Wednesday, October 14, 2009

A Word on the Dollar from Mr. Wolf

Another commentary on the state of the dollar, well worth reading, is that written by Martin Wolf and presented by the Financial Times this morning (see “The Rumours of the Dollar’s Death are Much Exaggerated”:

Wolf begins by stating that “It is the season of dollar panic.” He then specifically lists two, gold bugs and fiscal hawks that believe that the dollar “is on its death bed. Hyperinflationary collapse is in store.”

I presume that Mr. Wolf would classify me as a “fiscal hawk”, but I do not believe that “Hyperinflationary collapse is in store.”

I do believe that the dollar will remain weak as long as the fiscal stance of the United States government remains as it is, so that the trend in the value of the dollar will continue to be downward. I do not believe that a “hyperinflationary collapse” is imminent.

The reason I believe that this will be the case is that the international investment community will continue to be on the sell side of the dollar as long as the United States government continues to run the size of deficits that it is now running and has no credible plan to bring future deficits under control.

I believe this for the same reason that was stated by Robert Altman, former deputy US Treasury secretary, in his commentary in the Financial Times yesterday (see “How to Avoid Greenback Grief”: Altman was present when the international investment community moved against the dollar in the latter half of the 1970s. He was also present in the 1990s when the Clinton administration had to calm international markets that had battered the dollar from 1985 until attention was given to its falling value. He has seen, at first hand, how international sentiment can respond to fiscal irresponsibility and monetary ease to force a country to adjust its economic policies.

And, this response on the part of international investors was a common thread in the latter part of the 20th century. France, as well as a dozen or more other countries can provide similar stories.

And Altman argues that “the dismal (US) deficit outlook poses a huge longer-term threat. Indeed, it is just a matter of time before global financial markets reject this fiscal trajectory.”

I support Wolf’s reading of the recent decline in the value of the dollar. He states: “In the recent panic, the children ran to their mother even though her mistakes did so much to cause the crisis. The dollar’s value rose. As confidence has returned, this has reversed. The dollar jumped 20 per cent between July 2008 and March of this year. Since then it has lost much of its gains. Thus, the dollar's fall is a symptom of success, not of failure.”

Note, however, Wolf’s statement, I believe, that the mother, the United States, “did so much to cause the crisis” through “her mistakes” needs to be clarified. What he doesn’t say is that United States monetary and fiscal policy contributed a decline in the value of the United States dollar of about 40 per cent ending in July 2008! I agree with Wolf that the jump of 20 percent came about due to the fact that “In the recent panic the children ran to their mother.”

The subsequent decline in the value of the dollar, in a perverse way, is therefore “a symptom of success” because through the actions of the United States government (as well as many other governments throughout the world) the financial panic ended and so “failure” was avoided.

To me, the return to a declining value for the dollar is nothing more than a return to the pre-crisis situation in which the world investment community is concerned with the huge deficits being produced by the United States government and the fact that there is really no credible scenario being presented by the leaders of the government that these will be in any way reduced in the future. The connected concern with this fact is that, historically, governments cannot contain the underwriting of these deficits by the nation’s central bank over the longer haul. It’s not the fact that the international investment community sees hyperinflation coming down the path, just that historically the evidence is not in place to have a strong belief that an independent monetary authority will be able to offset the substantial increases in debt that are forecast.

I also agree with Mr. Wolf’s assessment that nothing, at the present, can replace the dollar. Whereas I don’t have the space in this post to go into the very cogent discussions that are presented by Mr. Wolf on this issue, I can come out where he does, without having travelled exactly the same road that he has followed.

I believe that over time the global role of the dollar will lessen. I believe with Mr. Wolf that “the global role of the dollar is not in the interests of the US. The case for moving to a different system is very strong.” I agree that the reason that a different role for the dollar is needed is because the current role “impairs domestic and global stability.”

I would just like us to get to this new system by a different path than that proposed by Mr. Wolf or by his colleague at the Financial Times, Gideon Rachman (see my post of October 6, 2009: “The G20: Time for a US Attitude Adjustment”:

The world has changed and will continue to change. The United States and the United States dollar will continue to be powerful; they just will not be as relatively powerful in the future as they have been in the past. This has to be taken into consideration by the United States government as it goes forward, but the new system must not be negotiated with the United States government reeling and in a defensive position from continued pressure on the value of its currency.


Flow5 said...

The twin deficits have the potential at some indeterminate future date to "wash" the U.S. and the Foreign-dollar "down the drain". These deficits have a dangerous relationship. Positive interest rate differentials support the dollar's exchange rate. And an "overvalued" dollar in turn is the principal contributor to our burgeoning trade deficits.

The volume of dollar-denominated liquid assets held by foreigners is extremely large. Any significant repatriation of these funds, by reducing the supply of loan-funds, will force interest rates up - thus increasing the federal deficit and the burden of all new debt. These events alone could trigger a downswing in the economy resulting in more unemployment, more unemployment compensation, less tax revenues and larger federal deficits. Truly a vicious cycle.

Without foreign investment, we probably would have already passed the point where the problem of servicing the national debt could be solved without violating the principles of a free economy.

With a chronically depreciating dollar foreigners will be much less inclined to invest in the U.S. on a creditor ship basis, thus pushing up interest rates. The rising cost and diminishing volume of imports will contribute to an increase in inflation, and the expectation of further inflation will also push up interest rates. This spells stagflation.

Nearly every one of our currency crisis stems from a very restrictive monetary policy, e.g., 1987 - at that time, the most restrictive policy since 1918. This same logic also applies to the july 2008 until march09 period.

Flow5 said...

Alfred Marshall, the Cambridge economists, is responsible for developing the cash-balances approach to money.

For example, if individuals collectively desire expanding their cash balances (increasing the period over whose transactions purchasing power in the form of money is held), they will initiate a chain of events which will lead to a net reduction in their aggregate holdings of cash.

That is, an over-all increase in the demand for money leads to falling prices, a decline in profit expectations, reduced borrowing from the banks -- and therefore a smaller volume of cash balances.

Money thus is truly a paradox - by wanting more, the public ends up with less, and by wanting less, it ends up with more.

All motives which induce the holding of a larger volume of money will tend to increase the demand for money - and reduce its velocity.

Therefore, if there is a flight from the dollar, there will be hyperinflation in terms of dollar denominated assets.

Flow5 said...

Imports of Goods & Services:

2000-01-01 -335.238
2000-04-01 -359.979
2000-07-01 -379.264
2000-10-01 -375.951
2001-01-01 -351.850
2001-04-01 -350.776
2001-07-01 -340.615
2001-10-01 -327.160
2002-01-01 -314.037
2002-04-01 -351.123
2002-07-01 -365.464
2002-10-01 -368.447
2003-01-01 -355.079
2003-04-01 -373.618
2003-07-01 -387.291
2003-10-01 -399.237
2004-01-01 -399.457
2004-04-01 -440.872
2004-07-01 -455.767
2004-10-01 -473.125
2005-01-01 -454.833
2005-04-01 -495.865
2005-07-01 -513.772
2005-10-01 -532.259
2006-01-01 -516.151
2006-04-01 -558.458
2006-07-01 -576.755
2006-10-01 -560.679
2007-01-01 -540.037
2007-04-01 -583.093
2007-07-01 -602.896
2007-10-01 -618.564
2008-01-01 -603.146
2008-04-01 -664.059
2008-07-01 -684.619
2008-10-01 -570.708
2009-01-01 -439.427
2009-04-01 -455.584

These figures are responsible for the decline in the exchange value of the dollar. After the fact, the colossal federal budget deficit currently absorbs foreign short-term claims.

I.e., which comes first, the chicken or the egg? Not the Federal Budget Deficit. Otherwise instead of foreigners parking their funds in governments, our trading partners, given the current imbalances, would invest in other areas.

Flow5 said...

The U.S. became a deficit country in 1985. Since then this country has accumulated a deficit in its balance of payments of 7.5 trillion dollars. I.e., 63% as large as the 12 trillion dollar federal budget deficit.

Dr. William Poole (former president of the St. Louis FED, the maverick institution):

The academic literature is also full of papers trying to explain exchange rate fluctuations after the fact – after you have all the data that you can put your hands on – data that you can’t accurately forecast, but data that after you get your hands on it might logically explain the fluctuations of currency values. And those models aren’t worth a damn either.

Poole is likable, but he is wrong. Anyone who understands money & central banking knows why the dollar started to collapse beginning on 10/02.

Flow5 said...

All Euro-Dollars are created abroad. The foreign commercial banks, and foreign branches of U.S. banks, which create this money, operate on the premise that they will always be able to convert E-Ds into U.S. dollars on demand on a one-to-one basis.

Two principal factors were responsible for the origin of the E-D banking system; (1) the possession by foreign commercial banks of an EXCESS VOLUME OF SHORT-TERM CLAIMS against the U.S. dollar, and (2) the preeminence (at that time) of the U.S. dollar as the reserve, standard-of-value, and transactions currency of the world.

As the number of banks participating in the E-D transactions increased, the E-D bankers discovered that the E-D deposits they created for borrowers often did not result in any diminution of their U.S. dollar balances – the System was merely shifting balances within itself.

That is, drafts drawn on E-D banks increasingly were deposited in other E-D banks. Thus was laid the economic basis of an international system of “prudential” reserve banking – the discovery that the amount of actual U.S. dollar reserves required to support the E-D loans made – and E-D deposits (money) created.

The prudential reserves of the E-D banks consist of various U.S. dollar-denominated liquid assets (U.S. Treasury bills, U.S. commercial bank CDs, Repurchase Agreements, etc.) and interbank demand deposits held in U.S. banks. These are liquid balances in the U.S., or any other major currency country.

The volume of prudential reserves held by each E-D bank presumably is dictated by “prudence” – NOT BY ANY LEGAL REQUIREMENT administered by a monetary authority.

Until the early sixties there was a chronic shortage of U.S., dollars available to finance international transactions. But the E-D system came about precisely because the U.S. balance of payments deficits had finally supplied a more than adequate volume of international liquidity (FED CONTINUOUSLY BY U.S. TRADE DEFICITS). The E-D figure is many times the U.S. means-of-payment money supply.

The acceptability of the E-D is totally dependent on the acceptability of the U.S. dollar.

This vast addition to the world’s money supply has substantially contributed to the dollar's decline.

Flow5 said...

THE DOLLAR IS NOT A TOOL THAT U.S. POLICYMAKERS USE, Dallas Federal Reserve President Richard Fisher said Friday, according to news reports. Speaking in Dallas, Fisher said "no policy maker is going to argue for a weak dollar," Reuters reported. Recent movement in the dollar "has to do with trade adjustment," Fisher said. "How quickly people forget we were the refuge for a long period -- MARKET WATCH