October 10, 2009

Dollar Dilemma

By Doug Noland - October 09, 2009

Renewed U.S. dollar weakness has evoked calls for Washington to implement a true strong dollar policy. Larry Kudlow is calling for a supply-side cut of marginal corporate tax rates and for the Federal Reserve to hike rates 25 bps in support of our currency. He knows “none of this is gonna happen.” Others believe the focus should be trimming our massive federal deficit. A move to fiscal and monetary restraint is surely needed to help stabilize the dollar. Restraint is not going to happen.

Perhaps chairman Bernanke tossed a tiny bone to the currency markets yesterday evening. Yet everyone in the world knows U.S. policymaker focus is on aggressive short-term stimulus with the objective of jump-starting rapid economic recovery. Officials from both the Federal Reserve and Treasury have stated their view that a strong U.S. economy is the best prescription for a strong dollar. Simple enough. So, perhaps they’ll increasingly be compelled to tweak their comments in hope of influencing currency trading. But don’t hold your breath waiting for a meaningful shift in strategy – say aggressively boosting rates or slashing spending – to protect the value of our currency. Current policy is not the primary issue anyway.

Non-productive Credit expansion/inflation is the bane of currency stability. The dollar’s fundamental problem these days lies with the underlying structure of the U.S. economy. As much as near zero interest-rates and Trillion dollar deficits don’t improve the situation, they are symptomatic of much broader systemic issues. Indeed, ultra-loose monetary policy, scary deficits, and ongoing dollar devaluation are all consequences of deep structural maladjustments to the services and consumption-oriented U.S. “bubble” economy.

And I would make the point that this maligned economic structure has been the driver for both policy and dollar weakness. With the collapse of the Wall Street/mortgage finance Bubble, acute structural fragilities required unprecedented stimulus in order to stem implosion. Once stabilized, policy focus turned immediately to short-term performance – positive GDP growth, spending recovery and job creation. Not surprisingly, the focus remains on finding a quick fix, with scant attention to structural issues.

As it relates to the dollar stability, I would argue that the central policy issue should be to create a backdrop conducive to far-reaching adjustment and repair to the economic structure. Aggressive stimulus would be expected to spur short-term performance gains. However, this would be at the cost of delaying necessary structural corrections. This dynamic may help explain why the bulls have been right on stocks this year but wrong that U.S. recovery would boost the dollar. Washington may believe that big GDP growth numbers will support a strong dollar, but global markets (and policymakers) seem to recognize clearly that the course of U.S. policy undermines the long-term value of our currency (and their dollar holdings).

Decades of credit excess cultivated an economic structure that produces too little and survives on too much credit. The Credit inflation/dollar debasement dilemma was masked for years. The dollar indulged both in its global reserve status and the world’s keen desire to participate in our financial asset Bubble. For years, the U.S. “private”-sector Credit apparatus (Wall Street securitizations, GSE obligations, derivatives, etc.) was the global “asset class” demonstrating the strongest (most alluring) inflationary bias. As fast as our Credit system inundated the world with dollar liquidity, these financial flows would as quickly be recycled right back into U.S. securities. The dollar was king on the back of reflexive speculative flows.

The dollar was not ok – it was fundamentally weak. But it looked ok relatively, in a world of weak currencies and expansive global speculation. And as long as this recycling mechanism functioned smoothly, the U.S. Credit system could easily expand Credit on an annual basis sufficient to boost various types of “output” that tallied in GDP. And with Wall Street and mortgage credit at the heart of the U.S. Credit Bubble, financial excess fed a self-reinforcing boom in lending, asset inflation, consumption, business investment and government expenditures. Moreover, any bout of financial turmoil would see U.S. yields collapse and a virtual buying panic for agency and mortgage-related securities – rapidly reflating our Bubbles.

Many things changed with the bursting of the Wall Street/mortgage finance Bubble. For one, our “private”-sector Credit mechanism was no longer capable of creating sufficient Credit to sustain inflated real estate Bubbles or the inflation-distorted Bubble economy structure. For two, the U.S. Credit system decisively relinquished it status as the most alluring global “asset class.” Years of dollar debasement had already worked to sway the inflationary biases away from the U.S. toward energy, gold, commodities and the “emerging” markets and economies. The unfolding post-Wall Street Bubble reflation has found – for the first time - the “developing” and commodities worlds supplanting the U.S. as the favored destination for speculative finance. This is big.

Granted, deleveraging and unwinding of dollar bearish bets initially propelled the dollar higher. Yet I would argue that the global crisis will be looked back on as a seminal event for our currency. Our policymakers have much less flexibility in the new financial and economic landscape. Both fiscal and monetary measures have lost potency. Trillions of dollars of deficits, zero interest rates and a $2 Trillion Fed balance sheet today get less system response than hundreds of billions and a few percent would have achieved previously. This hurts the dollar. And acute financial and economic fragilities ensure extreme policy measures will remain in place for much longer than would have previously been necessary. This also hurts dollar confidence.

Meanwhile, the “developing” world currencies, markets and economies dramatically outperform the United States. Global reflationary dynamics have put a premium on asset markets in China, Asia and the developing world. This robust inflationary bias, then, places a premium on things consumed in - and demand from - these economies.

So much of our economic structure evolved during - and for - a different era. Our Bubbles were inflating; market dynamics had created great power and flexibility for policymaking; the U.S. consumer was the king; and our securities and economic booms were the focus globally. While some of our multinational companies will benefit, too much of our economic structure is poorly positioned for today’s new global landscape. Not only does our maladjusted economic structure today require too much non-productive Credit creation, it lacks the type of real economic returns necessary to attract global financial flows. This is a big predicament not easily remedied.

It is worth noting that Australia’s central bank was this week the first major central bank to begin the process of removing monetary stimulus. Global markets reacted by pushing the dollar even lower. The “commodity” currencies, gold, energy, commodities and global equities surged higher.

I’ll take the markets’ reaction to uncommon central banking rationality as early confirmation that attempts to tighten ultra-loose monetary conditions globally will be impeded by speculative inflows already bent against the dollar. This dynamic reinforces already strong reflationary forces in non-dollar markets, while intensifying speculative selling pressure against the greenback. Expect foreign central banks to be pressured to buy a lot more dollars and global markets to experience even more destabilizing Monetary Disorder.


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