dollar

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Trade and The Dollar

You all know that the dollar is steadily declining in value. It has been in a slow motion decline for years, but since March it has lost value at a slightly faster pace and has devalued about 16% since then. If this keeps up we will be headed into a full blown currency storm which could well foul up the Fed’s ability to keep rates steady in order to stimulate the economy.

That’s for another day.

Today I want to make a quick mention of the dollar’s decline on our trade balance.

According to the standard text book a drop in the dollar should allow US exporters to lower their prices, win more business, and thus increase trade. This would both stimulate domestic production and add jobs, but it would reduce the trade deficit. The impact of a cheaper dollar is the opposite on the import side: as the dollar slides import prices are driven higher and, in theory at least, Americans would buy fewer foreign made goods and services by switching to cheaper US made stuff.

That’s the theory.

So what went wrong?

Today’s news is that the trade deficit grew rapidly to $36.5 billion in September, up from $30.8 in August. This deterioration will hamper GDP growth since a larger trade deficit reduces domestic wealth. And the textbook says it’s not supposed top happen this way.

The answer is straightforward: oil.

America suffers from an addiction to oil as we all know. We import about half of our consumption. And oil is priced and traded in dollars. So as the value of the dollar depreciates each barrel of oil costs more. A quick look at the details of the trade balance confirm this: petroleum imports of various kinds make up about two thirds of the increased trade gap.

So we are stuck. Our manufacturers may well be able to sell more stuff abroad and thus add jobs here. That will help the economy enormously. It will certainly boost GDP. But all that good work is being undone – more than undone – by our complete inability to get an energy policy that is not oil-centric. Our addiction is steadily corroding the economy.

Which is why all that talk from the administration about alternative energy and so on is not silly left wing eco-chatter. It is sensible economic policy. We need to reduce oil consumption any way we can. That way the fall in the dollar will have the beneficial effects we need.

Further, and on a deeper level, one of the big economic problems in the world today is the persistence of the American trade deficit. That deficit – accounting being what it is – is balanced by an opposite surplus on our capital account. Think of it this way: we import the cash [surplus on capital] to pay for the goods we buy [deficit on trade]. This flow is huge. It also means that the US economy is awash with money that tends to be recycled into cheap loans. More to the point: it allows loans to be cheaper than they otherwise would be. This massive imbalance is a worldwide problem – some people call it a savings glut in the exporting countries. Until the world savings and investment flows are in better balance we will continue to suffer periodic consequences such as over-lending in certain areas … American real estate was the last big example of this phenomenon. And we know how that worked out.

So getting the trade balance under control needs us to cut oil consumption, radically over the medium term, and by any amount we can in the near term. It also needs us to save more and spend less. That produces a knock-on effect: it will require big exporting nations like Germany, Japan, and China to spend more rather than save.

Interconnectedness is not just a banking problem. Our trade balance is also part of a global set of imbalances that need international cooperation to sort out.

Meanwhile our trade balance is getting worse just when it should be getting better.

What a mess we’ve made for ourselves by not confronting the tough issues for the last three decades.

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Bernanke Maps The Future

In a speech given yesterday Ben Bernanke gave us a few hints about the future of the world economy. Unfortunately most of his commentary is similar to speeches given throughout the years by other American officials.

The main story line deals with ‘imbalances’. This is central banker speak for the really big deficits or surpluses that haunt the global stage and are viewed as primary causes of much of the current trouble.In particular are the various trade balances between the US and its main trading partners, and the seemingly unending Chinese surplus that is a source of destabilizing capital flow.

The problem is this: the US consumes too much and does not save. It therefore has to borrow money from other countries to maintain its standard of living – as long as standard of living is defined as GDP growth. This is an historical anomaly of huge proportions because in bygone eras the then dominant economy was always a creditor – it lent some of its surplus wealth to other countries who could then improve their economies. The US is the first dominant economy to depend on weaker or growing neighbors for its growth.

The early years of American development was largely financed by European – particularly British – capital. So as the US grew is sucked in money and ran deficits in order to build for the future. Those deficits were tolerable because they were contributing to future wealth. They could be paid off comfortably from that wealth once the economy became self-sustaining.

Right now this scenario is being played out backwards.

China, which is roughly analogous to the young America, is not sucking capital, it is exporting it. Instead of consuming its capital through domestic investment, and therefore constructing the platform for future wealth, China is content to grow more modestly and export its cash to the US. The reason is straightforward: the US is China’s largest market and therefore it is in China’s interest to have the US continue to consume and grow. Slower US growth is seen, in this scenario, as a threat to Chinese strategy.

Other Asian countries are doing the same thing: they are relying on the US to keep going deeper into debt in order to prop up its consumption habit.

All these trading partners of the US are implicitly suppressing their own domestic demand and are relying on growth abroad to provide an engine for their own growth. This is one reason why the American implosion last year ricocheted so quickly around the world economy: it wasn’t simply that the US financial system crippled the world, it was that the subsequent US contraction in demand left Asian suppliers with an overhang of unused production.

The flip side of this dependence is, of course, that the US is able to run huge deficits with comparative impunity: foreigners are more than willing to pour capital into the US in the belief it is the safest place to invest. Unfortunately this allows the US to avoid confronting its own issues, notably its rapidly deteriorating competitive position and its long run loss of advantage with respect to innovation, education, and other aspects of economic infrastructure. This is why I call the economy at present an ‘illusion’: it looks as if it is healthy, but underneath it is compiling problems and debts at a prodigious rate.

These imbalances have been around for decades: the US shifted into debtor status and a dependency on foreign capital in the Reagan years, but it took the emergence of China and other Asian economies to bring the issue to a head.

The flood of capital flowing onto the world market from the trade surplus countries was a primary cause of the financial bust in the US. Money from China, Japan, Germany, and Asia generally swamped the US economy, drove down interest rates here, facilitated persistent Federal deficits, and ended up being channeled into things like the sub-prime market because there was a lack of sensible investment opportunities here: our manufacturing sector has migrated abroad.

This is odd because in a high wage economy like the US it is normal to see a constant attempt by capitalists to substitute capital – which is relatively cheap – for expensive labor. This constant substitution should drive productivity higher and thence allow the retention of those high labor costs. It was exactly this effect that drove the emergence of the Industrial revolution in the early 1800’s – British wages were much higher than anywhere else, so capitalists were driven to invent automated ways to perform production tasks, the result being a virtuous cycle of higher productivity followed by yet higher wages and thus a new impulse to innovate.

The problem we have had is that our industry has simply off-shored to lower wage nations rather than innovate or invest. So the virtuous cycle was more muted here than it ought to have been. That has allowed the steady erosion of competitiveness and, more recently, threatened US wages. Instead of inventing its way to a higher wage scenario the US has accepted the need to lower, relatively speaking, wages here.

This means that the inflow of capital caused by our constant deficits and our debtor status has been used to support consumption rather than investment – it has not been turned into expanded future wealth opportunities at all.

This unfortunate trend has been noted for years by a succession of American and foreign experts, but there was never the predicted crisis to bring to a head the needed international reforms. In particular thee was never the will to deal with the American deficits – American consumers grew attached to spending what they didn’t earn. On the contrary during the Bush years concerns about deficits were dismissed as the silly whining of old fashioned analysts, and the American ability to keep growing its debt was seen as a virtue – it spoke to the romantic, but not economic, notion that there was nowhere safer than America to invest. That the rest of the world was apparently to keep on plowing cash into the maw of American consumption was, from the Bush administration’s view confirmation of American superiority rather than a symptom of long term degradation. Foreigners went along with the ruse as long as they could extract good returns, and besides, the Us is the world’s largest economy – where else could they invest?

This charade is now teetering on the edge. Foreign countries like China make periodic references to the massive amounts of dollars they now own, and to the inevitable risks that position entails. There is even talk of ending the dollar’s role as a reserve currency due to its over abundance o world markets.

This is where Bernanke steps in: he is simply stating the obvious. The US will have to start to consume less as a proportion of its total GDP. That means it will import less and will want to export more. The problem then becomes what to do about those foreign export dependent economies? How do we get the Japanese, Chinese and Germans to consume more and rely less on America for sales of their goods? The answer is clear, and Bernanke lays it out in plain terms: they have to shift their domestic economic policies towards encouraging spending and placing less emphasis on saving.

That is all easier said than done.

Shifting Americans from their obsession with acquiring ever more stuff, or getting Germans to save less and spend more, will require heavy lifting.

Here in the US we also have to get to grips with our Federal deficit which will require us to raise taxes and to face difficult spending cuts: in particular we are likely to have to confront our defense bill, which in turn, implies a re-evaluation of our role in the world. It is nice to have a huge military presence with which to bully the world, but the long term cost should not be the hollowing out of the domestic economy and the loss of our standard of living.

Likewise, the American system of entitlements needs to be tightened up and made more cost effective. This is the major impulse underlying my support of health care reform: those dollars need to be allocated towards future wealth generation and not simply consumed on today’s generations health issues.

That Bernanke spoke about all of this is symptomatic of the concerns in Washington that the US is finally wearing out its welcome as a debtor. We will be reliant upon the inward flow of capital for many more years as we re-tool our economy to produce more domestically. So we cannot be precipitous in our actions: quick movements in the dollar could undermine confidence in the US economy and threaten that flow of cash. Likewise a continuation of the Bush era indifference to deficits is also destructive: that too would imply a devaluation of the dollar and thence could cause the same ill effects.

So Bernanke needs to keep reminding the world of our determination to get our house in order, and our understanding that the Reagan/Bush era’s dependence on debt will end. Given the short term explosion in the Federal deficit this is doubly true.

But he also needs to communicate that we will not be shifting to a more conservative, and therefore anti-Reagan/Bush, fiscal policy too soon: we need to get past the crisis first.

Which explains the fact he keeps on turning up saying the same thing and then ignoring his own advice when he gets back to his desk.

This is all about positioning and preparation. So that map he keeps showing us is one for the future – let’s say 2011 and 2012 – rather than right now.

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The Dollar Falls

A few of you have asked what I think about the recent sharp decline in the value of the dollar. In general it’s a good thing. Let’s have more decline.

The problems we have with the dollar stem largely from the flood of money we have created to bail ourselves out of the mess the banks put us in last year. That was a necessary evil, but it unleashed a tide of dollars on the world. The simple laws of supply and demand imply that such a flood will inevitably reduce the value of the dollar. Each incremental issuance of US debt we make to pay our bills needs investors willing to buy them. Under the normal conditions of the last half century the US dollar and US debt has been a bastion for safety for investors. The demand for US debt has been steady because everything else is seen as more risky by comparison. So whenever there was a worldwide recession the US benefitted from an inflow of credit.

We became addicted to this inflow. So much so that we built our economy around being able to get other people’s money to pay for our own spending. Our trade deficit ballooned and has been negative for years – although today’s news is that it shrank a little last month. This was the central premise of the Reagan inspired fiscal policies we have pursued for decades. We were able to run trade and Federal budget deficits precisely because there was a steady stream of foreign investors who had spare cash and wanted to invest it safely.

In fact the existence of those foreign sources of cash is often used as a reason for our real estate bubble: were there no foreign cash we would never have had the money to inflate our house prices the way we did. This is the ‘savings glut’ argument some economists – including, at one time, Bernanke – to explain our bubble problems.

But all good things come to an end.

The world seems sated.

They have so many dollars in their investment portfolios that they are now getting concerned about having too many. So demand is ebbing.

Plus our economy has been exposed as being less reliable than people thought. Other economies are now in better shape and offer better returns. This also reduces demand for US debt.

The effect on the dollar is to depreciate its value. Dollars are so abundant that they are worth less than before. Especially when our interest rates are so low.

In general I think we should look forward to the dollar declining more. Most Americans won’t see much immediate impact. Our products will become cheaper when sold in foreign countries, so that will stimulate demand for American goods. Imports will increase in price and that would make things that are originally produced and priced in foreign currencies – cars for instance – more expensive. But anything that is produced and priced in dollars – oil being a good example – will not change in price in America. That means our trade balance should narrow and our domestic economy will grow a bit faster than it otherwise would.

One of the reasons the stimulus has been slower to percolate through our economy – it has worked, but could have worked sooner – is that it was designed to increase spending. To the degree that the spending was on foreign goods, the jobs the stimulus created were abroad not here. So a declining dollar helps prevent that exporting of jobs.

A more difficult problem, and one with profound long term political impact, is that the flood of dollars and the decline in their value has irritated enough foreign governments that they are actively discussing eliminating the dollar as the world’s primary trading currency. Plenty of commentators here treat this threat as shallow and temporary. I disagree: I think we ought to be very aware of the possibility of such a move. The impact on us would be severe.

Since oil and many other basic commodities are priced in dollars and not in the currency of the country producing them, anyone who is producing such things is getting hammered. The Third World is up in arms because of this. So are the big oil producers. Since this is the same group who feel aggrieved over trade conditions generally they are in the van of those demanding that the dollar lose its pre-eminence. They would prefer a stable currency, or possibly a ‘synthetic’ one made up of a mix of things such as the dollar, gold, and the euro.

But that argument is only just brewing. The point is that the days of the dollar being the world’s currency seem numbered because we have been profligate for thirty odd years and have not run a tight fiscal ship since Reagan cast us adrift in debt. You cannot keep printing money and relying on foreign sources of cash for ever. That was the Reagan way. Unfortunately we built our entire economy around foreign debt.

Throughout history, the world’s largest and richest nation has always been the world’s largest creditor. That was true in ancient Rome and it was true for the British in the 1800’s. It was true here as well up until Reagan. The post Reagan American economy is an historical anomaly: despite its wealth and power it borrows rather than lends to the world. It depletes its capital rather than adds to it. Eventually the game ends. We run out. Goodwill dissipates. And we have to start paying for our standard of living from cash we earn rather than cash we borrow.

Maybe the fall of the dollar signals that we have reached that end.

If so good.

Meanwhile we need to manage the dollar’s decline carefully. Too precipitous and we will have to drive up interest rates so we can keep borrowing enough to pay our bills. That would nip the recovery in the bud.

A lingering and slow decline is more desirable. That would buy us time to start saving enough of our own money so that we don’t need to keep on borrowing abroad.

Nothing’s easy in currency trading. That’s why predicting the dollars value with any notion of precision is a fool’s game. It is a game of trends and not exact values.

So: look for the dollar to fall some more. In general I would expect it to be lower next year than this. But be careful: some of those foreign economies are worse than ours so their currencies will fall faster.

Caveat emptor.

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The Dollar’s Decline

As if right on cue, given my comments yesterday about the US fiscal dilemma, the dollar has begun to take a beating in the currency markets. It is quite possible that this is the beginning of a long decline, lasting a few months, so it’s worth reflecting on the root causes of the decline. Two words: recovery and deficits.

One of the ironies of the past year or so is that the dollar has held its ground in value because the US economy, and hence its currency, was seen as a ‘safe haven’. The worse things looked in Europe and Asia, and especially the worse things became in the emerging economies, the better the US looked even though it was seemingly tottering on the brink of a new depression. This is even more ironic when we consider that the US was the cause of the worldwide melt down. Nonetheless inflows of cash flooded into the US as foreign investors sought to protect themselves against even worse conditions elsewhere.

This flood of money not only protected the dollar against decline, but actually boosted its value. It also helped the administration in its ongoing fight against the recession because it made it easier to issue bonds and other Treasury securities in order to fund the burgeoning deficit.

The only area where the dollar’s relative strength was a problem was in trade where it hindered efforts to boost exports, although it also made imports cheaper. Parenthetically: cheaper imports also lowered inflation and added to our original fear of deflation. But, given the collapse in world trade, the dollar became an issue to neither exports nor imports: there simply wasn’t anything to do about trade. Any dollar effect was swamped by the drop in worldwide demand.

Now though things are changing.

As fears of further decline in activity abate, and as confidence starts to re-appear, the ‘safe haven’ effect will wear off. Investors will start to look for returns based onfactorsother than just safety and so will start to pull their money out of the US and re-invest it elsewhere.

The consequences of this will be twofold: the dollar will decline so as to keep dollar denominated assets attractive relative to assets based in other currencies; and, possibly more importantly, US interest rates will start to creep up because investors will demand a higher return in order to retain all the US bonds they bought last year and earlier this year.

This latter issue is magnified by the sheer volume of bonds we have been pumping onto the market. It isn’t just that the US has been running an extraordinary budget deficit, but the Federal Reserve Board has been engaged in an equally unusual monetary policy called ‘quantitative easing’. Under this policy the Fed has been trying to pump money into the economy by buying up bonds – it pays in cash for the bonds and so adds to the money supply. This has to be a temporary procedure because it implies a potential upturn in inflation we want to avoid, so the markets are expecting the Fed to reverse course at some point in order to stave off this inflationary effect. The implication is that all those bonds will have to be sold back into private hands and this, obviously, adds to the supply of US government bonds in the market. Hence the need for higher interest rates to attract buyers for those bonds.

As you can see the administration will have to tread delicately in order to make sure it can extricate itself from the fiscal hole it now finds itself in without spooking the bond market. The best way to do this will most likely be to make a strong commitment to reducing the deficit quickly, say over the next four to five years.

In any case the dollar will fall. The surfeit of US debt on the market and the loss of the ‘safe haven’ status will combine to keep the downward pressure on for a while.

This is why I don’t think there’s much upside left to the dollar until the world economy is humming along again. And that seems to be quite a way off.

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