Washington Going Nowhere: Dollar Hits New Lows

For fifty years, the United States government has followed a policy of credit inflation.  And, I am blaming both parties…the (Keynesian) Democrats and the (“we’re all Keynesians now”—Richard Nixon) Republicans. 

The current discussions going on in Washington, D. C. don’t really give me much hope for the future.  Congress and the White House may talk about reducing deficits now, but both sides of the talks don’t seem to have any idea about creating a sustainable government policy with respect to the creation of federal debt.

As I have reported before, since January 1961, the public debt of the United States has increased at a compound rate of growth in excess of 8 percent per year.  This has resulted in the public debt now being in the neighborhood of $14 trillion. 

Over the past two years, I have argued that in the next ten years, the federal debt will at least double from its current level.  If we cut the deficit by $4 trillion…or $3 trillion…or $2 trillion…figures that have been tossed around in the current debates…we will still add massive amounts to the existing debt levels. 

This amount of debt, I don’t believe, is sustainable even after these cuts. 

Why has the United States government amassed so much debt during this time period?

The reason is that the number one goal of the government’s economic policy has been to achieve high levels of employment…low levels of unemployment.  

As I have written elsewhere, the achievement of this goal is impossible.  And, all the government’s efforts to attain this objective have just resulted in making the employment situation worse.  Not only has the official unemployment rate been greater than the target unemployment rate for this period, the level of under-employment in the United States has risen to the point where about one in five people of working age are underemployed…either unemployed, employed part time but want to be employed full time, or have dropped out of the labor market. 

So, the federal government has followed a policy of credit inflation for fifty years and has not only not achieved its goal but has made the employment situation much worse.

In addition, the policies of the federal government have resulted in a tremendous skewing of the income/wealth distribution in the United States away from those earning the least and in favor of those earning the most.  This was certainly not something desired by the perpetrators of these policies.

Wasn’t there any indication that something was wrong? 

In my view there was some very clear evidence that something was wrong.  The value of the United States dollar against other currencies in the world has been an indicator that investors throughout the world thought that the economic policies of the United States government were not sound and that there was little or no hope that the United States government would re-establish any discipline over its budgeting process.  The feeling was that as long as the United States continued to pursue the effort to achieve full employment, fiscal discipline would be ignored.

My argument is that the United States has followed an explicit policy of credit inflation since the early 1960s.  The period began with the value of the United States dollar pegged against gold.  However, the credit inflation of the 1960s brought this to an end as President Nixon took the dollar off the gold standard on August 15, 1971 and floated the dollar in the foreign exchange market. 

Since then, the trend has been downward.  This is shown in the following chart. 

There are two exceptions to the downward movement in the value of the dollar.  The first is the Volcker monetary tightening coming in the early 1980s which resulting in the short term peak in the value of the dollar in February 1985.  The second is the Rubin fiscal tightening that took place in the late 1990s with the near term peak in the dollar’s value occurring in July of 2002. 

Otherwise we have the following results:

Measured from January 2, 1973, the value of the dollar has declined by around 37 percent to the present;

Measured from the its peak value in February 1985, the value of the dollar has declined by about 54 percent;

Measured from its peak value in July 2002, the value of the dollar has declined by almost 40 percent;

Measured from the “flight to quality” peak value during the recent financial crisis in March 2009, the value of the dollar has declined by over 20 percent.

Although the value of the dollar rose during the first European sovereign debt crisis in 2010, it has declined almost constantly during the most recent problems.

International financial markets don’t think much of the economic policies of the United States government.  And, the basic reason the United States has been able to get away with this total lack of discipline has been that the United States currency is the reserve currency of the world.

Now, I am not one that believes that the budget of the United States government has to be balanced at all times or even over time.  I do believe that fiscal discipline must be established so that credit inflation is kept under control.  Over the past fifty years, the real compound growth rate of the United States has been slightly more than 3 percent.  If the government could constrain its budget so that the public debt and the economy grew at no roughly in line with one another, I think the country could live with that and credit inflation would not be a major problem.

However, I don’t see our current crop of politicians capable of exhibiting such discipline.

How Much Should the United States Cut the Deficit?

How much should the United States government cut its budget deficit?

This seems to be the big debate in Congress surrounding discussions/negotiations related to the new fiscal budget.

The problem as I see it is that the United States government is focused on the wrong objective! It is focused on an objective, low levels of unemployment that it cannot achieve without creating all other kinds of distortions in the economy, distortions that produce, in many cases exactly the opposite result from what the government is attempting to achieve.

Let me tell you what objective I believe the United States government should focus upon in determining its economic policy stance, which includes its fiscal budget.

I believe that the primary economic focus of the United States government should be on the value of the United States dollar. I believe that the United States government should attempt to stabilize and maintain the value of the dollar in international currency markets.

The current focus of economic policy in the United States government is employment…or low levels of unemployment. This objective was memorialized in The Employment Act of 1946 which set placed the responsibility for achieving high levels of employment, or low levels of unemployment on the back of the United States government.

In 1978 this objective was re-enforced by a new act, The Full Employment and Balanced Growth Act (known informally as the Humphrey–Hawkins Full Employment Act). This act just made stronger the government’s commitment to the achievement of low levels of unemployment.

The ability of a government to achieve full employment was contested in 1968 by the economist Milton Friedman who contended that continued governmental stimulus to achieve a “hypothetical” level of employment, called “full employment” would only achieve more and more inflation as people came to expect the government’s efforts to stimulate the economy through the creation of credit expansion…credit inflation.

Friedman’s expectations proved to be true as the government continued to promote government deficits and the expansion of government debt in economy.

From 1960 through 2010, the gross federal debt of the country expanded at an annual compound rate of more that 7% per year.

From 1960 through 2010, the purchasing power of the United States dollar declined by about 85%.

From 1960 through 2010, the United States removed itself from the gold standard and allowed the value of the United States dollar to float in foreign exchange markets. The value of the United States dollar has declined by more than 30% since it was floated and expectations are for it to decline further.

From 1960 through 2010 under-employment in the United States has gone from a relatively modest number which was not measured at the earlier date to more than 20% in the current environment.

From 1960 through 2010 manufacturing capacity has declined from about 95% to about 75%. The peak capacity utilization has every cycle since the early 1970s has been at lower and lower levels.

From 1960 through 2010 the income distribution of the United States has become dramatically skewed toward the higher levels of income earned. This is the most skewed income distribution curve ever for the United States.

I cannot see how the United States government can continue to keep “full employment” as a goal of its economic policies. Not only has “full employment” not been maintained, it has generated side effects that, it seems to me, has substantially worsened the life of many Americans.

Why should the government substitute the maintenance of the value of the United States dollar as its primary objective for the conduct of its economic policy?

Here I quote Paul Volcker: “a nation’s exchange rate is the single most important price in (the) economy; it will influence the entire range of individual prices, imports and exports, and even the level of economic activity. So it is hard for any government to ignore large swings in its exchange rate.” This quote is from Paul Volcker (“Changing Fortunes: the World’s Money and the Threat to American Leadership,” by Paul Volcker and Toyoo Gyohten, Times Books, 1992, page 232.)

Yet “ignore large swings in its exchange rate” is exactly what the United States did and is doing. The consequences of ignoring this value? I have reported those above.

By focusing on the level of unemployment the way the United States government did and pursuing an economic policy of credit inflation, the United States government actually weakened the country and hurt its citizens. The “unintended results of good intentions!”

The United States government should not, and realistically cannot, reduce its budget deficit too rapidly. Markets realize that.

But, the United States government must signal that it is changing the objective of its economic policy and is sincerely pursing a path to reduce or even eliminate the credit inflation it has inflected on its country…and the world…for the last fifty years.

My guess is that until international financial markets see this shift in policy objectives and sense a realistic change in the attitudes of the politicians in Washington, D. C. the dollar will continue to decline in value because participants in international financial markets will just see the government continuing to act in the same way it has over the past fifty years, acting in a way that will continue the policy of credit inflation.

And, if the government continues to act in this way, the economic health of the economy will continue to deteriorate and the standing of the United States in the world will continue to become relatively weaker.

In my view the government does not have to reduce the deficit by massive amounts this year. It does, however, have to signal that it is changing its goals and objectives and then provide enough evidence of this change in focus to convince the international financial markets that it is sincere.

In the current political environment, however, this may be too much to ask.

The 10-year Treasury Bond Yield

On December 21, 2010, I made the following brash prediction:” my view of long term Treasury yields for 2011 is up, with the 10-year Treasury security reaching 4.5-5.0% in the upcoming year, a rise from around 3.3% to 3.5% now“ (http://seekingalpha.com/article/243018-long-term-treasury-yields-in-2011).

I still believe that this is where the yield on the 10-year Treasury security should be. The reason that it is not at this level for two reasons: first, because United States Treasury issues are still attracting a lot of money that is staying away from risk elsewhere in the world; and second, the Federal Reserve System is supplying lots and lots of liquidity to the financial markets (through QE2) in order to keep banks, state and local governments, and the housing market afloat (http://seekingalpha.com/article/246081-the-world-debt-crisis-lingers).

As can be seen from the chart, the yield on 10-year Treasury securities dropped off at the start of the recession which began in December 2007, but then nose-dived as the investor “flight-to-quality” accelerated in 2008. After some stability was re-established in 2009 the yield rebounded into the 3.5% to 4.0% range until 2010 when the sovereign debt crisis took place in Europe.

Note that the Federal Reserve maintained the effective Federal Funds rate within the 15 to 20 basis point range from December 2008 until the present. Excess reserves in the banking system that were less than $2 billion in August 2008, rose to just under $800 billion in December 2008 and averaged around $1,000 billion from October 2009 to the present. Thus, banking and financial markets were sufficiently liquid during this time period.

Right now, the yield on the 10-year Treasury securitiy seems to be dominated by what is going on in Europe. (See the next chart.) We see that this yield was moving in the 3.6% to 4.0% range at the start of 2010. However, as the sovereign debt crisis picked up momentum in the early part of the year, money flowed from European financial markets to United States financial markets.

As the European Union and the European Central Bank seemed to be working out a “bail out” plan for the eurozone nations and banks, confidence seemed to pick up in Euorpe and money once again flowed out of the United States and back into European financial markets.

Perhaps a leading indicator of this money flow could be the value of the United States dollar relative to the Euro. Although the yield on the 10-year Treasury did not begin to decline until April 2010, the United States dollar got stronger relative to the Euro beginning in January 2010. As the European bailout became a reality in the summer, the Euro began to gain strength in June 2010. The yield on the 10-year Treasury started to pick up again in August 2010 but its rise did not really accelerate until October 2010.

Note that as the concern over the sovereign debt problems in Europe rose again toward the end of 2010, the value of the Euro started to weaken again relative to the United States dollar. The rise in the yield on the 10-year Treasury security stalled.

This week, Greece issued bonds on Monday and these securities were relatively well received. Likewise, Portugal had a good reception for its issue of bonds brought to market yesterday. Spain comes to market tomorrow. Along with these successes, the value of the Euro relative to the US dollar rose slightly.

In addition to this, the yield on the 10-year Treasury issue rose Tuesday and was up again this morning.

It appears as if the near-term movement in the yield on the 10-year Treasury issue will depend more on how international investors move their money between European financial markets and the financial market in the United States.

The impact of the Federal Reserve on this? To me, the Fed is primarily interested in the liquidity available to the financial markets and the solvency of the American banking system. It is not going to change its policy stance at the current time. But, its effect on the 10-year yield will be minimal at this time.

Thus, the 10-year Treasury yield is going to bounce around as it has for the last year based upon how successful Europe is in overcoming its debt problems. I still believe that the Treasury yield would rise to the 4.5% to 5.0% this year if the European situation were not having such an impact.

The Basics of Turnarounds: the United States Situation

A part of my life has been connected with company turnarounds, bank turnarounds to be more precise. I would suggest that the United States is in a turnaround situation right now but its leaders claim that the economic model it is using is still relevant and that all that is needed is a little more time and a little more co-operation from others and everything will turn out alright.

My experience has led me to some conclusions about what is needed in a turnaround situation. (By-the-way, all my turnarounds were successful and I can say that now because I am not doing turnarounds any more.) We don’t have much space to discuss these things so let me just summarize what I believe to be the four most important factors in achieving a turnaround: the business model; information coming from the market place; the need for transparency and openness; and the existing business culture.

Although these factors relate to a business situation, I believe that they can be applied to any “turnaround” situation, including the “turnaround” of a government.

First, and foremost, an organization gets into trouble because its business model, or economic model, is not working. But, because a leader or a management team believes that the organization has gotten where it is because of that business model, they tend to stick with the model and apply the model even more forcefully.

In some cases, the success of the model has come because of the timing of the model’s use and not because of any inherent characteristics of the model are correct. To justify this statement I refer the reader to the book “Fooled By Randomness,” by Nassim Nicholas Taleb.

In terms of the economic model that the United States government is applying, and has been applying for a very long time, there is no real evidence that it works. I am, of course, speaking of the Keynesian macro-economic model.

Ever since the 1930s when the model was first presented, all I have ever heard in times of difficulty is that the reason the Keynesian model falls short is that not enough stimulus has been forthcoming. Keynesian economists contend that the Great Depression continued on for as long as it did because governments did not create sufficient budget deficits. Only the war effort, World War II, got the US out.

This criticism has been applied over and over again during the last fifty years. All we have been hearing from the fundamentalist preacher Paul Krugman is that the Obama stimulus package must be greater. He has been consistent in applying this remedy since early on in the Great Recession. More spending, more, more!

Maybe the economic model the government is using is wrong!
The application of this model over the past fifty years has produced falling capacity utilization, rising under-employment, and greater income inequality.

Maybe the economic model has not been applied correctly!

Defensive comments like these are heard over and over again within a company that is in decline.

Second, it seems that others recognize the decline in the company even though the leaders and management of the organization do not. That is, the market recognizes that the model of the organization is not working and that the organization is in decline.

And, what is the response of the leaders or managements of the targeted organization. The response is “The market doesn’t understand us!” I don’t know how many CEOs I have heard express this sentiment in the face of a falling stock price.

The thing is, the market does understand the company and the fact that the company is applying an inappropriate business model.

The market response to the economic policy of the United States? Well, the behavior of the United States government in the 1960s resulted in the need for the United States to go off the gold standard. Since the United States has been off the gold standard, the value of the United States dollar has declined almost constantly (with the two exceptions, when Paul Volcker was the Chairman of the Board of Governors of the Federal Reserve system and during the 1990s when Robert Rubin was the Secretary of the Treasury).

Obviously, for the value of the United States dollar to substantially fall, almost continuously, over a fifty year period, indicates that something must be wrong with the economic model the government is using. During the past fifty years, the government has relied on a credit inflation whose foundation is a federal deficit that has resulted in the federal debt increasing at an annual compound rate of growth of more than 9% over this time period. The government has created other avenues of credit inflation through programs like those built for housing and home ownership. The whole economic model was based upon inflating the economy causing people to constantly “leverage up” and take on more and more risk.

Third, transparency and openness goes by the wayside as organizations experience decline. Cover ups abound! President Obama came into office declaring that he was going to change the way things are done in Washington. Yet, his administration is now charged with opaqueness and obfuscation like every other presidential administration. Even little bits of information, like the recent report by the special inspector of the TARP program, only adds to the accusation that this administration is hiding things. This was in all the papers this morning. (See “Treasury Hid A. I. G. Loss, Report Says,” http://www.nytimes.com/2010/10/26/business/26tarp.html?ref=business.) This does not help!

Fourth, the culture of an organization begins at the top. In a turnaround situation, a new culture
must be implemented and that culture must begin with Number One. The new leader that takes on a turnaround situation must change the way things are done and introduce a new business or economic model into the organization.

However, this new business model cannot be introduced or implemented if the (new) leader assumes that little or nothing needs to be changed. And, this implementation cannot be carried off unless the members of his or her team are all on board.

In my view, things need to be changed in Washington, D. C. The evidence in the market place is hard to ignore, although Washington has done its best to shift attention to others. But, the weakness of the United States position has been observed and others (China, Brazil, and India, and others) have moved into the void to take advantage of it. (See my post http://seekingalpha.com/article/229112-the-imf-bowl-u-s-vs-china.)

Even if the philosophy of economic policy used by the United States government was appropriate forty or fifty years ago, things have changed since then. (See my post http://seekingalpha.com/article/232044-maybe-things-have-changed.) The United States needs to be “turned around”. But, to do a turnaround, those that are in leadership positions must accept the fact that a turnaround is necessary. I don’t see this happening any time soon.

The "Do-Nothing" G-20

The finance ministers of the G-20 just finished meeting. Result: the Yankees and the Phillies are not going to be in the World Series this year. The leaders of the G-20 are going to meet in Seoul, South Korea in November. I think that we can expect little or nothing to come out of this get-together.

The whole cloud, I believe, hanging over international finance at the current moment is the economic policy stance of the United States government.

Oh, we can point our fingers at the Chinese, but it is the Americans that have set the tone for the world. And their current pronouncements about future fiscal and economic policy promise nothing more than a continuation of the past.

Martin Wolf, in the Financial Times stated it very clearly: the United States is trying to inflate China and in so doing inflate the rest of the world. (See http://www.ft.com/cms/s/0/9fa5bd4a-cb2e-11df-95c0-00144feab49a.html.)

Joseph Stiglitz, the Nobel Prize winning economist, argues (in “Why Easier Money Won’t Work”, http://professional.wsj.com/article/SB10001424052702304023804575566573119083334.html?mod=WSJ_Opinion_LEADTop&mg=reno-wsj) that “Such policies (Quantitative Easing on the part of the Federal Reserve) may come with a price…That money is supposed to reignite the American economy but instead goes around the world looking for economies that actually seem to be functioning well and wreaking havoc there.”

Mohamed El-Erian, CEO of PIMCO, stated just last week that when the Federal Reserve creates liquidity it just spreads throughout the world going where ever it wants to. Worldwide capital mobility is a feature of the 21^st century international financial system.

Stiglitz continues: “The downside is a risk of global volatility, a currency war, and a global financial market that is increasingly fragmented and distorted. If the U. S. wins the battle of competitive devaluation, it may prove to be a pyrrhic victory, as our gains come at the expense of others—including those to whom we hope to export.”

But, the United States has been conducting an economic policy for the past fifty years that has relied upon credit inflation to keep unemployment low, to provide individuals and families with homes, and to keep American manufacturers operating at high levels of output. (See my post “Maybe Things Have Changed” for October 22, 2010 at http://maseportfolio.blogspot.com/.)

Things began to get out-of-hand in the 1990s during the stock market boom connected with the tech bubble. Stiglitz again, “In 2001, (then) record-low interest rates didn’t reignite investment in plant and equipment. They did, however, replace the tech bubble with an even more dangerous housing bubble. We are now dealing with the legacy of that bubble, with excess capacity in real estate and excess leverage in households.”

And, these bubbles became world wide as the debt of the United States and the liquidity provided by the Federal Reserve System spread almost everywhere. The conditions we are living through at the present time were a long time in coming and have damaged other countries as well as the United States.

The world seems to be dividing into three (I previously thought it was just two) parties. The first is the emerging countries who seem to be doing OK and seem to be in the strongest position right now. These nations are the BRIC countries and others (like Canada) who have weathered the recent economic and financial meltdown in relatively good shape. The second group consists of the more developed countries, primarily in the West, that have followed economic policies not too different from the United States, like Great Britain, France, Spain, Italy, Greece, Portugal, and Ireland, who have experienced a sovereign debt crisis over the past year or so and are re-grouping by getting their financial affairs in order and adopting a different economic strategy for the future.

The third party contains just one nation, the United States. The United States is not showing any signs that it is getting its financial affairs in order. Furthermore, the economic policy philosophy prevalent in the United States government differs from what existed over the past fifty years only in terms of magnitude. The economic policy philosophy of the American government just seems to be even more of the same.

The leaders of the United States government have presented a common front to the world: our economic policy stance is a given. Now, let’s work out world financial reform.

I don’t see how anything new can be worked out in the G-20 or any other international body if the United States continues to take such a strong position. I believe this is the underlying message sent by the finance minister from Brazil who declined to attend the meeting that was just completed.

Nothing can be done to solve the imbalances in world finance if the United States continues to be un-moveable when it comes to its economic policy stance.

The world has changed. Things within the United States have changed. This is what my Friday post (http://maseportfolio.blogspot.com/) was all about.

But, the leaders in the United States continue to focus on their navels and claim that the problem is “out there”.

And, that is the problem.

World co-operation cannot come about when one country believes it has all the answers.

As such, I see the value of the dollar continuing to decline; the world situation will continue to remain unsettled with regard to countries co-operating with one another; and I see continued economic imbalance and dislocation, both in the United States, itself, and in the world.

"Currency Chaos: Where Do We Go From Here?"

I would strongly recommend you read the “Weekend Interview” published in the Wall Street Journal on Saturday. The interview is with Robert Mundell, 1999 Nobel prize-winning economist who teaches at Columbia University. Mundell has been referred to as the “father of the euro.” (http://online.wsj.com/article/SB10001424052748704361504575552481963474898.html?mod=WSJ_Opinion_LEADTop)

Let me just summarize some of the points Mundell makes in the interview because, I believe, that more people should be aware of them.

First, Mundell reflects a bit on history and states that the major event of the post-World War II period was the United States going off the gold standard in 1971 and letting the value of the dollar float. “The price of gold was fixed at $35 an ounce in 1934, but by the time the U. S. got through the Korean War, the Vietnam war, with all the associated secular inflation, the price level had gone up nearly three times.” The U. S. lost more than half its gold stock and had to get off the gold standard.

No one has suggested any system, gold or whatever, to stabilize prices since. And, the “secular inflation” has continued into the 21st century.

Second, the dominance of the United States and the dollar in the world economy, which began in the 1930s, has declined. “”To be fair, America’s position (in the international community) is not nearly as strong now.” But, Mundell doesn’t “think the U. S. has any ideas, they don’t have strong leadership on the international side. There hasn’t been anyone in the administration for a long time who really knows much about the international monetary system.”

Third, it is wrong to think that the world situation revolves around the United States versus China faceoff. “It’s a multilateral issue because the U. S. deficit is a multilateral issue that is connected with the international role of the dollar.” Mundell supports the suggestion of French President Nicolas Sarkozy that discussions should begin on reforming the world monetary system. But, he argues that the Europeans must play a very important part in any discussions because the dollar-euro relationship is so important in world financial markets. “The dollar and the euro together represent about 40% of the world economy.”

Fourth, the world currency system needs to be based on fixed exchange rates and not flexible ones. Mundell believes that almost all of the volatility in foreign exchange markets is “noise, unnecessary uncertainty.” World trade will be better off without having to deal with this “noise” because “it just confuses the ability to evaluate market prices.”

The argument against fixed exchange rates is that, in a world where capital flows freely between nations, a country cannot run an independent economic policy aimed at achieving things like full employment and price stability and still maintain a stable exchange rate. This argument is called “the Trilemma problem” of international economics: you can only achieve two of these goals; capital mobility; fixed exchange rates; and an independent governmental economic policy. (For more on this see my post, http://seekingalpha.com/article/227990-monetary-warfare-can-nations-have-independent-economic-policies.)

What about a country losing the ability to run an independent economic policy?

Mundell is asked the following question: “I suppose the Fed officials would argue that their mandate is to try to achieve stable prices and maximum levels of employments.”

The answer: “Well, it’s stupid. It’s just stupid.”

“The Fed is making a big mistake by ignoring movements in the price of the dollar, movements in the price of gold, in favor of inflation-targeting, which is a bad idea. The Fed has always had the wrong view about the dollar exchange rate; they think the exchange rate doesn’t matter. They don’t say that publically, but that is their view.”

Hence, the fifth point is that monetary and fiscal policy should not be conducted independently of what is going on in the rest of the world. A country, even the United States, cannot continue to inflate its currency without repercussions. The government cannot continuously ignore what is happening to the value of its currency. If a country does ignore what is happening to its exchange rate there will be consequences to pay down the road.

Sixth, “the price of gold is an index of inflationary expectations.” What is it reflecting? Mundell argues that a rise in the price of gold might indicate “that people see huge amounts of debt being accumulated and they expect more money to be pumped out.”

“Look what happened a couple weeks ago: The Fed started to say, we’ve got to print more money, inflate the economy a little bit. The dollar plummeted! (The price of gold rose!) You won’t get a change in the inflation index for months.” But, the decline in the exchange rate and the rise in the price of gold is a “first signal.”

Read the article.

"There is no limit to the dollars the Fed can create"

I read Martin Wolf’s column in the Financial Times this morning and was taken aback by what I read there. (See “Why America is going to win the global currency battle”: http://www.ft.com/cms/s/0/fe45eeb2-d644-11df-81f0-00144feabdc0.html.)

Here are two quotes:

“There is no limit to the dollars the Federal Reserve can create”;

and,

“In short, US policymakers will do whatever is required to avoid deflation. Indeed, the Fed will keep going until the US is satisfactorily reflated. What that effort does to the rest of the world is not its concern.”

In other words, “the US must win” the currency wars!

This sounds something like the fundamentalist preacher Paul Krugman who, seemingly, will never see a federal government deficit that is big enough to satisfy his tastes.

This argument is countered by Allan Meltzer, a historian of the Federal Reserve System.

“The Federal Reserve seems determined to make mistakes. First it started rumors that it would resume Treasury bond purchases, with the amount as high as $1 trillion. It seems all but certain this will happen once the midterm election passes.” (See “The Fed Compounds Its Mistakes,” http://professional.wsj.com/article/SB10001424052748704696304575538532260290528.html?mod=ITP_opinion_0&mg=reno-wsj.)

“We don’t have a monetary problem, we have 1 trillion or more in excess reserves so it’s literally stupid to say we’re going to add another trillion to that.” (This can be found at http://www.bloomberg.com/news/2010-10-12/further-fed-easing-could-alarm-bond-market-hawks-historian-meltzer-says.html.)

Meltzer argues that the end to this will come through the marketplace. He states in the Wall Street Journal article:

“The market’s response to the talk about renewed bond purchases includes a 12% or 13% decline in the value of the dollar against the euro. This depreciation occurred despite a weak euro, beset by potential crises in Ireland, Greece and Spain. The dollar’s decline is a strong market vote of no confidence in the proposed policy.”

And in the Bloomberg article

“Sooner or later the bond market hawks are going to say, ‘How are they going to get rid of that $2 trillion of excess reserves?’ and the answer is they don’t know.”

The question is, in my mind, how long can the Washington policymakers hold out against the pressure of the international investment community?

In my professional experience…the international investment community always wins…it is just a matter of time!

I know that Robert Rubin is not much in favor these days, but I still believe that he was absolutely correct as the Secretary of the Treasury in the Clinton administration when he argued that the United States could not continue to create large fiscal deficits because the bond markets would not continue to support government debt issues if the deficits were continued.

President Clinton accepted Rubin’s arguments and moved to reduce the budget deficits. The result was a decline in United States interest rates and a huge run-up in the value of the United States dollar.

Rubin sensed the threat the bond market and the foreign exchange market represented to the ability of the United States government to continue along in an un-disciplined fashion.

I see no one in the United States government now that accepts the conclusion of the foreign exchange market.

My experience in business, both in running financial as well as non-financial companies, is that one ignores what the market is trying to tell you at enormous expense. I don’t know how many chairmen, presidents, and CEOs I have heard that claim that “the market just doesn’t understand what we are doing.”

Guess what?

The market does understand what you are doing and that is why it is moving against you.

I find it scary for someone to say,

“There is no limit to the dollars the Federal Reserve can create”;

and,

“What that effort does to the rest of the world is not its concern.”

The voices of the dogmatists are getting “shrill” now. The world is not behaving according to their model. Let’s just hope that a government that does not see things going its way does not do anything rash out of desperation.

The recovery is taking place. However, it is taking place at a much slower pace than anyone wants. Maybe, just maybe, the healing needs to take its time so that a solid recovery can be attained. Quick fixes may do more damage to the patient over time than making sure that the recovery really heals the illness.

Globalized Finance: Advantage China

In recent posts I have written about how international capital mobility has expanded since the 1960s to the point where one cannot imagine the world without freely flowing capital. Sebastian Mallaby has presented a confirming essay on this in the Financial Times, “The Genie of Global Finance is Out of the Bottle,” (http://www.ft.com/cms/s/0/9084f8c8-d527-11df-ad3a-00144feabdc0.html).

“The truth is that, however cogent the case for reining in financial globalization, sheer momentum will carry it forward…the bottom line is that, once a country has a sophisticated capital market, it is tough to keep foreigners out.

It is even tougher to exclude a particular class of foreigner, which is why the understandable urge to impose portfolio sanctions on China will prove impractical. The US has sold around $3,000 billion worth of Treasury bonds to foreigners, and perhaps only a third of those are held by China—if Beijing wants to bulk up its holdings tomorrow, it can buy plenty from Middle Eastern sovereign funds. Once finance is globalized, it just is not possible to deglobalize it cleanly. The genie is out of the bottle. We must find ways to live with it safely.”

Take de-globalization off the table.

What is one way to live with this freely flowing capital mobility? Certainly not inflation.

Yet the United States government has acted over the past 50 years on an economic philosophy that has created an almost constant credit inflation. This has left the United States is a weakened bargaining position relative to other nations in the world. (See one of several posts I have recently written on this subject: http://seekingalpha.com/article/227990-monetary-warfare-can-nations-have-independent-economic-policies.)

The United States has justified the need for this “independent” economic policy to ensure high levels of employment within the country. However, international financial markets have not given the United States high marks for such a policy as the value of the United States dollar has declined by about 40% throughout the period this policy has been in effect.

The justification for allowing the dollar to decline in value has been that this will help to stimulate American exports and help correct the American balance of payments.

Well, the Chinese (and other emerging countries) are buying goods from the rest of the world. However, they are not consumer goods…they are capital goods.

A headline opinion piece in the New York Times by Andrew Ross Sorkin trumpets “Worrying over China and Food” (http://www.nytimes.com/2010/10/12/business/12sorkin.html?ref=business). The concern is over the fact that a “consortium of state-backed Chinese companies and financiers may make a takeover offer for Potash that rivals a $38.6 billion hostile bid from BHP Billiton.”

Sorkin states that “The politically charged subtext is this: Do we really want the Chinese to control the company that has the largest capacity (in the world) to produce fertilizer?”
But this is not all from the morning papers as other headlines read “China Takes New Bite at U. S. Energy” (http://professional.wsj.com/article/SB10001424052748703794104575545992992771182.html?mod=ITP_moneyandinvesting_7&mg=reno-wsj) and “China Turns to Texas for Drilling Know-How” (http://professional.wsj.com/article/SB10001424052748703358504575545183782651388.html?mod=ITP_marketplace_0&mg=reno-wsj). It seems as if the China National Offshore Oil Company (Cnooc) is investing money in Chesapeake Energy, an investment “in onshore U. S. energy assets.”

Contrary to an earlier effort by Cnooc to acquire Unocal, a bid that caused grave concern in the United States Congress, this bid seems to be gaining favor because the Chinese will only have a minority ownership (one-third of the company) which means that this position will not be a “credible threat to national security.” The reason for this is that “Chesapeake will retain operational control of its…shale assets.”

What is the old saying about someone who gets their foot in the door?

But, this pattern is occurring all over the world as China intentionally expands its global reach in owning or influencing physical capital…owning all or part of companies.

And, who is underwriting this expansion? The United States government!

The United States government has outsourced to China and others the savings it needs to finance its massive deficits. The Federal Reserve System continues to keep interest rates excessively low exacerbating the credit inflation that that was begun at an earlier time.

And the response of the United States government? It is China’s fault that they are taking advantage of the excessive amounts of credit that have been created in the United States. And China will not change its behavior even as the United States government signals it will continue to follow the same policy it has followed for most of the last fifty years. No matter that this economic policy has brought the United States to the position it now finds itself in.

Bottom line: as Mallaby has argued, finance has been globalized and this trend cannot be cleanly reversed. Given that this is the case, continued efforts to inflate credit in the United States will only worsen the trade position of the United States and make the value of its currency sink even further. In such a situation, who cares about US firms outsourcing jobs to other countries. Instead, let’s just sell US companies to foreign interests and keep those jobs right here in the United States. That is, the jobs will not have to be outsourced to another country…they will just be outsourced to foreign-owned American firms located here in the United States.

National Discipline or the Lack Thereof

I read with dismay an editorial piece in the Financial Times this morning entitled “Germany’s rebound is no cause for cheer,” (http://www.ft.com/cms/s/0/2becafc4-b398-11df-81aa-00144feabdc0.html) by Wolfgang Mϋnchau. The conclusion of the piece: “Germany’s economic strength is likely to be persistent, toxic and quite possibly self-defeating in the long-run.

Germany’s economic strength is likely to be persistent because it is more disciplined than other countries in the Eurozone. The German fiscal budget is more under control than is that of other Eurozone countries, especially those on the periphery like Belgium, Italy, Greece, Spain, and Portugal and German wage moderation is significantly different from these other areas. This discipline is likely “to be persistent.”

Germany’s economic strength is likely to be toxic because the adjustment mechanisms do not seem to be in place within the European Union because it seems that “it remains surprisingly hard to shop cross-border in Europe and “the European labour market remains almost perfectly fragmented.” Furthermore these “peripheral” nations seem to lack the fiscal discipline of the Germans and they seem to be more dependent upon labor unions and those receiving “social benefits” than do the Germans. After years of giving out substantial “social benefits” to their people and after years of credit inflation to stimulate local economies and “keep the dance going” the politicians of these nations are not going to back off what has kept them in office in the past. Without changing their path, the peripheral nations will continue to suffer relative to the Germans and will continue to identify the Germans as the real problem-maker.

And, according to Mr. Mϋnchau, Germany’s economic strength is likely to be “quite possibly self-defeating in the long-run” because the European Union cannot allow these imbalances to continue and still keep the Union together. That is, Germany must become like these other countries or the political union will fall apart. Thus, by continuing to maintain its self-discipline, Germany could cause the dissolution of the European Union which would not be beneficial to it in the long-run.

I am very uncomfortable with this argument.

This argument, to me, says that in playing golf I should not work several hours every day on the practice range hitting ball-after-ball-after-ball, and I should not play several rounds of golf every week against very competitive golfers, and I should not practice my putting for each day for a lengthy period of time, and I should not train in the gym or run 35 miles every week to develop my physical conditioning, and I should not watch my diet and weight. Such discipline gives me an unfair advantage relative to those that are not willing to maintain this kind of discipline. My efforts will cause the resulting inequality in performance “to be persistent, toxic, and quite possibly self-defeating in the long-run.” Thus, I should not practice, etc..

Discipline, in the longer-run, conquers lack of discipline.

Now, I am not advocating the making of discipline into an idol. It is just that in order to achieve other goals and objectives, hopefully good goals and objectives, discipline is an important factor helping one to accomplish these other things.

One problem that arises when one fails to maintain self-discipline is that other problems often arise making it even more difficult to re-establish discipline when you try to get your life back in order. That is, a lack of discipline can make it just that much harder and painful to become competitive when one finally reaches the stage that getting back in the game is a vitally important goal.

The United States, to me, is an example of a nation that has lost its self-discipline. But, this loss is not just a recent problem. The movement in this direction began in the early 1960s and has been going on for about fifty years. Beginning in January 1961, the Gross Federal Debt has increased at a compound rate of more than 7 percent every year up to the current time. Inflation became such a problem that wages and prices were frozen in August 1971 and an extremely restrictive monetary policy had to be enforced in the late 1970s.

Economic leadership of the United States currently rests in the hands of individuals that were an instrumental part in the excessive credit inflation of the 2000s. Ben Bernanke was a member of the Board of Governors of the Federal Reserve System and a vocal supporter of Alan Greenspan’s move to keep the Federal Funds target rate around one percent in 2003 and beyond, having joined the Board in 2002. Timothy Geithner became President of the Federal Reserve Bank of New York in 2003. This position has a permanent vote on the Open Market Committee, so that Geithner was in on all votes during this time as was Bernanke. After a short stint as the Chairman of the President’s Council of Economic Advisors in 2005-2006, Bernanke became Chairman of the Board of Governors of the Federal Reserve System in February 2006. Geithner moved from the New York Fed to become Treasury Secretary in January 2009.

These two leaders, arguably the most important leaders in economics and finance in the United States government, have held top positions and been voting members of policy boards during one of the most un-disciplined times in United States history. And, their lack of discipline continues, as is evident by the speech given by Bernanke last Friday at Jackson Hole, Wyoming. The only policy that these two people follow is one of throwing everything they can at a problem and seeing what works.

The problem is that their interest rate efforts in the 2003 to 2005 period led to a housing bubble and stock market bubble which resulted in the collapse of the sub-prime market in 2006 and 2007. Their response to this break-down resulted in the financial disaster of the 2008 to 2009 period when the government threw just about everything it could at the disaster in order to try and avoid worse. We are now in 2010 and the evidence of the lack of discipline is still around us. Consumers are plagued with debt fostering record numbers of foreclosures and personal bankruptcies. Businesses are overwhelmed with debt, not only with high-yield bond debt but also with commercial real estate loans and foreclosures and bankruptcies are also high in this area. State and local governments are piled high with debt and we find that states and cities are cutting back on the most basic of services including the release of fire fighters and police. And, the federal government faces budget deficits that some estimate will result in $15 trillion or more in additional debt over the next ten years.

The United States has lived off of its position as Number One economic and military power for years and this has allowed it to be so profligate. Only China, in my lifetime, really seems as if it might be a potential threat to this position.

This lack of discipline has shown up in one spot, however. Since the United States dollar was floated in August 1971, it has declined by about 40 percent in value. There were three periods within this time frame when this general trend was challenged. First, was during the time that Paul Volcker headed the Fed and caused interest rates to reach post-World War II highs. Second, during the Clinton administration as the federal budget moved into surplus territory. Third, during the financial crises when the world seemed to be falling apart and there was a “flight to strength.”

In my book, history shows that discipline wins over the longer run. The United States is struggling because it lost its self-discipline. The criticism of Germany presented above shows the mentality in the west that is indicative of this undisciplined approach to living in the world today.

Looking at the Dollar Again

As European financial markets seem to be stabilizing, it is time to look again at the value of the dollar. After the heat over the sovereign debt crisis cooled somewhat the value of the dollar, once more, headed south. Over the past two years or so, global markets have seemed to be saying, if the financial world is going to fall apart today, I want to be holding some kind of dollar assets. However, if I am to bet on the value of the dollar over an extended period of time, then I want to hold assets denominated in other currencies.

As one can see from this chart showing a trade-weighted index of the United States dollar against the major currencies of the world, the general drift of the value of the dollar since the early 1970s has been downward. There are two major upswings. The first relates to the tightening of credit by the Federal Reserve under the leadership of Paul Volcker. This is the upswing that goes from about 1980 to 1986. The second upswing came during the federal budget tightening led by Treasury Secretary Robert Rubin which eventually resulted in a budget surplus and lasted from about 1995 into 2001.

During the last two years or so, there have been two minor upward movements in the value of the dollar. These minor swings came during the fall of 2008 into 2009 and in the spring of 2010 connected with the sovereign debt crisis in Europe. This last upswing seems to have peaked as the dollar, once again, heads downward.

Although the rise in the value of the dollar during the first of these movements was “across the board”, the primary reason for the rise in the value of the dollar in the latter period was the movement of money out of the euro. But, given the actions of the European Union and given the results of the “stress tests” applied to European banks, confidence seems to be returning to the Euro.

So, the long-run trend in the value of the dollar still seems to be downwards.

To me, the price of a nation’s currency is still the most important price in that nation. The fact that the long-run trend of the dollar is down highlights the fact that the international financial community continues to believe that there are still structural problems in the United States that must be dealt with. And, one can add, that these structural problems are not connected with one political party or the other. Both parties have contributed to these structural problems and, until there is a major change in the way Americans think, these structural problems will not go away. Hence, the bet is still on a falling value of the dollar.

What are the major structural problems?

Let’s start with just three. First, is the federal government deficit. Again, this is not a problem that has just occurred. The gross federal debt of the United States has increased at a compound rate of about 7% from 1961 through 2009. “Official” estimates of the deficit over the next ten years are for the deficit to increase by $8 to $10 trillion. I have been a little more pessimistic, arguing that the deficits will be more like $15 trillion. The lower estimate will still keep the growth rate of the debt above 7% a year.

Second, the commercial banking system has over $1.0 in excess reserves! The Federal Reserve is planning an “exit” strategy to remove these reserves from the banking system as the economic recovery picks up steam. However, there is little evidence provided over the past fifty years or so that the Fed can or will be able to keep these reserves from getting into the spending stream especially given the amount of the federal debt that is going to have to be financed over the next ten years.

Third, there are major dislocations in terms of the allocation of corporate assets, of corporate capital, both physical and human, in the United States. (See my post http://seekingalpha.com/article/216450-the-source-of-economic-success.) To correct these dislocations will take a lengthy period of time which indicates that the country will not recover as rapidly as it would if these dislocations did not exist. This will just exacerbate the problems caused by the two situations mentioned above. Again, this is seen as a negative in terms of pricing the dollar in foreign exchange markets.

I have been a dollar “bear” for a long time. The reason is that the general thinking about economic policy in the United States has been wrong since the early 1960s. International financial markets seem to support this assessment. And, this thinking appears in both the Republican and the Democratic leadership. I had hopes that changes were taking place when Paul Volcker was Chairman of the Board of Governors of the Federal Reserve System. I had similar hopes when Treasury Secretary Robert Rubin led the charge to reduce the federal deficits in the 1990s. In each case, “the dark side” eventually prevailed.

There is nothing I see in the future to make me think that the value of the dollar will rise except in times of global financial crisis where there is a “flight to quality”. But, these will eventually run out if nothing is done to resolve the longer-run issues. As far as I can see, there certainly is no leader on the present stage that can bring about the changes that are needed. Therefore, I remain “bearish”.

A Strong Dollar?

“It is very important to the United States that we have a strong dollar.”
So said the United States Secretary of the Treasury.

Yes, Paul O’Neill said that.

Oh, yes, John Snow said that.

And, Hank Paulson.

Oh, you say, that the quote is attributed to Tim Geithner, who made the statement yesterday at a news conference of Asia-Pacific finance ministers.

As my good friends would say, “you have to walk the walk, not just talk the talk!” Or, in the case of those looking on, “watch the hips, not the lips!”

The only public person alive today that, in my mind, has any credibility on this issue is Paul Volcker. And, it is Paul Volcker that has written, “A nation’s exchange rate is the single most important price in its economy; it will influence the entire range of individual prices, imports and exports, and even the level of economic activity. So it is hard for any government to ignore large swings in its exchange rate…” (This quote is found on page 232 in the book “Changing Fortunes: The World’s Money and the Threat to American Leadership” by Paul Volcker and Toyoo Gyohten, Times Books, 1992.)

The United States government has no credibility left when it comes to the value of the United States dollar.

During the administration of Bush 43, the value of the United States dollar fell by 37% against an index of major currencies from February 2002 to March 2008 while the dollar fell in value by 45% against the Euro from February 2002 to July 2008.

The United States dollar did rebound at the time of the financial crisis: up 19% against the index of major currencies and up 23% against the Euro.

However, since February of this year the United States dollar fell back by about 13% against the index of major currencies and by about 15% against the Euro.

In watching the hips, not the lips, we see, for the United States government, potential cumulative fiscal deficits of $15 to $20 trillion over the next 10 years. We have a banking system with almost $1.1 trillion in excess reserves during the two week period ending November 4, 2009. We are faced with an unknown “exit strategy” to remove these excess reserves on the part of the Federal Reserve System.

And all this with several other “shocks” on the horizon. Obama “owns” Afghanistan now and it is totally unknown what his “new strategy” for that country will mean in terms of more government spending. Then there is the health care initiative. Obama has said that the program should not add “one dime” to the deficit, yet all indications are that whatever is passed will add to the deficit, although we don’t know what that amount will be. Then there is the climate change bill along with some other proposals that are setting in the wings.

Oh, yes, people within the administration have suggested that the rest of the TARP money, whatever that amounts to, can be applied to reducing the deficit. Whoopee!

I hear the Obama administration talking the talk. I don’t see them walking the walk.

And what about Bernanke. He is staying particularly silent these days. Oh, yes, we learned from the New York Times earlier this week that he is letting Barney Frank do all his talking for him.

The strong dollar is, at present, a myth!

It will continue to remain weak and its value will continue to trend downward for the foreseeable future.

How far am I looking forward?

I will continue to believe that the dollar will remain weak until someone emerges that has some credibility. Right now, I don’t know where that person is going to come from.

It's the Dollar, Stupid!

“A nation’s exchange rate is the single most important price in its economy.” Paul Volcker

The value of the United States dollar is heading to the lows it reached in the summer of 2008. My belief is that the value of the dollar will reach these lows in the fall and then proceed to even lower levels in 2010.

The reason given for the current decline? The U. S. economy is getting stronger and the recession (Bernanke) is “very likely over.” In other words, uncertainty and, consequently, the financial market’s perception of risk are declining. A simple measure of the risk the financial market perceives is the interest rate spread between Baa-rated bonds and Aaa-rated bonds. The near term peak, 338 basis points, in this spread occurred in November 2008, a time when all hell was breaking lose in the financial markets. In recent weeks this spread has narrowed to about 120 basis points, a level that has not been seen since January 2008, one month after the current recession is said to have begun.

Financial markets are relatively calm and so market participants can direct their attention to some of the longer term issues that still have to be addressed in the world.

Of particular interest is the economic policy stance of the United States and not just the recent reprieve from economic collapse. The crucial elements? First, there is the massive amount of government debt that is projected to accumulate over the next ten years: maybe $10 trillion in additional debt; maybe $15 trillion; maybe more. Second, there is the Federal Reserve balance sheet that currently shows over $2 trillion in assets, substantially more than the $840 billion in asset the Fed held as late as August 2008.

This is a tremendous cloud hanging over the financial markets!

We know that the value of the United States dollar rose in late 2008 because of the crisis in world financial markets. Almost everyone concerned contends that this move came about as financial market participants moved to what they considered to be less risky assets, and that move brought them to U. S. Treasury securities and the U. S. dollar. This concern over risk was exhibited in the Baa-Aaa spread.

But, now with the strengthening of the U. S. economy and other economies around the world and with the calming of the financial markets, investors are moving their money out of dollar denominated assets. And, they are once again focusing upon the fundamentals of the economic policy of the United States government.

And what are the fundamentals? Just looking at the numbers one would have a difficult time telling the difference between what the Bush 43 administration did and what the Obama administration is doing. During the Bush 43 administration, there were massive increases in the federal debt and the Federal Reserve kept interest rates extremely low for an extended period of time. Now in the Obama administration we are seeing massive increases in the federal debt and the Federal Reserve is keeping interest rates extremely low for an extended period of time.
This is not a financial mix that participants in international financial markets like.

Let’s take a look at the historical record. We start during the Nixon administration because until August 1971 the value of the dollar was fixed in value relative to other currencies. But, once the value of the dollar began to fluctuate we saw some very consistent behavior in the currency markets. During the Nixon administration the gross federal debt increased at an 8.5% annual rate. The value of the dollar declined by 12.7% during this time period.

In the period between 1978 and 1992, the gross federal debt rose at a 12.6% annual rate. The value of the dollar only declined by 4.6%, but we must remember that during this time there was the period that Paul Volcker was the chairman of the Board of Governors of the Federal Reserve System and short term interest rates were pushed above 20%. As a consequence, the value of the dollar actually rose during the early part of the period even though the federal debt was continuing to increase. However, it was all downhill for the value of the dollar after 1985.

The exception to the other periods of time examined here was the 1992 to 2000 period. During that time the gross federal debt rose at a miserly annual rate of 3.6% and the value of the dollar actually rose by 16% during this period. By the end of the Clinton administration, the federal budget was actually showing a surplus.

Now we get back to Bush 43. During the 2001 to 2009 period the gross federal debt rose at an 8.5% annual rate. From January 2001 through to January 2009, the value of the dollar declined by 23.0%! (Through one stretch, the value of the dollar actually declined by more than 40%.)

With substantial budget deficits forecast into the foreseeable future, the Obama administration is causing the gross federal debt to continue to increase at annual rates that are relatively high by historical standards. The result? Since January 20, 2009, the value of the dollar against major currencies has declined by about 10.5%; the value of the dollar against the Euro has declined by more than 12%

I don’t believe that the current declines in the value of the dollar are just a result of the strengthening of the United States economy. To me, the fall in the value of the dollar is just a continuation of the market’s response to the general economic and fiscal policies of the latter part of the 20th century. Since at least 1971, the United States government has consistently deflated the value of the dollar.

In 1971, President Richard Nixon, as he embraced deficit spending, said that we had all become Keynesians. Unfortunately, he was right then and I fear that he is still right about the policy makers now in charge in Washington! Because of this I cannot see any long term relief in sight for the dollar. The debt of the federal government will continue to increase at a very rapid pace and the value of the dollar will continue to decline.

Long Term Treasury Yields and the U. S. Dollar

I still feel that the yields on long term Treasury issues and the value of the United States dollar are tied together. I have believed for some time now that long term interest rates will trend upwards over the next 12 months and that the value of the dollar will decline during the same time period. The strong rise in the 10-year Treasury and strong drop in the value of the dollar on August 3 just reinforce this belief.

In looking back at the 2002-2004 period there are too many similarities to feel comfortable. The Federal government is presenting us with large and growing deficits. Monetary policy is ridiculously easy. And, the dollar is under pressure.

What about long term Treasury yields? Well, in that earlier period the United States had the Chinese to pick up large amounts of the exploding Treasury debt so that long term interest rates did not have to rise significantly and the Federal Reserve did not have to monetize the debt.

The reason for the Federal Reserve behavior at that time? Chairman Greenspan was concerned that we might experience a period of deflation!

There are two theories why long term interest rates have not risen further than they have this year. First, there is still a concern among major investors about investment risk and as long as this concern lingers, funds from these investors will remain in long term Treasuries.

Now, there is a second reason given for long term interest rates remaining low and that is the enormous amount of liquidity in the commercial banking system. In recent weeks, commercial banks have started to expand their holdings of U. S. Government securities and this has put funds into the Treasury market with some of it spilling over into the longer end.

Why are commercial banks expanding their holdings of U. S. Government securities? Because the Federal Reserve has given out signals that it may keep short term interest rates low for an extended period of time: even into 2011. If this is to occur, then the reserves that the Fed has put into the banking system will have to stay for a while. That is, there will be no quick exit on the part of the Fed. Since the banks don’t want to lend to businesses or consumers they might as well get a higher yield than they do on reserves at the Fed by investing in market issues.

The reason for the Federal Reserve behavior at this time? Chairman Bernanke is concerned that we might experience a period of deflation!

As a consequence of the specific conditions of the present time, long term Treasury interest rates may not rise appreciably in the near term. However, I still believe that they will show a significant rise in the next 12 months.

I feel more certain about the decline in the value of the United States dollar. Participants in international markets are very reluctant to stick with the currency of a country that runs huge deficits with the strong likelihood that these large deficits will not go away for a long time.

Can you imagine a $2.0 trillion deficit this fiscal year and a Federal deficit of around $1.0 trillion a year for up to ten years! This is unsustainable, even for the United States.

And, what is going to fuel the further decline in the value of the United States dollar?

Oil prices. And, copper prices. And, gold prices. And, stock prices, And, housing prices. All these are rising now. As these asset prices continue to show strength, the value of the dollar will continue to decline. On August 2 I wrote a post called “Looking for Signs of a Recovery” (see http://maseportfolio.blogspot.com/). In that post I laid out some things to look for in determining whether or not the economic recovery is taking place. Rising asset prices is an important factor.

The trouble with rising asset prices at this time is that these increases are being underwritten by the extremely loose monetary policy. It is entirely possible that these asset prices may continue to rise while real economic growth remains dismal at best. And, in such a situation, consumer prices may not rise appreciably. Again, this is consistent with what we saw in the 2002-2004 period—asset bubbles and only moderate consumer price inflation.

Of course, a scenario that contains a continuing decline in the value of the United States dollar is not a good one for the Obama administration. It raises serious questions about the ability of the Federal government to finance such huge deficits as the ones that are forecast and still maintain relatively low long term interest rates without a major monetization of the debt. This whole scene seems like a replay of the first term of the Bush administration. There is just too much debt in existence. And, like the Bush administration, the Obama administration is experiencing a reduction in any “good” policy options that are available to it.

Known Unknowns

It is still too early to think that we are near or past the bottom of this economic downturn. However, in my mind, we are in the “working out” stage of the downturn, especially in the current economic restructuring we are going through, and we cannot expect this stage to be a short one.

The problem with many analysts and policy makers is that they continue to see our economic problems in Keynesian terms and think that the difficulties being experienced in banking and financial markets as a liquidity issue. Hence the search for evidence pointing to “green shoots” and for an “easing of credit.” Every day we hear when new statistics are released that the numbers just presented are “less bad” than before and this indicates that the economy is getting worse at a slower pace. An obvious sign that we are near the bottom!

In my mind, the two major issues facing the United States (and the world) are the structural problems in industry and finance and the debt problem. I have said all along that the basic cause of the financial collapse and the following economic dislocations comes more from the supply side of the economy than from the demand side as assumed by the Keynesians. And, because our problems are primarily supply side problems, governmental stimulus plans and deficit financing are not the incentives needed for restructuring the economy and putting people back to work.

In fact, demand side stimulus can even exacerbate the problems and slow down the changes that need to be made. Furthermore, treating the debt problem as a liquidity problem, as the Federal Reserve and the Treasury seem to be doing, can do the very same thing.

The “good news” is that most organizations and institutions have identified the major problems they will be facing in the near future. However, the “bad news” is that no one knows the depth or breath of the problems. The difficulty facing these organizations and institutions going forward is that these problems must be “worked through” and “worked out”. This “working through” and “working out” will take time and, since the problems are related and interconnected, the outcomes will be dependent on just how systemic and cumulative they are.

For example, greater unemployment due to structural reductions in the workforce who were employed making cars, producing parts, or selling cars will lead to more foreclosures on “prime” loans. (See “Job Losses Force Safer Mortgages to Foreclosure” in New York Times, http://www.nytimes.com/2009/05/25/business/economy/25foreclose.html?_r=1&em.) This will have further ramifications for the financial sector, housing construction and so on. The repercussions will continue on throughout the economy.

In the area of foreign trade, declining incomes lead to reductions in imports, but these imports are the exports of other countries. Countries that have built their economic growth and prosperity on their export trade face worsening times because of the decline in their exports. And, with the slowdown in these countries world trade declines. (See “Trade and Hard Times” in the New York Times, http://www.nytimes.com/2009/05/26/opinion/26tue1.html?ref=opinion.) There are more and more calls to prevent, if possible, further reductions in foreign trade in the world, especially relate to tariffs and other means of protectionism.

These are just two examples of situations where problems exist but where there is no real understanding of how far the cumulative interactions will take us. Many more situations like these exist at the present time. They are not problems that will be resolved through fiscal stimulus and the creation of government debt. There are three major problems with this response.

First, fiscal stimulus does not eliminate structural dislocations in the economy. The government (or no one else for that matter) does not know what the future structure of the economy will look like. Existing organizations, including financial institutions, can “re-tool” themselves, but this takes time and the exploration of different models for companies to find what works best. In terms of innovation, governmental funds can be made available for the next generation of energy sources and transportation systems and so forth, but no one knows exactly how these sources and systems should be put together. Restructuring and creative innovation take time and experimentation. One cannot “will” the right structure or the best innovation.

Furthermore, who wants to invest in something the government is the driving force in? Current events attest to emerging problems related to governance, decision making, and “the rule of law” when the government gets involved with a company or an industry.

Second, when the solvency problem is treated as a liquidity problem, the issue of solvency does not go away. The “toxic asset” program (P-PIP) developed by the Treasury and the efforts by the Federal Reserve to shore up various segments of the financial markets is just a “round-about” way of allowing the federal government to pay for the bad debts that are on the balance sheets of financial institutions. That is, the programs just allow the financial system to transfer financial losses to the government so that the tax payer will eventually end up with the bill for any insolvency that exists. Still, the question of the solvency does not go away.

Third, the government assumption that both problems, those related to economic restructuring and the amount of debt outstanding, can be solved by creating more and more debt is laughable if it were not so potentially tragic. International financial markets understand that in one way or another and at some time in the future, excessive amounts of government debt will end up being monetized. How this monetization works out in each particular case cannot be foretold. History has shown, over and over again, that at some time this connection between large amounts of debt and money creation becomes a reality. It cannot be avoided; it is just the timing that is uncertain.

The conclusions that can be drawn from this analysis are very straight forward. First, economic growth, even when it becomes positive again, will stay low for an extended period of time. My reading of the 1930s has lead me to believe that this decade was a time of industrial and financial restructuring (not helped very much by the government) and technological change. It was not a time that demand-side stimulus could help very much. The restructuring had to take place and World War II did not contribute to the recovery because of the added spending but because of the re-focus and restructuring of industry it forced on the nation. I believe that, like the 1930s, we may be facing an extended period of time in which we need to re-focus and restructure industry. One hopes that we do not need a world war in order to finally achieve this re-structuring.

Second, the continued creation of debt is not going to help. The government debt is going to be monetized at some time. The realization of this, I believe, has become a reality to the bond markets and the foreign exchange markets. To me, the yield on long term U. S. Treasury securities will continue to trend upwards in the foreseeable future and the value of the U. S. dollar will continue to trend downwards. The trends will continue unless some financial “miracle” takes place that eliminates the projected upcoming deficits in the government budget—perhaps an amazing recovering in tax receipts or massive savings discovered in the health care industry.

Third, whereas paper assets from the United States will not be that desirable internationally, physical assets will. For much of the two years or so ending in August 2008, the weak dollar allowed foreign countries and investors to buy U. S. companies at a record pace. With the rising strength of China, India, and Brazil, I believe that with the continued slide in the United States dollar, more and more U. S. companies and their physical assets will come into foreign hands. That is, until the U. S. Congress bans such transactions.