Euro Drops Below $1.30

This morning the value of the Euro dropped below $1.30.  The United States should thank the European Union for the diversion it has created.  With all the turmoil taking place in Europe, little attention is being paid to the monetary and fiscal policies of the United States and the impact these policies are having on the value of the United States dollar against other major currencies. 

As can be seen in the following chart the value of the United States dollar against other major currencies in the world continues its secular decline.  In terms of monetary policy and fiscal policy, international financial markets continue to give a negative rating to the United States and continue to see further future declines in the value of the dollar.

I continue to believe that, given the current policy leanings of the United States government, that the value of the United States dollar will continue to decline in the future.  Since the early 1960s the United States government, both Republican and Democrat, has generally followed a policy of credit inflation that resulted in the United States going off the gold standard and then resulted in the secular decline in the value of the dollar since President Nixon floated the dollar’s price in August 1971.  The two exceptions to this secular decline occurred when Paul Volcker was the Chairman of the Board of Governors of the Federal Reserve System in the early 1980s and when Robert Rubin was the Secretary of the Treasury in the Clinton administration in the latter part of the 1990s.

To me, there the Obama administration has continued the policy of credit inflation carried on by his predecessors and perhaps even improved upon it. 

The only times that the value of the dollar has rebounded over the past several years has been when there has been a “flight to quality” in US Treasury securities.  Other than this the value of the dollar has continued to decline except relative to the Euro.

Again, it seems to me that the United States should thank the European officials for all their follies because they have taken attention away from the political mess in the United States and the continued weakness in the value of the United States dollar in the world.   

The European Model: Broken Beyond Repair?

I am really tired of the German bashing!

The model for the Euro was unsustainable.  But, the lessons learned from the effort should not be taken lightly.

The major lesson from the experiment with the Euro is that a currency area cannot be set up without a central political body that is strong enough to enforce the rules of the currency area.  One can have separate states within the area, but, as in the United States, there must be a political union with enough authority to dominate the individual components of the area.

A second lesson from the experiment is that the economic model based upon “social engineering” is not sustainable.  The German economic model of low inflation, high labor productivity, and fewer government handouts has worked better than the model that includes substantial credit inflation, an inefficient private sector, and bloated government payrolls. 

And, as usual, the “losers” in the game cry foul against the successful. 

“The press review from around Europe does not make pleasant reading for the German foreign ministry these days.  ‘Look at this stuff, it’s just unacceptable,’ laments one diplomat—pointing to a front-page article from Il Giornale, an Italian newspaper owned by Silvio Berlusconi.  The piece links the euro crisis to Auschwitz, warns of German arrogance and says that Germany has turned the single currency into a weapon.  The Greek papers are not much better.  Any taboos about reference to the Nazi occupation of Greece have been dropped long ago.

Across southern Europe, the ‘ugly German’ is back—accused of driving other nations into penury, deposing governments and generally barking orders at all and sundry.

There is also a much more polite form of German-bashing going on at the official level.’ (http://www.ft.com/intl/cms/s/0/9d38ffee-5639-11e1-8dfa-00144feabdc0.html#axzz1mGnbTALH)

Economics, at one time, was defined as the study of the allocation of scarce resources.  That is, there are limits to what a country can attain given the amounts of human capital and physical capital that are available to it. 

Over the past fifty years, many countries came to believe that they had overcome these limitations and through credit inflation and social engineering they could achieve something beyond the boundaries set by the amounts of human capital and physical capital that existed.

Some of these programs included government created credit inflation that kept workers locked in jobs that were becoming legacy positions and that also promoted a home ownership scam that seemingly created middle-class piggy-banks; government hiring practices that resulted in excessive overstaffing of bureaucratic agencies (about one-third of the Greek workforce is in the public sector); and pension benefits that allowed for very comfortable early retirements. 

The economies of these countries just did not have the resources to sustain these programs. 

If everyone is following these policies then everyone is basically in the same boat.

However, a problem occurs if one or more other countries do not follow the same policies. 

The eurozone is having a problem because Germany, for one, has not taken the path most travelled.  And, over time, their more disciplined approach came out on top.

Germany now has the wealth, the resources, that others don’t.  Consequently, those that don’t have the wealth and are now struggling believe that Germany should compensate them for Germany’s success. 

The article quoted above states that the weaker countries in Europe are asking three things from the Germans: first, to commit more money to a European “bailout” fund that would be “so large that it would frighten the markets from speculating against southern European bonds”; second, to commit to Eurobonds to make the debts of individual countries the debts of the eurozone itself; and to stimulate the German economy so that Germans would buy more goods from southern Europe.

These requests, in my mind, are totally off-the-wall!

The Germans should not give in on these issues and they should maintain their position of strength.  And, the German-bashing should stop!

The eurozone is not going to get stronger by making every one of its members weaker!

This is because the eurozone is not the only game going on in the world.

Other areas in the world are maintaining their discipline and can only benefit, competitively, from a weaker eurozone.  Need I mention China?  And, Brazil?

And, these other areas of the world are growing in relative economic strength as Europe fights its own little family fights.  The pressures coming from this competition are not going to go away and Europe, as a whole, may have already postponed dealing with its problems for so long that it may still be years away from a resolution in which it becomes as competitive as it needs to be in the world of the 21^st century.

I still fail to see anyone in Europe that I would call a leader.  Consequently, I find it hard to defend the continued existence of the Euro, as we now know it.  At this point in time, I see several countries leaving the Euro over the next couple of years.  I see a much-diminished role for the eurozone in the world, both economically and financially.  I also see economic social engineering receding as a government policy in the western world even though Paul Krugman and Joseph Stiglitz will still be around.  The era of economic social engineering is past its prime, even though this fact is not fully recognized yet.

The United States should be grateful to the eurozone for the way it has conducted itself, otherwise we would be talking more about the fifty-year weakness in the value of the US dollar.       

Central Banks in Liquidity Action...Not Solvency Action

Here we go again!

The central banks acted yesterday and the markets went wild!  Six central banks acted in concert to make sure that European banks…and others…could get dollars if they wanted them.

This is a liquidity action!

It is an act to keep the flow of short-term funds flowing in world financial markets…just as these six central banks did after the Lehman Brothers failure. 

Once again, the definition of a liquidity crisis is that there is a short term need for “buyers” in a market because, for the short term, the “buyers” that are usually there are not there.  The “sellers” want to sell assets and obtain dollars.

“Buyers” without dollars are not what is wanted.  So the central banks are making sure that there are plenty of dollars available so that the “sellers” can sell their assets.

The emphasis, however, should be on the short-term nature of a “liquidity” crisis. 

The fundamental problem is still the solvency problem facing several of the sovereign nations of Europe. (See my post from yesterday, “European Debt Must Be Restructured,” http://seekingalpha.com/article/310994-european-sovereign-debt-must-be-restructured.)

Providing liquidity to the market will not resolve the solvency problem.  As almost everyone except the officials in Europe know, the efforts of the last two years or so to treat European debt problems as a “liquidity” issue has resulted in the situation we now find ourselves in. 

As in the past, central bank action has gotten a favorable response from stock markets around the world.  In the past, the quick, dramatic response to the central bank action has been followed by a retreat.  If nothing is done on the sovereign debt restructuring need, the stock markets will, in all likelihood, retreat once again.

The word out is that this liquidity action on the part of the central banks gives the officials in Europe some time to deal with the restructuring. 

But, the restructuring is also only a short-term response for eventually the eurozone must deal with the whole question of how the fiscal affairs of the eurozone will be handled.  The concern is that restructuring of the debt without reforming how the nations of the eurozone discipline their fiscal affairs just creates a situation in which fiscal irresponsibility can survive into the future.

Revising how the eurozone conducts its fiscal affairs, however, cannot be done overnight.  Yet, the financial markets must be given some kind of credible assurances that fiscal discipline will be forthcoming before they will really settle down. 

This seems to be the unknown…for the single currency framework will not last without the eurozone achieving some kind of fiscal unity.  Is this what Germany is holding out for?

So, is the problem going to be resolved now…or, are we just going through another cycle?

I still am not convinced that the Europeans, at this stage, possess the backbone to do what is necessary!

Oh, and once all these dollars get out into world markets…will they be withdrawn once the “liquidity” crisis is over?

Deficit Reduction: An Absence of Leadership

I spend a lot of time writing…and talking…about the credit inflation that has taken place in the United States over the past fifty years.  In my mind, this period of credit inflation set the stage for the Great Recession of December 2007 through July 2009.  It also set the stage for the debt overhang that burdens the United States economy to this very day.  It also will account for the mediocre economic growth that the United States will experience for the next four or five years.

Essentially this credit inflation laid the foundation for all the private sector credit expansion that took place during this fifty-year period and for the financial innovation that dominated the country in the latter part of the last century. 

Over the past fifty years, the Gross Public Debt of the United States increased at a compound rate of growth of approximately 8.0 percent.  Private debt rose somewhere between a compound rate of 10.0 percent and 15.0 percent. 

All of these figures exceed the growth rate of the economy, which averaged a compound rate slightly in excess of 3.0 percent.

When credit growth exceeds the rate at which the economy can grow, that is called “credit inflation.”  A good portion of this credit inflation has gone into consumer prices, but even more has gone into asset prices, or, has gone offshore.

The Gross Public Debt stands around $15.0 trillion as of this last October.  In just the past three years this figure has grown by about $4.0 trillion.

If this pace is continued, the Gross Public Debt will rise by more than $13.00 trillion over the next ten years, slightly below the forecast I have been putting out for the last year or more, which is $15.0 trillion or more.  I have argued that, given current attitudes, the government’s debt outstanding will double in the next ten years. 

I feel much more comfortable, at this time, arguing that the debt will double in the next ten years than I do that the debt will increase by only 50.0 percent or 75.0 percent. 

I have very little faith, at the present time, that much will be done to divert us from the path that we are on.  And, just ten years ago we were experiencing a surplus in the government’s budget.

It comes as no surprise, therefore, that I am not surprised in the breakdown in the deficit talks of the Congressional supercommittee.  There is no leadership in Washington to bring about a change in direction.  The President’s ability to lead the situation is almost non-existent given the evidence of the recent polling data on support.  And, Congress is even less able to lead given that polls on the public’s confidence in it are substantially below that of the President. 

The problem, as I see it, is that the leadership style of the President is to state, in general, what he would like…a health care bill, a financial reform act, an increase in the debt ceiling, and a deficit reduction plan…and then turns it over to Congress to come up with a plan.

The Republicans in Congress knows that they will not be punished if they stand up and take a very intransigent position.  They have become very direct in this in the last two skirmishes, because they knew that there was no way they would be called out.   They learned this from the first events surrounding the development of the health care bill and the financial reform act.  The Democrats in Congress have just been left out to “hang”.  You really don’t hear anything from them anymore.  They know they have the weak hand. 

So, I continue to predict that the federal debt outstanding will grow…and grow…and grow.

And, as the debt continues to grow, the value of the dollar will continue to trend downward.  Over this time period the debt of the United States government has trended upwards. 

Since 1971, when the dollar was taken off the gold standard, the dollar has declined in value by about 33.0 percent.  Since 1971, the debt of the government has increased by 39 times.  The reason that the dollar has not declined by more is that other countries have followed policies that are similar to those of the United States and the U. S. dollar is still the reserve currency of the world.

As the debt continues to grow, the value of the dollar continues to decline.   Here is the chart of the value of the U. S. dollar against other major currencies over the last ten years.   

The chart begins near the start of the Bush (43) administration.  The two years previous to the beginning of the Bush (43) administration, the federal budget was in surplus.  As can be seen, the value of the dollar was about 10.0 percent above the level it was at the time the dollar was removed from the gold standard.  As federal deficits rose through the last decade, the value of the dollar continued to decline, reaching historic lows earlier this year. 

Thus, I continue to be a pessimist about the ability of the United States government to get its budget under control and I continue to be a pessimist about the future value of the dollar.  We cannot expect to see the value of the dollar really get stronger until we achieve some control over our fiscal affairs. 

Given this view about the future, I continue to be a pessimist about the ability of the United States to maintain its economic lead on the rest of the world going forward. (See http://seekingalpha.com/article/309054-signs-of-the-future-developed-countries-vs-emerging-countries for more on this.) Right now, that is the environment I believe businesses and investors should prepare for.

Does a Declining Value of the US Dollar Reduce the Balance of Payments Deficit?

This blog was begun in February 2009. From the very beginning, I have been a “weak dollar” person, believing that the longer-term trend in the value of the dollar is downwards.

My reasoning for this is that the underlying economic philosophy of the United States government has generally been one of credit inflation in order to achieve rapid economic growth and low rates of unemployment and that this has been the case since 1961. And, my belief is that this economic philosophy has permeated both political parties, Republican and Democrat, so that the blame lies with “us” and not with a specific political party.

A consequence of this has been an 85 percent deterioration in the purchasing power of the dollar over this fifty-year period.

And, over this fifty-year period, the value of the dollar has declined by 35 percent against the currencies of major trading partners and more than 35 percent against many other currencies.

Many readers of this blog continue to argue that a decline in the value of the dollar is good because it helps the United States to achieve a lower balance of payments deficit since a decline in the value of the dollar will help us export more goods to other countries and will help reduce imports into the United States.

Floyd Norris has given us an article in the New York Times, “Euro Benefits Germany More Than Others in Zone,” that is important for us to consider. (http://www.nytimes.com/2011/04/23/business/global/23charts.html?_r=1&ref=business) In this article, Norris discusses how Germany has gained in “competitiveness” relative to other eurozone countries since the creation of the Euro. The point of the article is that as Germany gained in competitiveness, it’s balance of payments went from a deficit in 1999 to a surplus by 2002, with the surplus growing from there. Other eurozone nations have experienced just the opposite movement.

The competitiveness of a nation “is based on currency movements and changes in unit labor costs in major industrialized countries” Norris writes.

“German competitiveness against the rest of the world was probably helped by the fact that the relatively poor performance of other members of the eurozone held down the appreciation of the euro against other countries.”

Because of this, the other countries in the eurozone “lost competitiveness because unit labor costs have risen more rapidly in those countries. Absent the euro, many of the countries probably would have devalued their national currencies, but that is not possible as long as they remain in the eurozone.”

In effect, credit inflation plagued the other nations in the eurozone while Germany maintained its fiscal discipline keeping a constraint on unit labor costs.

Due to the loss of competitiveness, the balance of payments in these other countries either turned negative or became more negative.

I believe that the leaders of the United States should learn from this experience. To me, the United States has lost competitiveness relative to the rest of the world over then last fifty years. This loss of competitiveness has resulted in an increase in the balance of payments deficit carried by the United States, in spite of the falling value of the United States dollar.

Thus, since the dollar was floated in 1971, the value of the dollar against major currencies has declined by 35 percent. But, the United States lost the surplus it had in its balance of payments and moved into a deficit position in the early1980s. It was almost balanced around 1991 but then the deficit grew throughout the rest of the 1990s reaching its lowest point around 2007. Throughout this time, the declining value of the dollar did not seem to help correct the movement of the balance of payments into deficit territory.

And, I continue to believe that nothing has changed on the economic front. Both political parties in the United States continue to work out of the same playbook…regardless of all the rhetoric.

By focusing just on economic growth and low unemployment, the United States has worked its way into a very uncomfortable situation domestically, internationally, and with respect to the responsibilities it assumed in providing the world’s reserve currency.

As long as the leaders of the United States keep their eyes on the level of unemployment and economic growth and fail to appreciate the role that the value of the United States dollar plays in the overall strength of the country, the United States will continue to decline in international competitiveness and will continue to see the value of the United States dollar decline.

I know the United States is a world leader in many, many areas of the economic spectrum. Yet, the markets tell us a different story when it comes to the aggregate position of the United States in the world.

Yes, the United States is Number One…but, the value of the dollar has declined over the past fifty years, the bargaining position of the United States has arguably declined in world trade circles and more and more concern is raised over the use of the dollar as the world’s reserve currency.

What are the markets telling us? And, not just the short-run movements in the market but the general trends we see?

I believe that the world is telling us that we are fundamentally undisciplined, in our lives and in our finances. We innovate and are among the best at it. We have many of the best educational institutions in the world. There is so much that is good in the United States.

Yet, we live beyond our means and we take advantage of the privilege of having the world’s reserve currency to postpone the day when our debts come due.

There are some goals a government can achieve in terms of the economic policies it follows. Pushing higher rates of economic growth than the economy can attain does not seem to be one of these things. The United States economy has grown at a compound rate of growth of 3.1 percent for the last fifty years. The variance in this growth, on a longer-term basis, is very narrow. We do not seem to be able to grow much in excess of 3.0 percent over the long run, regardless of what we do.

In terms of achieving high levels of employment, low levels of unemployment, the record is not very good at all. In fact the variation in the unemployment rate over the past fifty years is quite high and the growth in under-employment over this time period is substantial.

But, the United States government has been very good in achieving a high rate of growth in its debt, the basis of credit inflation. The compound rate of growth of the public debt over the past fifty years has averaged around 9.0 percent per year. As a consequence, our overall competitiveness as a nation has declined and the balance of payments has remained substantially in deficit territory in spite of the substantial decline in the value of the United States dollar over this time period. You can point out all the areas you want in which the United States is a leader. The dollar continues to decline and our balance of payments fails to improve.

Here Comes the Chinese Yuan

What evidence have I got that the United States has mis-used its responsibility as the provider of the reserve currency of the world?

Look at the morning papers.

“Singapore Aims to be Renminbi Trade Hub,” in the Financial Times (http://www.ft.com/cms/s/0/64bac520-6a4f-11e0-a464-00144feab49a.html#axzz1JsjXsOj5).

“China Speeds Yuan Push,” in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052748704740204576272802457892870.html?mod=ITP_pageone_0&mg=reno-wsj)

In the first article we learn that Singapore has moved to become the first overseas center for trading the renminbi.  It was learned that Beijing will designate a Chinese bank to clear renminbi trades thereby allowing banks in Singapore direct access to the Chinese currency. 

In the second article we learn that China’s central bank is changing its rules so as to make it easier to bring funds raised offshore back onto the Chinese mainland.  This would mean that companies and governments could fund bonds and the purchase of goods in Hong Kong and the Chinese could move those monies around both into China and out to the rest of the world.

Although there seems to be no rush to make the Chinese currency fully convertible into other currencies, most analysts see this as just another step toward the Chinese currency playing a larger and larger role in world trade and finance. 

In the Financial Times article the authors claim that “The People’s Bank of China is pushing for a greater role for the renminbi in global trade and investment to reduce China’s almost total reliance on the US dollar.”

As is typical of Chinese strategy, there is no real hurry to achieve full convertibility and global position for their currency.  The move is slow and steady, building toward inevitability.  We need to remember this as the slow, patient, ascension of China proceeds in the twenty-first century.

No other country has really threatened the position of the United States dollar as a reserve currency since World War II.  This has been of great benefit to the United States and has allowed the US government to get away with a lot of things in international financial markets that it could not have done if it had not had the world’s reserve currency. 

Still, the failure of the United States to act in a fully responsible way relative to its providing the world’s reserve currency seems to finally be catching up with it. 

Beginning in the 1960s, the United States government began fifty years of credit inflation.  The first victim of this prolificacy was the international gold standard, which ended on August 15, 1971 when president Richard Nixon announced that the value of the dollar would now be floated in the foreign exchange markets. 

The second victim was the purchasing power of the United States dollar.  A dollar that could purchase a dollar’s worth of goods and services in 1960 could only purchase about fifteen cents worth of goods and services in 2011.  That is, the purchasing power of the dollar declined by 85 percent during this fifty year time period!

The third victim was the value of the United States dollar in the foreign exchange markets.  Since the United States dollar was floated, the value of the dollar against the currencies of other major trading partners has declined by about 35 percent.  It has declined by even more against the currencies of other countries the US trades with. 

The United States has profited greatly over the past fifty years or so by having its currency serve as the reserve currency of the world.  Treasury Secretary Geithner drew on this fact the other day when he claimed that the world was still very comfortable buying US Treasury securities. 

Yet the confidence of the world Geithner claimed for the purchase of US Treasury securities is sadly tarnished by the performance of the United States dollar in world foreign exchange markets.  The United States has benefitted from its position as the supplier of the reserve currency, but it has abused its responsibility of being the supplier of this reserve currency by following a path for fifty years of fiscal and monetary policy that undermined the value of the currency.

Now, there is a rising star in the world that threatens the position of the United States dollar.  As I remarked above, the Chinese currency still has a long way to go to dethrone the United States dollar.  What we must notice, however, is that the fault lines seem to be forming.

It will be interesting to see what the leaders of the United States government do as this situation becomes clearer. 

Almost One-Half of Cash Assets in Commercial Banks are Held by Foreign-Related Institutions

Check this out: on April 6, 2011, Commercial Bank Reserve Balances with Federal Reserve Banks totaled $1.503 trillion (Federal Reserve Release H.4.1); for the two weeks ending April 6, 2011, Excess Reserves at depository institutions in the United States averaged $1.431 trillion (Federal Reserve Release H.3); and on March 30, 2011 Cash Assets held by Commercial Banks in the United States were $1.558 trillion (Federal Reserve Release H.8).

All these measures of excess cash in the commercial banking system seem to center around $1.5 trillion.

The Federal Reserve also reports that on March 30, 2011 the cash assets held by Foreign-Related (banking) Institutions in the United States totaled $702 billion or right at 45 percent of the cash assets held by commercial banks in the United States on that date!

The Federal Reserve policy of Quantitative Easing (QE2) is supposed to spur on bank lending which, hopefully, will contribute to a faster growing economy and lower unemployment.

The published figures indicate that a very large portion of the funds the Fed is injecting into the economy is going into the “carry trade” and contributing to the spread of American liquidity throughout the world.

One rationale that has been given for the policy that the Fed has been following is that when commercial banks aren’t lending (that is, there is a liquidity trap), the Federal Reserve needs to inject as much liquidity into the banking system as possible until the banks begin to lend again. This is the essence of quantitative easing.

This rationale was developed by people who studied the history of the Great Depression. Milton Friedman contended that a central bank should follow such a policy when faced with a banking system that was not expanding the money stock. Professor Ben Bernanke also suggested that such a policy be followed.

However, in the current environment, there are two things that seem to be different from that earlier period. The first relates to the international mobility of capital: in the period around the 1930s nations did not support the free flow of capital throughout the world because the international financial system was based on the gold standard and foreign exchange rates fixed in terms of the price of gold.

Thus, with international capital flows constrained, it was argued that a country could keep a fixed foreign-exchange rate for its currency and conduct its economic policy independently of other countries, thereby allowing the country to focus on reducing unemployment to more acceptable levels. The policy prescription advocated by Friedman…and Bernanke…could, therefore, be followed within such a world without major foreign repercussions.

This is not the situation that exists now. Capital flows freely throughout the world.

The second factor is that there was no designated national currency that was designated as the “reserve currency” of the world. Thus, currencies were seen as either fixed in value or were allowed to freely float in foreign exchange markets. (I am not dealing with “dirty” floats and so forth at this time because they are related to currencies that are not designated as “reserve” currencies.)

And, since the United States dollar serves as the reserve currency of the world and, because of this, is the default currency when there is a “flight to quality” in world financial markets, the value of the dollar does not fall to the level that is needed to allow the Federal Reserve to conduct its monetary policy independently of all other nations.

The consequence is that the Federal Reserve is inflating the whole world!

It is great for the currency of a country to be the reserve currency of the world. However, being the reserve currency of the world carries with it responsibilities.

One of these responsibilities is that the United States cannot conduct its monetary policy independently of everyone else!

The value of the United States dollar is higher than it would be if it were not the reserve currency of the world. As a consequence, the behavior of the value of the United States dollar does not act exactly as if it were determined if it were a freely floating currency in the foreign exchange markets.

Therefore, the monetary policy of the Federal Reserve, given the free-flow of capital throughout the world, cannot be conducted in isolation.

We are seeing the result of this situation right before our eyes.

The Federal Reserve is pumping money like crazy into the commercial banking system. And, 45 percent of the money is ending up in foreign-related financial institutions.

This, I believe, is not what the Federal Reserve wanted.

This, I believe, is not what the people of the United States wants.

And, I believe, that this is not really what the rest of the world wants.

Still, QE2 continues, unabated.