The Great Debate UK
U.S. debt downgrade: Who cares?
By Laurence Copeland. The opinions expressed are his own.
As I write this blog, it looks as though the U.S. Congress is going to pass a bill raising the debt ceiling and making modest cuts in Federal Government spending over the coming years. Although it is, quite rightly, being presented as a somewhat hollow victory for the forces of reason, there is one extremely puzzling aspect of the crisis.
It is being reported on all sides that the credit rating agencies may well downgrade U.S. sovereign debt in spite of this “happy ending” – indeed, Egan-Jones, one of the smaller agencies, cut its rating of U.S. debt some weeks ago, and there is much talk of Moody’s and S&P following suit in the very near future.
This is all rather puzzling. After all, a credit rating is an assessment of how reliably lenders can count on the borrowers repaying their dollar loans (principal plus interest) in full and on time. Now the only scenario I can imagine in which the U.S. Treasury fails to meet its legal obligations to its creditors is one in which the Congress blocks a rise in the debt ceiling explicitly so as to bring about a default – and even then it would presumably require the collaboration of the executive because, as many people have pointed out in the current cliffhanger, even if further borrowing is impossible, U.S. tax revenues are far greater than the cost of servicing the debt.
In other words, the Administration can always pay its legal debts – it is only about to run out of money on August 2nd, in the sense that tax revenues are insufficient to cover legally required payments to Uncle Sam’s creditors plus hundreds of billions of dollars of other commitments which the federal Government is politically (and no doubt to a great extent morally), but not legally bound to pay, such as: social security payments, purchases (unless already ordered), wages to civil servants without contract, and so on and so forth. It can delay most of those payments without contravening criminal or civil law, and in most cases can walk away from its commitments altogether with no legal penalty, though of course the outcome might be politically or socially explosive.
In short, whichever way you tell the story, as far as I can tell, default by the USA (or indeed by Britain) could only occur as a result of a conscious political decision to do just that. By contrast, all the forecasts are that Greece will have no choice in the matter. The distinction, as I have pointed out before, is that while Greece’s debts are in a “foreign” currency – it has no right to print euros – the Fed or Bank of England can print as many dollars or pounds as it takes to repay their debts. In the process, of course, the domestic and foreign purchasing power of their currencies will be devastated, but they will have discharged their legal debts. As far as America is concerned, with the exception of a relatively small quantity of so-called TIPS (Treasury Inflation Protected Securities), U.S. bondholders have what economists call a purely nominal claim i.e. one that is denominated in current dollars, not dollars of constant purchasing power. By lending to the USA, they have given a hostage to fortune, a risk which, if they were wise, ought to have been reflected in the yield they demanded before buying the bonds in the first place.
All of which does nothing to resolve the original puzzle, because however dishonest, disreputable or unethical one may think is this scenario, “backdoor default”, as Mark Calabria of the Cato Institute has called it, does not qualify as a default in the sense relevant to the a country’s credit rating, nor (I assume) does it count as a credit event for the purposes of credit default swaps, the main instrument for insuring investors against default by bond issuers.
The U.S.’s big, fat political debt problem
By Kathleen Brooks
The U.S. has practically zero chance of solving its debt problem in the foreseeable future while politicians line up to contest the 2012 Presidential elections.
We have already heard President Obama lay out his partisan cards. He called for Congress to come up with a plan to trim $4 trillion from the U.S. deficit in the next 12 years. His favoured way to do this: end tax cuts for the rich – a well versed refrain from Democrats throughout the ages.
Ironically it was Obama who extended these tax cuts – for everyone – at the end of 2010, which arguably has contributed to the U.S. becoming the only G10 nation to have a rising budget deficit this year, according to the IMF.
The tax question obviously goaded the Republicans and the Speaker of the House of Representatives John Boehner immediately responded by saying that tax hikes were a non-starter. He argued that the U.S.’s fiscal problems were not down to a lack of revenue, but due to unbridled spending coming out of Washington. So there we have it: deadlock before we have even got started.
The wrangle over funding the 2011 budget that nearly closed the U.S. government earlier this month came down to an ideological fight between left and right, with those on the far right demanding cuts to programmes that didn’t support their ideology such as abortion programmes.
This highlights the level of detail and depth of discussion that will be held over the coming weeks and months to make even more radical cuts than those proposed for this year’s budget. Middle ground is virtually non-existent in Washington right now so a failure to come up with a credible deficit reduction plan in time for President Obama’s June deadline is looking increasingly more likely.
Another condescending “our system is better than yours” point of view from an European. Is there anyone east of the Atlantic with an unique perspective or does everyone get so much joy out of regurgitating the same point of view, that the need never arises?
And why do Europeans even feel the need to post an opinion on American politics?
Did the Fed catastrophically mis-time QE2?
The sternest criticism of QE2 is the way it pumped up asset prices like commodities in recent months without making much of an impact on U.S. economic growth. Rising fuel and food costs have weighed on inflation everywhere from emerging markets to the UK. But this criticism might step up a gear if Middle East tensions lead to a spike in oil prices and the Fed tries to protect growth using a similarly blunt tool as QE2.
The political crisis in the Middle East has been the game-changer for the global economic outlook in the past couple of weeks. In just five days WTI oil (U.S. crude) jumped $10, and Brent (European oil) surged to within touching distance of $120 per barrel. This showed us what fear is like: since the 1970’s each recession has been preceded by an oil price shock. You don’t need much more evidence than this to see the extremely close relationship between oil and growth especially in the U.S., the largest consumer of crude in the world.
The West is extremely sensitive to the Middle East. The region is undergoing a period of transition and what the new post-crisis Middle East will look like or how it will function has yet to be figured out, so investors are left to contemplate the worst case scenario in a vacuum of uncertainty. Right now the worst case would be if protests and public uprisings in North Africa spill over to the Middle East, specifically to Saudi Arabia – the most powerful nation in the region, an ally of the West and home to the world’s largest oil reserves.
In this case we could see oil well over $200 per barrel sending economists scrambling to reduce their forecasts for U.S. growth. Far from considering an exit plan the Federal Reserve would probably start planning QE3. After all, if it pumped the economy full of dollars during a blip in global growth last year then surely it should do so when the U.S. faces a real threat of recession?
The answer seems like a no-brainer – but not quite. QE2’s critics have pointed out two flaws to the current stimulus plan. Firstly, although the Fed pledged to bring down unemployment with its second stimulus plan the jobless rate still remains uncomfortably high at 9 percent, and arguably only started to moderate after the announcement that President Barack Obama would extend the Bush-era tax cuts in December. Secondly, even before Middle East tensions arose the Fed’s $600bn stimulus programme was blamed for artificially pumping up global commodity prices, with most of the liquidity flowing into the financial markets rather than the U.S. economy.
This is evident in the price action of commodities. WTI crude has been on an upward trajectory since August when Ben Bernanke first touted the prospect of QE2. Back then it was trading at $75 per barrel and finished 2010 nearly $20 higher. While the spike to $100 isn’t bad for the U.S. economy by itself, it’s the rate of change that causes the biggest impact on headline inflation rates. The $25 increase in 7 months could just be the start, especially if we see an escalation in tensions in the Middle East.
Unlike Europe where oil consumption has been falling, in America it has been growing since the 1970’s, so a supply shock, or price spike, would weigh on headline inflation and has the potential to have a devastating impact on growth. As more of peoples’ pay checks get used up on gas and other commodity prices, the more it depresses core inflation as consumer confidence gets hit slowing spending and thus economic growth.
What to make of the U.S. resurgence
-Kathleen Brooks is research director at forex.com. The opinions expressed are her own.-
Back in the summer, things in the U.S. were so dire that the Fed had to step in to the breach and boost the economy with a $600 billion cash injection. This was only formally announced in November, yet within two months the outlook for the U.S. economy has brightened markedly. The dollar has had a flying start to the year and appreciated more than 2 per cent against the other major currencies.
But is this reversal in fortunes too good to be true and can the huge juggernaut of the U.S. economy really turn around this quickly?
The chief reason for the boost in investor sentiment, particularly towards the dollar, is the uptick in some of the major U.S. economic indicators. The widely watched ISM surveys have jumped in recent months and there are positive signs that the recovery that was noticeable in the manufacturing sector of the U.S. economy is now spreading to the much larger services sector. Investment houses rushed to revise higher their growth forecasts at the end of last year after President Obama agreed to a two-year extension of the Bush tax cuts. All of a sudden the U.S. economy was hitting the headlines again for all of the right reasons, and after giving the dollar a wide berth for most of the second half of 2010 investors are once again happy to own the greenback.
The U.S.’s economic outlook is even brighter when it is compared to its western counterparts. The euro zone and the UK face a year of tax hikes and austerity measures designed to reign in budget deficits, which should keep a lid on growth. Already at the start of the year we have seen the UK services sector slip back into contraction and Europe’s core economies are leaving the weaker peripheral nations in their wake when it comes to the growth stakes. In the last months of 2010 investors were willing to support the euro on the back of a bright outlook for the core economies, but not so in 2011 – the motto seems to have changed for investors to one of “the euro zone is only as strong as its weakest members”, which at the moment means it is extremely weak. So part of the dollar’s attraction is relative: at the moment its future is brighter than its neighbours’.
But, the U.S. is far from out of the woods itself and investors could be accused of lowering their standards. Jobs growth is mediocre at best and it will take many more months of 100,000 per month job creation to bring down the unemployment rate to a level more acceptable to the Federal Reserve. This doesn’t suggest the U.S. is in rude health. Due to these headwinds, we don’t think that the U.S. growth path will follow a straight line. But if we get another economic hiatus like the one last summer, will the Fed be able to provide another round of quantitative easing? Probably not that easily.
So while the near-term outlook for the U.S. economy is one of gathering momentum lending support to the dollar, the very policy measures that are supporting growth now will hurt it later. Quantitative easing and the extension of the Bush tax cuts are only exacerbating the U.S.’s unfathomably large debt mountain – at last count it stood at $14 trillion. The U.S. needs to sort out its debt problems at both a federal and state level (California has a budget gap this year of more than $20 billion). This means a lower dollar for the long term and higher inflation to try and erode the debt load.
The unemployment rate, the REAL rate, in NYC is around 25%. New college graduates packing $100K in student loan debt find two years of looking for work is not enough. My daughter and her friends help one another find part time work, almost enough to live on if not for the student loans. We help her by using my retirement checks for her loans, but my retirement checks cover about 1/2 of the loan payments. In America it is more important to funnel billions of dollars into banks rather than provide free education for the next generation like any rational society would do. The situation is made worse when the Lawmakers decided that a bank can go bankrupt for cheating their customers for years, but a struggling new graduate is prohibited from filing bankruptcy. They must pay back the loans even if they have to sell a kidney or two for the money. America cares not a whit for it’s future citizens and if they are smart the kids will find a way to leave the country to raise their families in civilized environments.
Has QE2 worked?
– Kathleen Brooks is research director at forex.com. The opinions expressed are her own. –
Ever since the U.S. Central Bank formally announced its second round of quantitative easing back in November, bond yields have trended higher. Ten-year Treasury yields have jumped by 100 basis points and are back at levels last reached in May 2010. Higher yields underpinned the dollar, which has risen by more than 5 percent over the same time period. So what does this tell us about the market, and has the Fed’s grand plan actually backfired?
Those in the ‘yes’ camp argue that quantitative easing was designed to help the most interest rate-sensitive sectors in the U.S. economy such as the housing market. However, the housing market in the U.S. remains depressed and rising Treasury yields are pushing up long-term mortgage rates, which on average rose to 4.86 percent in the week ending 10 December up from 4.66 percent the week before.
Rising borrowing costs are unlikely to attract buyers to purchase homes especially when house prices continue to fall. Without a convincing recovery in the housing market they argue, it is difficult to see how consumption and growth can pick up to levels that will ward off deflation and help push the unemployment rate lower.
So what about those who believe the Fed did the right thing and QE2 is working? They say that QE2 will work with a lag and so-far-so good. Since Fed Chairman Bernanke first touted the idea of more QE back in August he has helped to re-flate the global economy after the financial crisis threatened to cause the worst depression since the 1930s.
While inflation isn’t showing up in consumer prices (core inflation in the U.S. remains a fairly meagre 0.8 percent) it is very much alive in the stock markets and in commodities fuelled by Fed-generated liquidity. Global stock markets have reached pre-Lehman Brothers highs and commodity prices are also reaching record levels; for example, oil is back above $90 per barrel.
This signals that investors are willing to take on more risk, and a risk-on environment is always inflationary. In contrast, a risk-off environment is deflationary as it signals weak growth. The key to sustaining the U.S. recovery is inflation. Thus QE2 was necessary to promote inflationary forces that, after a lag, will finally start to show up in the U.S. economy. Once prices are rising in line with the Fed’s 2 percent annual target then the unemployment rate should start to recede and, hey presto, the Fed has achieved its duel mandate and saved the economic day.
Should a country always stand behind its banks?
Ever since the financial crisis broke in 2008 some of the world’s major banks have their governments to thank for their survival. The fates of Royal Bank of Scotland or Citibank would have been much worse without large injections of capital from the UK and U.S. authorities. The UK government pumped more than £37 billion into its largest banks in the immediate aftermath of the Lehman Brothers crisis. Ireland took that a step further when it guaranteed all of its banks’ deposits and liabilities. This was affordable, the Irish government said at the time.
However, this policy failed spectacularly. Ireland’s bailout of its banking sector brought the country to the edge of bankruptcy and forced it to accept a 82 billion euro bailout loan from the IMF/ECB and the European Union. More than 30 billion euros of this loan is to re-capitalise the Irish banking sector and the rest is to shore up the state’s finances. The conditions of the loan mean that Ireland will have to implement harsh austerity measures for many years to come that will inevitably hurt growth.
So should governments always stand behind their banks? There are some success stories. Back in 2008, when the global financial sector teetered on the brink of collapse, it was necessary for the world’s major central banks and governments to offer unlimited support to their banks. The chief reason for this was to ensure that credit flowed through the economy to foster growth. In truth however, a mixture of stringent capital rules caused banks to shrink their balance sheets in the teeth of the recession, which didn’t help the overall economy but did boost their balance sheets. In the first six months of 2010 the UK’s four largest banks: Lloyds Banking Group, Royal Bank of Scotland, Barclays and HSBC (the latter two did not receive bailouts) made combined profits of £13.6 billion. This is a far cry from the £22.3 billion they lost in 2008.
The U.S. banking sector has also seen earnings recover sharply. The Federal Deposit Insurance Corporation (FDIC) announced that the earnings for U.S. banks rose by $14.5 billio in the third quarter of 2010. Now that the banking sector is back on its feet again one can hope that credit conditions will also become more supportive of economic growth. And strong earnings also increase the chances that taxpayers will profit from the capital injections at some point.
So why did things go so wrong for the Irish? There are two reasons. Firstly, the government’s guarantee to cover banks liabilities was too hasty. It didn’t inject capital, instead it promised to write an unlimited number of blank cheques. Secondly, there was a mis-match between the size of the banks’ liabilities and the size of the state. Ireland’s economy was 210 billion euros in 2008, the cost to bailout Anglo Irish Bank alone is at least 30 billion euros, and by some estimates it could be 50 billion. This makes the $40 billion plu capital injection (which then turned into equity) into Citibank look like small change for a $14 trillion economy like the U.S.
The trick is for governments not to bite off more than they can chew, and make sure they have conducted a rigorous analysis of a bank’ liabilities before underwriting its future losses. If you don’t do this then the punishment can be harsh, as Ireland has found out.
On paper Ireland’s banks guarantee doesn’t look like such a good idea, but a bank is also part of a country’s social fabric. Its citizens trust the banks to look after their deposits and expect 24-hour access to their money to fund their living costs – paying for a mortgages, school fees, clothing and food. If customers can’t access their money this hits confidence in the central plank of capitalism – the banks. The US has the FDIC to protect deposits of up to $250,000; Ireland didn’t have an equivalent institution so in October 2008 it had to offer a government guarantee for deposits. This was the right thing to do; however, it should have stopped there. A government should protect the hard-earned savings of its citizens, but it is learning how expensive it can be to essentially take on the risk for banks’ bondholders as well.
Thank you, Gordon Brown
–Laurence Copeland is a professor of finance at Cardiff University Business School. The opinions expressed are his own.–
If the economics profession has sunk in public estimation in the last two or three years, it would hardly be surprising. Our failure to predict the crisis is something which cannot be simply brushed aside lightly, as some of my colleagues would love to do.
To ordinary folk, claiming to be quite good at explaining and even forecasting events in normal conditions, but admitting we simply can’t handle crises makes us about as much use as a doctor who knows how to treat ingrowing toenails and flatulence, but hasn’t a clue about how to deal with heart attacks or cancer.
Nor is that the only charge which could be levelled at the British profession. One could forgive any politician who felt bewildered by the sheer fluidity of the positions taken by the hordes of macro-economists offering advice, solicited and unsolicited, on the direction policy should take. After all, the overwhelming majority of the profession appears to be in favour of expansionary monetary policy (aka QE2) with an eye on keeping sterling weak against the euro and, if possible, the dollar (hence also against the yuan). Yet most of the same people were enthusiastic advocates of Britain joining the euro zone, in spite of the fact that the option of driving down our exchange rate in the way they advise is only open to us because we have stayed out of the single currency.
Likewise, many colleagues are equally confident in opposing too rapid a reduction of our budget deficit – “After all, we aren’t Ireland/Greece/Spain/Portugal……” they snort, whenever anyone points to the possible risk of delaying the cuts, as they would like us to do.
On this point, they are right, of course – we are in a very different situation from Ireland and the sunkissed PIGS. But why are we so different?
It’s certainly not because we have been running a tighter ship – in 2009, our deficit was 11.5% of GDP, compared to 14% in Ireland and Greece, 11% in Spain and a mere 9% in Portugal, and by election time, in May this year, our deficit was estimated to be running at 12% of GDP, compared with only 9% for Greece and less for every other EU member. Moreover, our accumulated debt, although less than many other European countries, still stood at 68% of GDP last year, 4% higher than Ireland, which is under intense pressure these days.
The main reason we are not in the debt position of the PIGS is the debt profile. The downturn in the economy – caused by the banks * – resulted in a slump. A fall in economic activity resiults in a fall in government income. That part of the UK debt was of the PIG type – to cover current expenditure in the crisis. In contrast to taht small element of the accumulated debt, most of our historic debt is investment related and with a very long term. The median UK bond is for 14 years. IE we have until 2015to pay off half of it and the other half starts to be paid off after that. Osborne plans to pay off the whole lot in the term of this parliament.
Greece in particular was borrowing to pay off borrowing, never advisable for individuals, companies or countries.
* I do not recall the IEA ever suggesting additional regulation of financial institutions. Please do not respond that it was Brown’s error that permitted the collapse of the banking sector.
Is the currency war over?
The communiqué from last week’s IMF G20 finance minister’s meeting was the first step in trying to resolve the so-called global currency war. The ministers released a joint statement on October 23 which pledged that all countries would “move towards more market determined exchange rate systems that reflect underlying economic fundamentals and refrain from competitive devaluation of currencies.”
Even fears that the U.S. and China could have a bust-up over the U.S.’s charge that the renminibi is undervalued relative to the U.S. dollar were put to bed when it was reported that Treasury Secretary Geithner popped in to China on his way back from the G20 in South Korea to meet Chinese Vice Premier Wang Qishan.
While there was hope that a full-blown war could be avoided, reports were soon hitting the wires that South Korea (the host of this year’s G20 meetings) was back intervening in the FX markets to weaken the won, which has strengthened more than 10 percent against the U.S. dollar since June. Later in the week South Africa joined Brazil, Indonesia and Thailand by announcing measures to stem the value of its currency by loosening domestic capital controls to get money flowing out of the country rather than pumping up the value of the rand, which has appreciated by 12.5 percent against the dollar in five months. So beggar thy neighbour policies are still alive-and-well even after the G20 finance ministers’ show of unity over exchange rates.
If you boil down the currency war to its crudest form then you’ll get emerging market countries with positive financial positions and strong growth trajectories lamenting the weakness of the dollar, which has been falling in value since making a high in June. They are concerned that further quantitative easing from the Federal Reserve will only cause the dollar to fall even further. In contrast, authorities in the U.S. are unlikely to talk up the dollar until they see some meaningful commitment from Beijing to allow the renminbi to appreciate.
Reaching an international FX accord is going to be an incredibly difficult thing to achieve due to conflicting view points and each country thinking they are right to protect their own economies first and consider global FX harmony second.
This might sound like the chances of a resolution are remote and we’ll lurch from one diplomatic nightmare to the next. But luckily the FX market is deep enough and liquid enough to swallow political rhetoric and set its own rules. Ultimately the currency war will be solved by the markets: genuinely weak currencies will continue to weaken, while undervalued currencies will strengthen.
There are tentative signs since the G20 finance ministers’ meeting that this has already started to happen. Some dollar short positions have been unwound as investors get nervous that the Fed won’t turn on the monetary taps indefinitely when they meet on November 2-3. This has put upward pressure on the greenback, which has risen by more than 0.5 percent this week, stemming its losing streak. Likewise, the Swiss franc has fallen as the economic outlook continues to deteriorate. The pound also had a stellar run, after economic growth surprised to the upside in the third quarter, thereby easing expectations that the economy may need more monetary support. Not even the Bank of Japan can stem the rise in the yen while investors continue to pile into the Japanese currency. Who knows what the market will do next, but if the euro continues to strengthen, which then hurts growth in the Eurozone, it could be investors’ next target.
Is there a way out of the currency war?
Competitive devaluation is no longer a possible danger – it is already here. Many people are worried that, after global stock market crashes and a collapse of most of the world’s banking system, a war over exchange rates completes a sequence of events that looks awfully like a rerun of the 1930’s. There is however one crucial difference. The Chinese role certainly makes matters more complicated, though it is as yet unclear whether it makes the outlook better or worse.
The key point to understand about the belligerents is this. In the context of purely self-interested beggar-my-neighbour economic policy, devaluation makes good sense for the Eurozone countries as a whole, the British, the Japanese, Swiss, Koreans… for everyone except the Americans. Whether they are deficit countries, like Britain, or surplus countries, like Switzerland, Korea or Japan, devaluation will increase demand for their exports and make their imports more expensive, giving a boost to their output and employment. And if other countries retaliate by counter-devaluation, they can tell themselves that their situation would have been worse if they had not taken the initiative and got their retaliation in first.
By contrast, America’s situation is very different. As long as China keeps its exchange rate more or less fixed, the dollar is not a wholly US currency – it is the currency of two countries, one massively in deficit , and one massively in surplus. The fact that they are separate countries in every other respect makes no difference. De facto, China and USA share a single currency every bit as much as France, Germany, Italy, Greece and the rest share the same currency, the Euro. The only difference is that in the Eurozone everyone uses Euros, whereas in the dollar zone the overwhelming majority use a dollar-certificate, a piece of paper bearing a picture of Mao Tse-tung and exchanging for about 15 U.S. cents.
It is hard to understand why China has voluntarily accepted this arrangement, which forces it to accept whatever monetary policy the U.S. Federal Reserve chooses. In any case, the implication is that the dollar cannot be devalued against one of its most important trading partners, because the two of them are bound together in a de facto currency union. In its desperate attempts to shake China off, like a celebrity trying to shake off a stalker, the Fed is printing more and more dollars, which are used by America’s consumers to buy more and more Chinese exports, thereby sending the new dollars flooding into China to swell the reserves of the People’s Republic, which must now be approaching $3trn.
There are two consequences of this linkage. First, it is the struggle over the dollar/RMB which has caused the other countries to devalue their currencies. The more the US drives down the value of the dollar, the more the exchange rate of the RMB is dragged down relative to all the other currencies, so the harder it is for third countries to live with the competition from ever-cheaper Chinese products. It was hard for them before, but with a cheaper RMB, life becomes impossible – so the Japanese try to devalue the Yen, the Swiss start to push down the value of their currency, and the Pound had already fallen a lot by the end of last year. In a sense, these other currencies are caught in the crossfire of the U.S.-China war.
The second consequence is this. China has now made a heavy investment in disaster. In the last few years, the world’s supply of dollars has expanded many many times faster than the U.S. economy. The result would have been a collapse in the value of the dollar, if China had not chosen to accumulate the massive excess supply in its own reserves.
Like second marriages, fixed exchange rate systems represent the triumph of hope over experience. History shows that in the end the dike never holds back the flood. When the dollar’s value collapses and the upward pressure on the RMB can no longer be resisted, China will suffer double pain – facing increased trade competition from a near-bankrupt USA with the dollar at its lowest-ever level, and at the same time losing hundreds of billions, possibly even a trillion dollars or more through the fall in the value of its reserves in terms of RMB (or indeed in terms of any currency other than dollars).
It is’nt so much that the Chinese accept the US dollar situation, (re: China voluntary accepted this arrangement).
It is like having the tiger by the tail, they and our government allowed American CEO to dismantle our factories and send them to China. Now those business interest are the driving force and they don’t care (if they realize) that the barn is on fire and disaster is imminent.
Why the world needs a weaker dollar
Kathleen Brooks is research director at forex.com. The opinions expressed are her own.
Ever since the last Federal Reserve meeting when the prospect of further policy stimulus for the US gripped the market, dollar weakness has been the dominant theme in FX. The Fed action is considered in some quarters as a backdoor form of currency devaluation, and there has been talk of a global “currency war” as a result.
But is a weak dollar really that bad for the global economy? Those countries who argue yes tend to concentrate on self-preservation since a weak dollar makes higher yielding economies’ exports less competitive. Since everyone wants to be able to sell to the US – the biggest single consumer market in the world – when the dollar moves in any significant direction the world takes notice.
Already Brazil and South Korea, whose currencies have risen strongly this year, have embarked on capital constraints to try and dissuade “hot money flows”, amid fears that a strong currency will derail economic growth. Chinese premier Wen Jiabao even went so far to say that a rapid strengthening of the renminbi against the dollar would be a “disaster for the world.”
Is it really as dramatic as the Chinese premier seems to think? There is a strong case for a weaker dollar and it all has to do with the spectre of deflation that hangs over the developed world. The current average inflation rate amongst the G10 economies is on the low side at 1.5 per cent. If you strip out Australia and the UK – both economies with high levels of inflation- the rate drops to a meagre 1.2 per cent. Combined with a weak growth outlook, especially for western economies facing fiscal austerity, this keeps the threat of deflation alive and well.
The problem with deflation is that most economies are unprepared for it. It can depress demand as consumers delay purchasing in the hope of lower prices in the future, this, in turn, causes unemployment. It also depresses asset values, which weighs on investor confidence creating a negative spiral of low or anaemic growth that can last for a long time (read Japan’s lost decade).
A weaker dollar is a crude cure for deflation. Since commodity prices from food stuffs to oil and industrial metals are all priced in dollars, a weak greenback means commodity prices go higher. This puts upward pressure on inflation and, more importantly, it helps keep consumers’ price expectations in positive territory, which avoids the negative growth spiral I mentioned before. It should also eventually lead to higher stock prices, which boosts investor confidence.
Units of currency are units of account in the economy to which the currency relates. If the overall value of an economy increases, while the number of currency units stays constant, then the value of the currency units will increase. Similarly, if the overall value of an economy decreases, while the number of currency units stays constant, then the value of the currency units will decrease. What is driving up the value of the currencies of fast-growing developing countries is their growth, and not the value of the dollar. What is driving down the value of the dollar relative to those currencies is the fact that the U.S. economy is not growing as fast as the economies of the fast-growing developing countries. It is true that the value of a currency may be affected by changing the number of units of the currency without changing the value of the economy (just like a 2:1 stock split cuts the value of a stock in half); however, the divergent growth rates between developed and developing economies appears to the be cause of the exchange rate differences we are seeing.
