Friday, April 8, 2011

"We Don't Expect Americans to Fight Temptation"

Suggested reading for today: Gillian Tett’s piece in the Financial Times, “ECB rate rise will spark new debate about US tightening.” (

She quotes a senior Latin American official in attendance at the recent annual meeting of the Inter-American Development Bank: “We don’t expect Americans to fight temptation” when the United States government has to make tough monetary and fiscal decisions. The speaker, Tett states, ended this statement “with a hint of the disdain developed nations used to deploy when discussing the third world.”

A specific concern is that United States monetary policy is flooding the world with liquidity and, in doing so, causing dramatic increases in commodity prices and asset prices.

Many countries in Asia and Latin America have responded with controls and other attempts at protection to stem foreign money coming into their countries via the carry trade. Brazil just imposed another round of controls this week.

Of course, Federal Reserve officials, including Mr. Bernanke, claim that the problem is “out there.”

American “officials insist it is poor local policy and excess savings in the emerging markets and not cheap dollars that are creating bubbles.”

And, anyway, a decline in the value of the dollar is good for America because the falling value of the dollar will make American goods cheaper in world markets and will help to improve the trade balance. Christina Romer, former Chairperson of the President Obama’s Council of Economic Advisors, just reiterated this claim when interviewed on national television this week.

Funny, but the statistics don’t seem to support this claim. Since the dollar was floated on August 15, 1971, the value of the dollar has declined by about 35 percent and the United States balance of trade turned negative in the late 1970s and, on an annual basis, has not been close to achieving positive territory since.

History does not support the conclusion that the falling value of a currency will improve a country’s balance of trade when that country is experiencing a period of sustained credit inflation.

Something happens to the production of a country’s goods and services when it is going through a period of sustained credit inflation. The productivity of that country declines relative to those countries that are not experiencing as severe a period of credit inflation.

For one, a country experiencing a sustained period of credit inflation will shift resources, building up finance and financial services at the expense of manufacturing. For example, about 35 percent of the output of the United States in 1965 came from the manufacturing sector. Early in 2011 this figure dropped to less than 14 percent. Also, exposure to risk increases during periods of sustained credit inflation along with increasing financial leverage and financial innovation.

Furthermore, in the United States the industrial use of capital declined from over 90 percent of capacity around the middle of the 1960s to around 80 percent at the last peak of capacity utilization. Capacity utilization now stands around 75 percent. The under-employment of labor also increases during such times. My estimates place under-employment of the American worker at around one in five people of employment age. I believe that over the next year or two this figure will not decline, even in the face of declining un-employment because of the wave of mergers and acquisitions that are going to take place.

The assumption of the economist that “everything else will not change” in the face of a declining value of the dollar does not hold. Yes, the declining value of the dollar does make American goods cheaper in world markets, but this does not account for the changes in the structure of the American economy when credit inflation pervades the nation for a fifty-year period. In the American case, the changing structure of the American economy has not helped solve the balance of trade problem.

The view from the “rest-of-the-world” is that the United States is not going to change its viewpoint. The United States has been able to act the way it has because it has had the “reserve currency” of the world and has been big enough to absorb the international capital flows that have existed over the past fifty years.

But, the United States fiscal and monetary authorities are in a battle now which, given their views, will not allow them act any differently than they have over the past fifty years.

They argue that government spending must be maintained or increased in order to put people back to work.

They argue that credit inflation must be forced on the American people so that the efforts of individuals and businesses to deleverage, to reduce the excessive leverage they had built in the past, can be offset and these individuals and businesses can get back to the process of re-leveraging so as to stimulate economic growth and reduce unemployment.

Ms. Tett speaks of the existence of the culture war between the European Central Bank and the Federal Reserve. Certainly, different worldviews seem to exist between the leaders of these two organizations.

But, it is the assumptions behind the worldviews that seem to be dramatically different and it is the assumptions that ultimately prove to be so important. The worldviews are derived from the assumptions, but it is the assumptions that people find so hard to give up because they become so personal.

As long as the United States continues to believe that the declining value of the dollar is good for the country, based on arguments similar to the ones attributed above to Christina Romer, and looks for excuses like “poor local policy” and “excess savings in emerging countries”, the leaders of the United States will continue to believe that it can proceed as it has for the last fifty years.

As long as the leaders of the United States continue to act as they have for the last fifty years then the value of the dollar will continue to decline.

And, the attitude toward American policymaking will continue to be: “We don’t expect Americans to fight temptation.”

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