down."

Now, you could argue that the extent to which Summers & friends will be able to achieve this goal is limited. The US competitive advantage is, after all, in financial wizardry and not exports. Nevertheless, that this is the long-run goal of Obama's policymakers is a statement of intent that deserves to be taken seriously. And I think that it is being taken seriously by a country whose policies will likely have an even greater impact on the future of the dollar: China.

China's Investment Strategy

"You should be screaming if your life savings are in dollars."
That's the assessment from FT Alphaville after further evidence that China is trying to quietly tip-toe away from the US dollar - something that is hard to do when you own about 1.5 trillion (!) of them. Nevertheless, China is attempting to escape its "dollar trap" by directing state-owned firms to start investing in dollar-alternatives like commodities and commodity-related companies. As China starts selling US dollar assets there will be more US dollars in the market, the value of any given dollar will go down and the currency will depreciate.

The long-term objective of this strategy is to eventually bring about the full convertibility of China's currency, the remnibi, and have it compete with (or replace) the US dollar as the world's reserve currency of choice. I say "long-term" because Beijing will need a long time to diversify away from the US dollar. But nevertheless, when you own 1,500 billion of another country's assets, your strategic decisions are going to be of some consequence.

Now, as I stated in the opening, currency predictions are fickle things. One could easily imagine a scenario where China's economy has an unexpected downturn and the safety of US assets will once again be appealing. Economic analysts are prone to overstating the long-run significance of current events. But caveats aside, the macro-level economic strategies of the two largest economies in the world suggest that the US dollar is going to weaken. Big time.

Quick hits and pink picks: Dowdy, gloomy, dire no more

-Last week, Michael Skapinker wrote a piece in the FT entitled 'Britain's years of progress were no illusion.' It remembers 1970s Britain and asks us to retain a little perspective on the tremendous progress of the past three decades (in Britain and beyond).

-The NYT looks at the likely response of the US credit card industry to regulatory reform.

-Brazil and China will begin using their own currencies in official trade transactions, accelerating an intended shift away from the dollar by two of the world's (emerging) economic powers.

-How the Russian military (and pop stars?) sees the country's energy diplomacy with Europe, set to song and dance. Funny, and frighteningly true.

-Say it aint so, Arsene.

Has The American Economy Lost Its "Alpha"?

Willem Buiter certainly thinks so. His essay is, as usual, probably too long and dense for casual readers so I'll try to draw out some of the main points here. Before doing that, here is some background:

For quite some time now, the United States economy has been taking in more foreign investment than its citizens are investing abroad. Despite this negative net investment, American investors are earning more from their foreign investments (in aggregate) than the interest being paid on debts owed to foreign investors. This situation is what is being referred to when we talk of "alpha" - being able to secure positive returns despite a situation of negative net investment. This alpha has resulted from two factors: the very low rate of return offered on US assets and the increasingly risky nature of US-owned assets abroad (leading some to describe the United States as the world's largest venture capitalist).

Buiter outlines one possible explanation for the existence of alpha:

"Because of its unique position as the world’s largest economy, the world’s one remaining military and political superpower (since the demise of the Soviet Union in 1991) and the world’s joint-leading financial centre (with the City of London), the US could offer foreign investors lousy US returns on their investments in the US, without causing them to take their money and run."

The problem is, to the extent that it ever existed, this situation has been undermined:

There is no chance that a nation as reputationally scarred and maimed as the US is today could extract any true “alpha” from foreign investors for the next 25 years or so. So the US will have to start to pay a normal market price for the net resources it borrows from abroad. It will therefore have to start to generate primary surpluses, on average, for the indefinite future.

Thems fightin words. In order to generate those primary surpluses, the American economy will need higher taxes and/or less government spending (as well as higher personal savings). Yet the prospective Obama administration's economic stimulus plan contains precisely the opposite: lower taxes and higher government spending.

Buiter doesn't expect to change the outcome of the stimulus package, but his point is this: while the short run effects of a stimulus package may be beneficial, it will destroy the long-run prospects for the entire US economy. In short, the US economy cannot afford a Keynesian stimulus package. He predicts a global dumping of US assets in 2-5 years.

I wouldn't spend too much time worrying about Buiter's specific predictions on asset-dumping. Keynes himself pointed out that our ability to forsee the long-run is so limited as to be practically useless. Moreover, currency predictions are fickle at the best of times because everything is relative. For instance, even with current US economic weakness, we're seeing a flood to the US dollar a safehaven from other crashing currencies. So in two to five years, just about anything could happen. For more counter-arguments, see Free Exchange here and here.

Nevertheless, Buiter's overall concern is a real one and I'm not willing to dismiss it out of hand. But I think the most important questions to policymakers with more short-run horizons still comes down to: what's the alternative? and can America really afford not to have a Keynesian stimulus? A political consensus appears to forming that makes the answer to that last question a resounding "no."

So either Buiter is overstating the extent to which investors will be scared off by higher US debt levels, or there could be some very real long-run consequences that will make Obama's Harlem-Globetrotter-esque economic advisors look like the Washington Generals.

That Was The Year That Was: Economia

IPE Journal looks at the economic events that defined our socio-political landscape in 2008, the year of the subprime.

- In The Beginning there was Northern Rock - nationalized in February by the UK government following a good old fashioned bank run. Following heavy losses in the subprime mortgage market, Bear Stearns was next to go: in March, the once-proud investment bank was sold to JP Morgan for pittance. In July, IndyMac Bank went into receivership.

- September Madness. Over the course of a few short weeks, the magnitude of the crisis hit home (so to speak) as financial giants fell like so many martini-and-oyster fuelled dominos. The highlights:

• Freddie and Fannie are taken over by the US federal government
• Merrill Lynch is sold to Bank of America
• The Federal Reserve offered loans to AIG and took an 80% share in the company
• Washington Mutual is seized by the FDIC
• Morgan Stanley and Goldman Sachs become traditional bank holding companies, bringing the era of independent investment banks to a temporary close.
• And Lehman Brothers - in what now appears to have been a hugely significant decision, Lehman Brothers was allowed to fall into bankruptcy and the credit crunch prompty shifted into a higher gear.

- Keynes returns from the wilderness. The collapse in consumer demand has led governments across the globe to initiate fiscal stimulus programs. The sheer rapidity of this about-face in policymaking is breathtaking. We've come to expect such measures from the likes of France and Sweden, but from the UK, US and (gasp!) Germany? Keynes was wrong on many counts and his proclaimed followers even more so, but Keynes' insights on the role of government during economic downturns have gained a new lease on life. For better or worse, the impact of government spending programs and fiscal guarantees will be a defining feature of 2009.

- Price of oil $140 -> $40. A May 5th Goldman Sachs report predicted oil would break $200 within 24 months. Ok, still possible, but six months later the commodity bubble had burst in spectacular fashion and oil was trading under $40 a barrel. The explanations for the remarkable run up in commodity prices of recent years are manifold: historic emerging market growth, global demand, dollar weakness, financial speculation, etc. The price apex was as much about psychology as it was fundamentals, what Donald Rumsfeld would eloquently call the realization of "known unknowns". The "peak oil" moment came in the minds of consumers, politicians and traders across the world, only to be swiftly disregarded as global demand collapsed. Even repeated OPEC production cuts couldn't halt the slide into 2009. Commodity countries from Russia to Mexico are feeling the pressure, with devaluations and political instability on the way.

- Dollar down, up...down? It is awkward to speak of benificiaries of the financial crisis, but the US dollar was exactly that in 2008. By the end of 2007, there was a growing debate over whether the dollar had entered into a sustained relative decline vis-a-vis the Euro, with many concluding the common currency would soon eclipse the greenback's status as primary global reserve currency. The credit crunch had undermined confidence in the US financial system, and hot money ran wild through commodity currencies and emerging markets. But then financial crisis accelerated, and the commodity bubble burst, and investors sprinted to the safety of US dollar. It hit multiyear highs against sterling, the Euro, and a slew of emerging market currencies. Looking ahead, the outlook for dollar appears decidely weaker in 2009. The massive spending plans of Barack Obama and easy money Fed will weigh on the gains of the past year, especially vis-a-vis the Euro and Yen. But the dollar will likely retain its strenght v. emerging market currencies and sterling, as investors continue to find security in the greenback and the UK falls into the abyss.

Notable economic events which could have shaped the course of our year [Update: for the better], but failed: WTO talks & the G20 meeting in November.

***Co-written by Rory Doyle

Fed Goes All In: Addendum

First off, read Rory's piece on Fed policy then check out the new Federal Reserve No-Limit Credit Card. We laugh because it's good satire, but how is this really different from what American consumers have been doing for a decade?

Except of course that the interest will be paid, not by the Fed, but by anyone and everyone who holds dollar-denominated assets.

The Macroeconomic Rebalancing Act

The rapid US dollar resurgence of the past couple of months is being felt in a number of very specific ways. Rory has been following this trend closely (see posts on USD resurgence, other currency stuff and the, er, "GreenPack.") so I won't spend too much time on the specifics. What I have been meaning to discuss is the significance of this shift in a broader context.

I'm referring to the issue of "global macroeconomic imbalances." What are these imbalances, you ask? The expression refers to situation that has arisen because A) countries in East Asia and the Middle East have a lot of money they wish to lend somewhere safe and B) the United States has until recently been very willing to borrow.

Japan, China and others have so many funds to lend because they have exceptionally high national savings rates, relatively low levels of spending (esp. China) and foreign currency reserves generated from trade surpluses. Since the US is the largest, safest, most open economy in the world, these excess foreign reserves have been pouring into their economy as low-yield investments. For instance, Japan holds about $1 trillion in US assets; China about $1.9 trillion. That means the US is indebted to these countries to the tune of several trillion dollars.

Fed Chairman Ben Bernanke has argued that this "savings glut" in developing countries is the main source of the imbalances. These precautionary savings have two problems. First, they provide low-yield return. For instance, China could take a portion of those nearly $2 trillion and invest it in their own country's education and infrastructure - this is in fact less of a savings glut than an "investment drought." Second, developing countries that rely on export surpluses are essentially relying on the United States to buy those exports. In short, the US must act as "consumer of last resort."

On the other side of the equation, the American economy has been saving almost nothing and accumulating debt like it's going out of style (this applies to other rich developed economies, but less so). This is partly because there was no need: cheap credit from abroad helped fuel equity bubbles in the late 1990s and the recent housing bubble - people were getting rich. But this system was only sustainable so long as American deficits continued to grow and American consumption continued to hold up the world economy.

Some people have argued that this balancing act is (was) sustainable, but they are wrong. The real question is when and how will things re-balance themselves. There are two worries. First, that US deficits grow to the point where China & co lose faith in the dollar, dump their assets and cause a recession in the United States. I think that fear has always been overstated. To paraphrase the old banking addage: when you owe the Chinese government $100 million, you have a problem. When you owe the Chinese $1.9 trillion, they have a problem. If the US economy drops 10%, say, these Chinese-held assets will suffer enormous losses. So the fear of a "hard landing" caused by foreign investors was always problematic.

The second worry is that of a Sudden Stop: a slowdown in the US economy prevents them from acting as "consumer of last resort" and emerging markets are forced to readjust internally on short notice. This could also result in a "hard landing" for the economies involved - something to be avoided.

However, last week John Kemp pointed out that we no longer need to worry about which outcome it will be since the decision has been made for us:

The unfolding credit crisis is producing a deep recession, cutting U.S. demand for imports, and forcing the long-overdue adjustment in the trade deficit.

He concludes:

With recession taking care of the current account deficit, financial crisis reducing gross capital outflows, and foreign official buyers continuing to support the Treasury market, the U.S. currency has been a strange beneficiary of the crisis. If the dollar’s earlier decline was a symptom of over-fast growth, its rise is a by-product of recession.

That's all fine and good for the dollar, but what about everyone who was relying on US consumers to fuel growth? A hard landing is still a strong possibility in some parts of the world. Over the next few months we're going to find out just how capable some countries are at redirecting investment inwards and stimulating their own demand.

Further Reading: Patrick and I discuss China's counter-move of devaluing the yuan. Checkitout!

(Photo: Daylife)

Adventures in Economic Stimulus, Part Deux

I have found a solution to the boring old government spending vs. tax cuts stimulus debate: it's QuikCash! Just in time for the holidays.

Part one.

Economic Crisis Felt in East Asia

A Dec 10 report by the World Bank forecasts that real GDP growth in East Asian developing countries will fall by 1.8% from 2008 to 2009, to a rate of 6.7%. When including developed countries, the rates drop by 1.7% to 5.3% over the same period.

This is not too surprising since, as discussed below, the heavily export-oriented economies in the region are seeing the effects of declining demand impact their balance sheets. I wonder, too, about the rapid increase in the relative value of the USD over recent months. Many countries in the region fix their currencies (in varying degrees) to the greenback as a hedge against fluxuations in exchange rates - a resurgent USD means their exports are going to be more expensive just as demand is declining.

The good news from the WB: countries in East Asia are much better prepared for today's turmoil than they were a decade ago. In particular, "the countries which have entered this crisis with low debt burdens, surpluses in their fiscal and external current accounts and large external reserves will have the most room to maneuver as the crisis unfolds."

Sounds like pretty standard WB-fare to me. Part of the point of building up those large external reserves in the first place was to prepare for just such an occassion. I just hope it pays off and the analysts are "more right" than they have been in the past.

Dollar surges to multi-year highs against major currencies

The dollar has hit multi-year highs against major currencies this week. The flight to safety, spurred by the financial crisis and bursting of the commodity bubble, has driven the dollar higher in spite of the ballooning US fiscal deficit.

I have been predicting a strong dollar rebound for the past few months, so the rally is nice for my ego. Unfortunately, I am presently paid in pound sterling.

Dollar denominated debt? Check. Sterling denominated income? Yes. That my friends is a (reverse) currency mismatch. Yay for me.

Faster, Higher, Stronger

In a previous post I discussed the recent rise of the US dollar. A number of factors have converged to support the greenback's reversal, and on a technical basis key resistance points have been breached in recent trading. Some reacted to my prediction of a sustained dollar rally with understandable skepticism. However, the past few weeks have reaffirmed the trends I believe will support a strong dollar. A few key points:

-The long commodities/short financials trade the fueled the speculative bubble is rapidly unwinding. This has weakened commodity currencies like the Aussie and Kiwi dollar, and seen a surge of money back into the greenback. The record losses of hedge funds in 2008 are directly tied to this trade. While I support the view that rising commodity prices are mainly attributed to fundamental shifts in supply/demand/capacity, financial speculation has clearly generated the froth. I believe the fundamentals support $100 oil, but $140 was all about the hot money.

-The US pleasantly surprised with a revised 3.3% Q2 GDP growth (although some are questioning the credibility of this figure). The expansion was mainly driven by exports, which have surged on the back of a weak dollar. While a strengthening dollar will nudge down exports levels, a measured increase in domestic consumption should keep the US economy above water in Q3 (fiscal stimulus typically takes 2 quarters to fully work its way through the real economy).

-Europe is on the brink of a formal recession, and according to Alastair Darling, economic conditions in the UK are the worst since WWII (how's that for confidence!). Sterling's slide continues, hitting its weakest level since the Euro's introduction in 1999, while the dollar reached an eight month high against the common currency in today's trading.

-Finally, the risk of at least one currency crisis in Asia has increased this week. There are reports that a number of central banks intervened to support their currencies (Thailand, South Korea, Malaysia, the Philippines). The conditions in Asia are uncomfortably similar to 10 years ago (although granted, large FX reserves and better financial supervision have countries like S. Korea better positioned to withstand a run). South Korea has already fired a warning shot to speculators, and the IMF publicly weighed in today in support of the won. With the political situation in Thailand deteriorating by the minute, it could well be the first shoe to drop...just like in 1997. Needless to say, expect a flight to safety ($).

No one should expect the dollar to hit the stratosphere any time soon. But a measured, sustained rise looks even more likely now than it did at the beginning of last month.