A New Illusion: The Falling Dollar
In his recent speech in Berlin, Greenspan was amazingly frank about the "increasingly less tenable U.S. current account deficit," suggesting that foreign investors would eventually reach a limit in their desire to finance the deficit and diversify into other currencies or demand higher U.S. interest rates.
In essence, he expressed the new consensus view in America that the dollar has to bear the brunt of reducing the U.S. current account deficit. Clearly, American policymakers want a lower dollar, apparently entertaining strong hopes that this will take care of the U.S. trade deficit, and we suspect that they regard it as an easy solution for this problem.
We doubt first of all that it is a solution at all. Such expectations essentially presuppose that an overvalued dollar is the main cause of the U.S. trade deficit. This is bogus. By the measure of purchasing power, the dollar was hardly out of line with the currencies of other industrialized countries.
The favorite American explanation for the huge and growing trade deficit is the U.S. economy's superior growth performance and lacking foreign demand. But the Chinese economy is growing much faster than the U.S. economy yet has a big trade surplus. So had Japan in the late 1980s, and so had Germany in the decades to the late 1970s.
This explanation of the trade deficit with superior U.S. GDP growth is another illusion among many others. What crucially matters for a country's trade balance is not its economy's growth rate, but its internal resource allocation between consumption and investment. High rates of saving and investment make for a strong trade balance, while high rates of consumption make for a weak trade balance. America's unusually poor trade performance reflects extremely poor rates of saving and investment. Overconsuming and undersaving America lacks the necessary capital stock to increase its exports.
These observations essentially raise the question of whether or not the falling dollar is prone to rebalance the U.S. economy's foreign trade. It is argued that the dollar's slide did a great job slashing the U.S. trade deficit from 1989-1993. This is true, but was it really the falling dollar that did it? It actually happened against the backdrop of a sharp slowdown in credit growth and a recession in 1991.
During the four years 1989-93, total credit in the United States - financial and nonfinancial - grew by a cumulative $3,255 billion, or $819 billion per year. In flagrant contrast, during the four years to mid-2004, overall credit grew virtually three times as fast, by $2.4 trillion per year, and there is no letup in sight. Drawing on past experience, a fall of the dollar, however steep, will hardly make a dent in the trade deficit by itself.
Lowering the trade deficit first requires a lowering of domestic demand growth, and a drastic shift in resource allocation away from consumption and toward investment in the longer run. A mere fall of the dollar is definitely no solution. Yet we very much doubt that policymakers in Washington have the slightest intention to implement or foster the necessary changes in demand and resource allocation with policy measures.
What about the risks for the dollar and the markets? In short, they are frightening. The most frightening risk is that the dollar's fall gets out of control. Superficially, the dollar's steep fall in the 1980s and '90s may seem encouraging in this respect.
However, there is something that makes all the difference between then and now. When the dollar's decline started in 1985, dollar assets held by foreigners were close to zero. This time, they are close to $9,000 billion, one-third of which is held by central banks.
The dollar's further behavior will largely depend on the flow of news about the U.S. economy. Bad economic news is bad for the dollar. For the reasons explained earlier, we expect very bad news that will shatter the hollow optimism about the economy and the stock market. While economic growth is sharply decelerating, inflation is accelerating, a main reason for this being an accelerating rise in import prices.
In such circumstances, the Fed will face a Catch-22. With CPI inflation above 3% at annual rate and a falling dollar, a new easing of monetary policy is absolutely impossible. Rather, the market will expect the Fed to continue its rate hikes. But doing so, it would prick the carry trade bubble in bonds with disastrous effects, first on the bond market and then on the economy.
A steeper fall of the dollar, just by itself, might please U.S. policymakers. Unfortunately, it is bound to have a variety of harmful effects - in particular on psychology, inflation rates and interest rates. It may finally dawn on people that due to the horrendous magnitude of the existing imbalances, the development in the economy and the markets is out of control.
After many months of stability during 2004, the dollar has turned south all of a sudden. Observing the U.S. economy's deteriorating performance since early this year, its protracted stability surprised us. Now its sudden slide perfectly concurs with our dismal expectations for the U.S. economy in 2005. Yet the abrupt general bearishness of dollar forecasts strikes us as ominous in comparison with the highly bullish consensus growth forecasts for the economy (those for Europe are distinctly bearish).
Let us try to make sense of these contradictions. Over time, we have learned the hard way that two different things govern the behavior of markets: first, the objective facts; and second, the general perception of the facts. They can differ like black and white.
Our opinion about the economic situation in the United States has been and remains diametrically at variance with the optimistic consensus view that discarded the economy's slowdown as a "soft patch" due to the rising oil price. In our view, the economy is rapidly losing steam because prior aggressive monetary and fiscal stimulation has largely spent itself, while having failed to initiate the desired self-sustaining investment recovery. Moreover, we hold a strong opinion that the existing outrageous imbalances and structural dislocations in the economy make a normal, sustainable economic recovery flatly impossible.
Pondering the causes and implications of the dollar's sudden plunge, it ought to be recalled that global currency experts were overwhelmingly forecasting a strong dollar and a weak euro, commensurate with expected strong economic growth in the United States and sluggish economic growth in Europe.
There rules a perception in the markets that the U.S. economy is fundamentally strong and, in addition, vastly superior to that of Europe in resilience and flexibility. All that is sheer nonsense. Due to years of unimaginable credit excesses and resulting monumental imbalances, the U.S. economy is highly vulnerable to a sudden downturn. It is, in fact, in worse shape than in 2000.
U.S. policymakers and economists are hailing the dollar's fall as a boom for exports, employment and profits. They fail to realize that the consumer borrowing and spending excesses of the past few years have grossly depleted the economy of available resources for sharply higher exports. A plummeting dollar does nothing at all to offset the profound structural shortfall of savings and capital formation. Rather, it fuels inflation.
Remarkably, the dollar has plummeted despite highly optimistic expectations about the economy's outlook as reflected in stellar growth forecasts. It is our assumption that increasingly bad economic news will shake this overconfidence and speed up the dollar's decline.
For reasons already explained, we expect that sharply weaker consumer spending will soon distinctly slow the U.S. economy. Two events in particular are putting the brakes on economic growth: first, the full stop of the income creation through tax cuts; and second, the waning of the housing and mortgage refinancing booms.
The risks are frightening.