The Dollar: Every Man For Himself
The Federal Reserve's (Fed's) strategy of firing up its printing press may have the debasement of the U.S. dollar as its goal (see Fed Targets Weaker Dollar), but it's important to note that the Fed does not act in a vacuum. In our humble opinion, Fed Chair Bernanke is wrong both on substance and politics - a potentially explosive mix.
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On substance, the Fed recently stated in the Federal Open Market Committee (FOMC) Minutes that businesses were holding back investments because of fiscal and regulatory uncertainties. In the FOMC's own analysis, the economic recovery should strengthen in 2011, even without additional stimulus. Additionally, commonly followed metrics used to measure the market's inflation expectations are, and have been, approximately 2%. Even if inflation expectations were to drop lower, the lone dissenting voice on the Fed, Thomas Hoenig, rightfully argues a little deflation may not be any worse than a little inflation. In our view, printing upwards of US$600 billion in fresh money may be the wrong prescription for the current situation.
We believe a key impediment to the U.S. economy is that policy makers are fighting market forces. Consumers would like to de-leverage further; however, de-leveraging may imply lower home prices, more foreclosures and bankruptcies; while such dynamics are sorely needed for a more sustainable recovery, promoting what may be the healthiest economically may be political suicide. Consumers that downsize may actually live in a house they can afford; such consumers will once again have disposable income, be able to save and possibly be able to afford a bigger home down the road. If, in contrast, a consumer is subsidized to stay in a home he or she cannot afford, that consumer will continue to be a slave to their mortgage, unable to have money to pay for unexpected repairs, such as a new roof; or have disposable income to spur growth in the economy. Indeed, some argue that the economic boom that followed the Great Depression was a result of weak businesses failing.
When enough money is thrown at an ailing industry, it may be possible to prop it up. However, such efforts will likely require a lot more money than policy makers anticipate. It appears Bernanke has already come to this realization - purchasing $1.3 trillion in mortgage-backed securities (MBS) didn't have the desired effect, hence QE2. The real Achilles heel for policy makers is a lack of control over where the money printed actually flows. Both fiscal and monetary stimuli may not flow to where the money is needed, but to where the greatest monetary sensitivity is. Intuitively, commodities, precious metals and currencies with a high correlation to commodities, such as the Australian or Canadian dollar may benefit the most. But let's look at the political dimension, which gives a more complex picture.
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We have no doubt Bernanke means well; he has devoted his life to studying the Great Depression and does not want to repeat the mistakes of those days. However, we should pause right here and take note that this may be a rather condescending attitude: those guys in the 1930s did not know what they were talking about; today, we are so much smarter. Without arguing the merits of all the policies of the 1930s, we would like to call for modesty: with the benefit of hindsight we can easily point to the errors of the past. It's also easy to think we are smarter than the Reichsbank in Germany during World War I: Germany's central bank a century ago was convinced that printing money to finance the Great War was 'exogenous' to the domestic economy and thus not inflationary; the hyperinflation that followed proved them wrong. Historians looking back at the current policies may be just as baffled by the absurdity of printing money to restore the wealth destroyed by capital misallocation. The point is that history repeats itself because we are human.
In our opinion, Fed Chair Bernanke, throughout his tenure, has completely underestimated the political dimensions of his policies. Under his leadership, the Fed decided to buy MBS, thereby engaging in fiscal policies via credit easing, traditionally the realm of government. These policies step directly on the turf of Congress. As such, the Fed has opened itself up for increased scrutiny since the onset of the financial crisis: it's simply not the Fed's role to make up for what the FOMC may perceive to be shortcomings of Congress. The same is happening through the renewed quantitative easing (QE2), as the Fed is responding to what it calls "fiscal and regulatory uncertainty" by printing money; the Fed is now printing money to finance the U.S. budget deficit. These steps only increase the political scrutiny of the Fed; that's a negative because the more political pressure the Fed is under, the less effective Fed policy may be (the more independent a central bank, the more effective policies are at creating price stabile environments). In a world of fiat money, it's all about trust; however, the political meddling may accelerate the erosion of trust in the Fed and the U.S. dollar.
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What scares us is that this may be exactly what Bernanke wants. In his Jackson Hole speech in late August, which set the stage for QE2, Bernanke mentioned that in an environment where inflation expectations are too low, it would not necessarily be bad if the market lost confidence in the Fed, as that would help increase inflation expectations. The remark may have been meant as a joke, but this is no laughing matter.
The political dynamics do not stop at the U.S. border. German finance minister Schäuble, referring to the announcement of QE2, said: "It doesn't add up when the Americans accuse the Chinese of currency manipulation and then ... artificially lower the value of the dollar." Brazil's president-elect Rousseff minced no words, warning: "The last time there was a competitive devaluation of currencies it ended up ... in the Second World War."
Of course, it should be noted that every country will pursue policies it perceives to be in its own national interest. If China decides to have a quasi-peg of its currency to the dollar, they must not complain when they import an inflationary U.S. monetary policy. But does acting in one's interest suggest one should ignore global ramifications of one's policies? The 1930s turned into the Great Depression because protectionism flared up and ultimately hurt everyone; every country finds it easier to time blame foreigners for their problems than fixing domestic issues. Policy makers in the 1930s were just like the policy makers of today: they were acting with the best of intentions, pursuing what they deemed to be in their national interest. The trouble then and now is that a unilateral devaluation of the dollar, such as going off the gold standard during the Great Depression, or engaging in QE2, may unleash a toxic set of dynamics. If and when protectionism flares up, countries with a current account deficit, notably the U.S., may suffer the most. That's because those who have been flexible enough to adjust and open up their markets to today's trade based world are likely to be the ones punished the most.
What should investors do? What should governments do?
As far as investors are concerned, there's an old saying: don't fight the Fed. The Fed has a larger credit line than you do. If the Fed wants to debase the dollar, then consider doing what central banks do: diversify to a basket of currencies. We have long argued that there may be no longer be such a thing as a safe asset and investors may want to take a diversified approach to something as mundane as cash. In our opinion, gold is the ultimate hard currency, as it cannot be easily inflated (gold production cannot be easily ramped up); as such, it's no surprise that the price of gold has been a prime beneficiary since the announcement of QE2.
What about governments? It's understandable many are furious: QE2 may unleash the greatest carry trade of all times: the Fed can print the money, but cannot control where it flows. Emerging markets in particular are concerned that the Fed's actions will cause asset bubbles in their domestic markets. It makes for good politics to their domestic constituents to complain about the U.S., but ultimately policy makers around the world must take care of their own backyards. Their choice is to fight or to embrace the instability that may be unleashed by the Fed's actions.
Brazil has chosen to fight, introducing measures to protect its domestic economy. Brazil's actions are not too surprising, as many of their exports are highly sensitive to the value of the Brazilian real. When Brazil exports its commodities, a stronger Brazilian real makes its exports less competitive. Having said that, over the years, Brazil's economy has shifted from exporting raw materials to exporting manufactured and semi-manufactured goods, many of which are less sensitive to currency price movements.
At the other end of the spectrum are Sweden, Australia and New Zealand. These countries have publicly rebuked currency intervention. New Zealand indicated it may be too small to stem the markets, but also suggested that one is naïve to think currency intervention won't lead to unintended consequences that may hurt the domestic economy. Sweden decries to fix one's problems by manipulating one's currency. Australia, a country with one of the more volatile currencies, has embraced a floating exchange rate, arguing that the floating Australian dollar in recent decades has been a substantial help in keeping inflation low.
At the risk of oversimplifying, more advanced economies have an easier time absorbing stronger currencies, as exporters in these countries may have greater pricing power. Very few exporters from the eurozone compete on price; the one area where there's little pricing power, the European brewing industry, has seen massive consolidation in recent years (your favorite Bavarian beer is owned by a Belgium firm these days that also owns Anheuser Bush). Similarly, we believe China has pricing power and should not be afraid of allowing its currency to appreciate. It's simply untenable for China to import U.S. monetary policy; using administrative measures to control inflation is far less effective than introducing higher real interest rates in conjunction with a stronger currency. At the other extreme, Vietnam exports low value goods and competes predominantly on price. As such, it's not surprising that Vietnam has instigated multiple currency devaluations in a desperate attempt to boost exports; desperate because the U.S. consumer is simply not kicking into the type of spending mood that Vietnamese exporters would like to see.
In our view, governments should not fight the Fed. The world is increasingly looking like a zoo of agitated animals, and the U.S. is the 800-pound gorilla in the room. What do you do with an 800-pound gorilla in the room? Do you feed it to keep it calm? That's what China and Japan have been trying to do by buying U.S. bonds. But what if that gorilla is going through a mid-life crisis, is impossible to control and refuses to take medication for various ailments? Maybe those other animals in the room should remember what survival in the wild is about, the days before a zookeeper could tame everyone. The wild is rather Darwinian. Policy makers need to not only recognize, but embrace that they are on their own.
QE2 is akin to the Fed placing a gun to China's head, telling them to revalue their currency. And indeed, what the world needs is to reduce its dependence on the U.S. dollar. This doesn't mean they need to dump their dollar holdings, but it means the best way to strengthen their own economies is to make their own currencies more relevant. Not through currency intervention, but through building a stronger domestic market. We are not suggesting giving consumers in China credit cards to "re-balance" the global economy. There have always been imbalances in the world, and there will always be imbalances. What we need are valves to allow imbalances to defuse potential bubbles. Free-floating currencies are one of the most effective valves to facilitate such flows.
One can of course argue that QE2 is clear market manipulation, that there's nothing free about it, except for the free money it creates. We don't disagree, but putting trade barriers into place is not the right answer. To get a more stable world, one of the best things that could happen would be to have substantial development of domestic fixed income markets in emerging markets. This may sound like an abstract concept, but in order to achieve a reduced dependence on the U.S., governments elsewhere must facilitate the creation and deployment of capital in their own domestic countries. While we criticize U.S. policies, the flip side of the current account deficit is the capital account surplus: foreigners like investing in the U.S.; they like it so much that the U.S. has gotten hooked on the Kool-Aid, having foreigners finance massive U.S. budget and trade deficits. If foreign governments now put capital controls in place to reduce the inflow of hot money, the world will continue to see emerging markets as places where capital may not be safe.
Of course, emerging markets may want to deter hot money that results from QE2. However, governments around the world would do themselves a favor by addressing the root causes rather than the symptoms. The more advanced an economy is, the easier it should be for them to embrace change. Countries like China and South Korea have pricing power; the same applies to the eurozone. What's wrong with Japan is not a strong yen, but the fact that Japan's business environment has not fostered businesses that invent products consumers actually like, such as the iPad.
Is it realistic that governments will stay calm and lay out a framework that suits QE2? The upcoming G20 meeting may provide a sign as to whether cooler heads will prevail. Unfortunately, cooler heads may simply suggest a boiling frog syndrome where we see inaction. In that context, policy makers venting their anger may lead to disruptions, but could ultimately provide for healthier discourse and facilitate accelerated reform.
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