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January 15, 2003

U S Fiscal Policy May Lower The Dollar
by Andrew Smithers

Last week I wrote about the dubious argument that the dollar needs to be weak because it is fundamentally over-valued. This does not of course mean that the dollar won't be weak. In fact the proposed US tax changes just announced make this more likely.

These proposals look like a damp squib. Estimates for the effective stimulus given to the US economy vary from around 0.2% to 0.6% of GPD. This is a nugatory change, given the potential for a much larger equivalent rise in the household savings rate.

The proposed tax changes make a weak dollar more likely not because the US Administration is being reckless with its budget policy, but because it is not planning to increase the deficit by enough to stimulate the economy.

The consensus estimate for US GDP this year is for growth of around 2.5%. This may prove wrong, but it is just as likely to prove too optimistic as too pessimistic. For a central estimate it is dangerously low.

Profits rise and fall relative to GDP, depending on whether growth is above or below trend. The consensus forecast for 2003 is at least 1% below the consensus estimate for trend growth. It therefore implies that profits will fall. If profits fall, the stock market, which is still over-priced, will probably fall and this will give an added downward push to the economy.

Economic policy therefore needs to be stimulatory. As the amount of fiscal stimulus proposed by the Republicans is disappointingly weak, the chances have risen that the Fed will have to be truly aggressive.

If US monetary policy is expansionary relative to the ECB's, then the dollar is likely to weaken relative to the Euro. If it does, the initial response will be a change in real terms, but over the longer term it will simply be a nominal fall, reflecting the fact that US inflation is likely to be higher than the Eurozone's.

If both the ECB and the Fed had the same attitude to economic management, then the Euro would be the more likely currency to weaken. Both Europe and the US are threatened with deflation, but the risk is higher in Europe. A balanced approach to monetary policy would therefore involve an easier policy in the Eurozone.

At the moment we have the opposite. Interest rates, both real and nominal, are higher in Europe and the monetary aggregates are growing more slowly. If the attitudes either side of the Atlantic were the same, changes in policy would now call for relative Euro weakness.

The fact that attitudes vary greatly was underlined by the comments from Dr Ben Bernanke, the most recent appointee to the Board of the Federal Reserve. He has remarked that the Fed could ease monetary policy indefinitely and would not be constrained even if short-term interest rates in the US fell to zero. If the economy still needed a boost, the Fed could buy in bonds. The yields on medium terms bonds and then long-term ones could thus be brought down to zero if necessary.

It seems unlikely that the collective mind of the ECB could even think this, let alone say it.

Across the Pacific, however, the chances of policy change are rising. The term of the current Bank of Japan's Governor, Masaru Hayami, ends in March. He has been a fervent opponent of monetary stimulus but his successor might have a completely different philosophy. There is a possibility that Nobuyuki Nakahara might get the job. His views are the diametric opposite of Hayamis' and very similar to those of Dr Bernanke.

If Nakahara, or someone with similar views, is appointed by Prime Minister Koizumi to be the new Governor of the Bank of Japan, then monetary policy could change in Japan even before it changes in America. The Euro could then rise against all other major currencies, doing further damage to the Eurozone's economy.

Andrew Smithers
Smithers & Co.

Smithers & Co. Ltd. provides advice on international asset allocation to about 100 clients based mainly in Boston, London, New York and Tokyo. Our work is based on the fundamental belief that no one's judgement is better than their information. We believe that our clients' decisions will be helped if we can provide them with important information that is not otherwise available to them. We therefore concentrate on research which aims either to tackle issues in greater detail and thoroughness than is otherwise available or to tackle issues of importance which seem to have been generally overlooked. Examples of the former include our work on stock market valuation, the profit distortions arising from the use of employee stock options and the underlying secular problems of Japan's economy. Examples of research into areas which have otherwise been largely overlooked include our work on the Japanese life insurance industry.

Our approach to research is also different. The standard approach bases market projections on economic forecasts of major economic aggregates, such as GDP and inflation. Stock market, bond and currency forecasts are then derived from the way these estimates differ from the consensus. We consider this approach to be flawed in two ways. It places excessive reliance on the ability of any particular analyst to produce forecasts which are consistently better than average. It also ignores the evidence that stock markets tend to lead economies, rather than the other way around. In contrast, we put greater emphasis on "information arbitrage", in which we include identifying factors which have been overlooked, drawing on data and academic research which have not yet been exploited and pointing to inconsistencies in the implicit forecasts of different markets.

Andrew Smithers, founder of Smithers & Co., is also columnist for London's Evening Standard and the Tokyo Nikkei Kinnyu Shimbon's Market Eye, and is regularly quoted in the New York Times, Barron's, Forbes, The Economist, The Independent, and the Financial Times.

Copyright © 2002-2007 Andrew Smithers

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