Monday, February 16, 2004

The Economist Agrees with the oldman,

The Economist agrees that the current situation of the dollar is going to become unstable at a future time:

"And the Americans will most certainly not intervene unless things get seriously out of hand. The Bush administration could not be happier about what is happening in currency markets now that John Snow, the treasury secretary, has learned to keep his mouth shut. For America it is, says one pundit, “the deal of the century”. The administration is delighted that the dollar has fallen as far as it has; insiders say that it would be more delighted still were the currency to fall another 15% or so. And it doesn’t much care who takes the strain. Europe is not the flavour of the month in Washington, DC, to put it mildly. If the ECB is so vexed about the unequal strain the euro is taking, why doesn’t it cut rates? That Japan’s policy sort of works means that it will carry on intervening. This is wonderful for the American economy. Any other country trying to devalue its currency would see its long-term interest rates rise (and sooner or later its short-term rates, too). But in America’s case, bond yields are actually falling, which helps fuel the recovery. In large part, this is because, as the yen rises, the Bank of Japan buys ever more dollars, and the dollars are usually parked in Treasuries: even in the Treasury market, $68 billion is a tidy sum.

None of the Asian countries wants to stop intervening, otherwise their currencies would shoot up and their economies would (more or less) shoot down as exports slowed. For now, moreover, they seem to be quite content to fund Americans’ profligate ways. Of course, this can’t continue for ever. America’s savings rate is just 1.3%, and even the Bank of Japan can’t carry on buying Treasuries like a Japanese housewife in a Gucci shop. At some point, though perhaps not yet, Americans will stop consuming so much, the Asians will stop buying so many Treasuries and everything will go crunch. As a friend says, “It’s a weirdly unstable equilibrium”. Rather like a duck-billed platypus, in fact, though perhaps not as long lived.

As the oldman has noted, the IMF disapproves of the fiscal deficit but does not disapprove of the currency revaluation. As the oldman has pointed out, as a rule of thumb he always assumes that the IMF is wrong. Despite the Weekly Standard's hand-wringing over Republican fiscal follies the main danger would be in the short term from the currency markets and a massive devaluation that could force up interest rates.

This would happen for three reasons. First to strengthen the currency (the price of money) it would have to raise interest rates. Second, Treasuries are denominated in dollars and a currency devaluation would include a sell off of T-bills and bonds (American national debt) causing a fall in their prices. In order to counteract that, a rise in their yeilds (again interest rates) would be necessary or the bottom might fall out of American denominated debt (which goes back to the fiscal follies). Thirdly, imports would become more expensive as the Greenback fell increasing CPI measured inflation which to combat the Fed would have to ... yes, raise interest rates. This would be touchy if at the same time the monetary supply was falling (as it seems to have been doing since September) already and generating an economic activity crunch (people borrowing and spending less) and triggering the exact same "tipping point" mentioned above of consumers spending less.

As Ingatius points out ...
"Discussing the falling dollar at a panel of the World Economic Forum here, a former U.S. senator said the greenback's decline was just a blip. The abiding fact was that for more than a century, in good times and bad, the world's investors have been in love with the American economy. And that ardor continues today.

Yes, responded a Chinese economist, but "love affairs always end.

If you want to, you can dig through Greenspan's Jan04'04 speech but basically what he says is that if inflation shot up (say if currencies became more volatile) he'd have to tighten monetary policy (raise interest rates). Using the IMF contra-indicator (always bet against the IMF) and Greenspan's deposition on monetary policy (never fight the Fed) we could be in real trouble here shortly.

This would of course also end up bursting the Real Estate Bubble I've blogged about before. How bad could a reset be? The Levy Economic Institutes has an analysis out by some economists indicating that besides a serious and broad stockmarket decline, we could see real estate prices decline in the United States by up to 25% in a short period of time. That would put some serious hurt on people who've borrowed against their houses using Home Equity Loans that have become much more popular in recent years.


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