United States At Blame for Eurozone Problems?

Recommended read this morning, the op-ed piece by Kenneth Rogoff, “The Global Fallout of a Eurozone Collapse,” in the Financial Times. (http://www.ft.com/intl/cms/s/0/e66a3d7c-9073-11e0-9227-00144feab49a.html#axzz1OaJbLwdu)

“It is ironic that the euro…is suffering from having an overly strong exchange rate, particularly against the dollar, and at precisely the moment when a huge depreciation would be most helpful.”

“I think it would be more accurate to say that markets are more worried... about the US’s lack of a plan A than Europe’s lack of plan B.”

“Unfortunately…the euro is looking very much like a system that amplifies shocks rather than absorbs them.  The UK, which of course did not adopt the euro, has benefited from a sharp sustained depreciation of the pound.  The peripheral countries of Europe are meanwhile stuck with woefully weak competitive positions and no easy adjustment mechanism.  European leaders’ plans to achieve effective devaluation through major wage adjustment seem far-fetched.  The only clean rescue for Europe would be if growth far outstripped expectations.  Unfortunately, post-financial crisis growth is likely to continue to be hampered by huge debt burdens.”

The worst of all worlds for this crisis…stagflation.

And, the United States continues to pound away creating more and more credit inflation for itself and the world…both in terms of monetary and fiscal policies.  (See my post about the Fed’s feeding of world inflation: http://seekingalpha.com/article/273506-cash-assets-at-foreign-related-financial-institutions-in-the-u-s-approach-1t.) 

“The markets are more worried about the US’s lack of a plan A…”

To me the world is seeing the current leadership in Washington, D. C. as little different than any group of leaders in Washington, D. C. over the past fifty years.   For the past fifty years the government debt produced by the United States government has risen at a compound rate of growth of more than 8 percent per year.  Economic growth has averaged a little more than 3 per cent every year for this same 50-year period.  

This is “credit inflation.”

And, the value of the dollar?

In 1961, at the start of this binge, the value of the dollar was pegged to gold.  In August 1971, President Nixon floated the dollar.  With the open capital markets that arose in the 1960s, a country could not independently follow a policy of credit inflation and keep the value of its currency fixed. 

Since the dollar was floated, the general trend in the value of the dollar has been downward with three exceptions.  The first was in the Volcker years of the early 1980s; the second was when Rubin was Secretary of the Treasury in the late 1990s; and the third was in the world rush to quality during the financial crisis of 2008-2009. 

The leaders of the United States have not had a plan to halt the decline in the value of the dollar for the past fifty years.  And, the Obama Administration is no different from any of the other administrations that preceded it since 1961. 

United States government officials have stated their support for a “strong” dollar throughout this time and yet have done little or nothing to stem the decline.

Again, “watch the hips and not the lips!”

And, the longer-term trend in the value of the United States dollar is still downward.

However, in an interdependent world, actions have repercussions elsewhere.  And that is what Rogoff is calling our attention to.  The policy actions of the United States government impact others.  And, the blanket government policy of credit inflation followed by Republican and Democratic Presidents over the last 50 years has come to dominate the world. 

Not only is it exacerbating the sovereign debt problems of Europe, it is spreading inflation throughout the world as the US dollars pumped into the US banking system by the Federal Reserve flow almost seamlessly into commodity markets throughout the world. (Again, see my post from yesterday.)

The irresponsible creation of debt and more debt does come to a limit.  And, as one approaches the limit, the number of options available to the issuer of the debt shrink in number as the desirability of those options also lessen. (“Debt Ultimately Leaves You With No Good Options,” http://seekingalpha.com/article/271651-debt-ultimately-leaves-you-with-no-good-options.)

The United States is experiencing this difficulty as we speak.  There are “things” the government would like to get into but can’t because there is no fiscal room for anything more, and there are “things” the government must get out of but don’t want to because they are in political favor. 

In a world of excessive debt, there are no good choices…period!

Rogoff goes on to talk about whether or not the world will succeed in forming a co-reserve currency system.  This would happen as the benefits of the co-reserve currency system were observed which would result in a trend towards the consolidation of currencies throughout the world. 

The current period of stress, Rogoff argues, is a period of learning.  “Having a smaller number of currencies is a phenomenon that makes a lot of sense economically, economizing on transactions’ costs and leveraging economies of scale.  The real question is whether common currency is sustainable politically.  My guess is that if the current slow patch in global growth does not quickly subside, we will not have to wait long for an answer.”

A Problem With Large Government Deficits

 When one discusses large government deficits the discussion generally centers on either the ability of the government to finance those deficits in financial markets or the need to “monetize” the debt, thereby creating the possibility of substantial future inflation.

There is another problem that doesn’t get as much attention yet is very, very important for the running of the government.  It is a problem the United States government is now facing. 

If a government (or anyone for that matter) is running a large deficit in its financial budget then the very existence of such an excessive budget restricts the government in what else it might be able to do.  That is, the government’s flexibility in taking on new expenditures is severly limited. 

The United States government is facing this problem in several areas at this very moment.  Let’s review a couple of them.

The United States government is facing tremendous competition from China in international trade and finance.  The United States is very limited in its ability at this time to respond to the initiatives that the Chinese are making in the world…politically and economically. 

“Flush with capital from its enormous trade surpluses and armed with the world’s largest foreign exchange reserves, China has begun spreading its newfound riches to every corner of the world—whether copper mines in Africa, iron ore facilities in Australia or even a gas shale project in the heart of Texas.”  This comes from the article “As China Invests, U. S. Could Lose,” in the New York Times. (http://www.nytimes.com/2011/05/04/business/global/04yuan.html?ref=business)

A “study, commissioned by the Asia Society in New York and the Woodrow Wilson Center for International Scholars in Washington, forecasts that over the next decade China could invest as much as $2 trillion in overseas companies, plants or property…”

The United States government and United States business does not have that much “dry ammunition” to combat such an investment program.  And, as U. S. government policy continues to underwrite a weak dollar, the ability to take on such an investment program internationally continues to fade into the background.  But, other BRIC nations pose such a challenge as well.

Yet, the United States cannot afford to be un-competitive in this area.

Also this morning we read about the plight of United States regulatory agencies: “US Regulators Face Budget Pinch as Mandates Widen.”  (http://dealbook.nytimes.com/2011/05/03/u-s-regulators-face-budget-pinch-as-mandates-widen/?ref=business)  In effect, as Congress has given banking and financial regulators more to do, due to the recent financial crisis, the regulators find that they are finding less and less money to carry out the new charge they have been given. 

Many of us may not be upset with this situation, still it points to the fact that with the large budget deficits forecast into the future, the United States government just cannot commit to fund certain programs people have wanted to see become more aggressive. 

One final situation that has recently occurred.  This has to do with the situation in Libya.  Many have argued that the United States cannot take on more military roles in the world because it just cannot pump up the expenditures on the budget to meet such responsibilities.  Consequently, since it favors military actions in selected spots, such as the one in Libya, it cannot fully participate in the exercise and must get others, like NATO, to carry the burden of the effort.

The question then becomes, “Is this budget constraint keeping the American government from doing things in other areas it believes it should be involved in?”  Like in Yemen or Syria?

The problem is that one can’t do everything…even if that “one” is the richest and most powerful nation in the world and oversees the reserve currency of the world.  And, this is the problem with lots of debt.  It allows “one” to live beyond ones means for a while…but then there is always the possibility that “one” will need to do more…and can’t.

It is an issue of management and discipline.  One cannot constantly push debt limits to the extreme and then expect to be able to go further into debt should the occasion arise at some time in the future. 

Boy, this idea seems “old fashioned”!

But, this is exactly what the United States government has been doing…and it has been doing it for an “extended period”…it has been doing it since the 1960s.  This is the foundation of the credit inflation we have been experiencing for the last fifty years.

And this is the foundation of the decline in the value of the United States dollar for the past fifty years and for the terrible balance of trade situation the United States finds itself in which has led to the surplus of dollars in the hands of the Chinese and others. 

I know…if the value of the dollar declines, the trade deficit should get smaller.  I tried to respond to this issue earlier.  See my post “Does a Decline in the US Dollar’s Value Reduce the Balance of Payments Deficit”: http://seekingalpha.com/article/265072-does-a-decline-in-the-u-s-dollar-s-value-reduce-the-balance-of-payments-deficit. 

The value of the dollar continues to decline because those in international financial markets don’t observe the “management and discipline” in the Unites States government that is necessary to change what goes on relative to the budget of the United States government. 

In my view, the United States government does not have to do much to gain the confidence of world financial markets.  The first thing the government must do is accept the goal of maintaining the value of the United States dollar in foreign exchange markets as its primary economic objective.  (I have discussed this in a post to my Instablog, “What is Needed to Reduce the Federal Deficit”: http://seekingalpha.com/author/john-m-mason/instablog.)

This would allow two things to happen.  First, the United States government could get away from its current primary goal, the Keynesian goal of achieving full employment, which it cannot accomplish anyway. (See my post from yesterday: http://seekingalpha.com/article/267307-the-new-way-of-conducting-business.)  The exchange rate goal incorporates an inflation goal within it.

Second, the government needs to focus on “good” long-term management and discipline in its budgetary practices.   Good, long-term management pays off.  My recent example of this is the efforts led by Treasury Secretary Robert Rubin in the latter part of the 1990s to balance the United States budget.  International financial markets saw this effort; believed that President Clinton and others within his administration supported the effort; and the value of the US dollar began to climb in foreign exchange markets even before a balanced budget was achieved. 

The important thing to note is that the economy also got stronger during this time so that the government achieved not only a greater balance in the budget and a rising value of the US dollar, but it also saw the US economy continue to grow.  International financial markets approved of the “management and discipline” that it believed it saw in the United States government.  Plus, this effort created some room for the Bush 43 administration to add additional “unexpected” expenditures to the budget ,as they were needed, such as the “war on terrorism.

Trichet: It's All About A Strong Euro

Jean-Claude Trichet, the President of the European Central Bank (ECB), made headlines toward the end of last week by suggesting that the ECB might have to raise its major interest rate in April.


This suggestion raised quite a bit of controversy and also helped the Euro to rise, briefly, to more than $1.40 per Euro. It also, some said, set the stage for the weekend in Europe and the upcoming discussions about fiscal affairs in the eurozone countries. (http://seekingalpha.com/article/256255-meanwhile-back-in-europe-a-view-of-the-ecb-inflation-and-other-matters)


Trichet has been as hardnosed as anyone in recent years about keeping inflation in check. And, since 2003 when he became President of the ECB, he has been adamant about maintaining an inflation target as the primary objective of the central bank.


In doing so, he has been relatively successful in allowing eurozone economies to expand while keeping the Euro strong, especially against the United States dollar.







In this chart we see an almost steady climb in the dollar/euro exchange rate from about 2002 until late 2008 when the financial markets began to collapse and there was a “flight to quality” toward the United States dollar.

As market participants moved back into “risk” in 2009 the dollar/euro exchange rate began to rise again, roughly reaching $1.50 per Euro. The sovereign debt crisis in the eurozone resulted in another drop in the exchange rate but the Euro began to rise again once Fed chairman Bernanke started talking up his plans for Quantitative Easing, Part II, for the Federal Reserve in late August 2010.


The strength of the Euro, especially against the United States dollar, should be seen as a source of pride for the President of the ECB. Trichet, a Frenchman, saw how upsetting inflation or the threat of inflation could be in international financial markets when he served in the Treasury Department in France during the time that Francois Mitterrand was the President of the French Republic.

Mitterrand was a socialist and who came to power in 1981. Early in his first term, Mitterrand followed a radical economic program, including nationalization of key firms. The economy developed a serious inflationary problem and money fled France causing a substantial decline in the French Franc. After two years in office, Mitterrand made a substantial u-turn in economic policies. In March 1983 he presented the so-called “Liberal turn”, in which priority was given to the struggle against inflation so that France could remain competitive within the European Monetary System.


The young Treasury Department official took note of this and applied the lessons learned when he became a Governor of the Banque de France, a Governor of the World Bank, an Alternate Governor of the International Monetary Fund and the President of the ECB.

Leading the European Central Bank is one thing, but the ultimate success of Trichet’s efforts to keep European inflation under control is also dependent upon the European Union (EU) getting its fiscal act under control. The sovereign debt issue and its resolution amongst the eurozone countries is crucial to the EU in keeping inflation under control and even whether or not the Euro will continue to exist.


The problem in the eurozone is that the limits or restrictions on independent sovereign nations to conduct their own fiscal policies have not been very effective. The leaders of the EU are going to have to reach some satisfactory solution to this problem or there will be continued attacks on the sovereign debt of the less disciplined countries and this will tend to bring with it attacks on the Euro.

In my view, the EU has two choices. It either moves toward the German model of conservative fiscal control of governmental budgets or it fails to bring sufficient controls on less-disciplined governments which, to me, is basically saying that the EU will err on the side of not offending anybody.


To err on this latter side is to seal the fate of the Euro. If one takes the “weaker” side, if one allows the less-disciplined to get-away with their lack-of-will, then the financial problems of the eurozone will continue and there will be a movement away from the Euro. Over time, the value of the Euro will slowly deteriorate. The Germans will not remain in such a union and the Euro will become “legacy.”

Trichet hopes, I believe, that the Germans will prevail in determining the fiscal parameters of the European Union now being discussed. This, to me, is the only hope for the Euro surviving in the longer run. In this, the Germans win…which a lot of people in Europe…and elsewhere…don’t really want to see.

Ultimately, however, the more fiscally prudent nation will prevail whether or not the Euro does. I believe the Germans don’t want the Euro to become history, but they are not willing to sacrifice their economic strength and benefits to live with the excesses of other governments. It is good to be economically strong!


Thus, to Trichet, it’s all about a strong Euro. He has done his job in setting the stage for the continuing discussions within the EU over the future of eurozone cooperation, fiscal policies, and debt restructuring. For the eurozone to be a strong player in the global economy in the future, the EU must have a strong currency. Trichet has done his job in an effort to achieve this goal.

The Bear and the United States Dollar

I continue to be a long-term bear on the United States Dollar.

The credit inflation that is looming on the horizon in the United States over the next decade is daunting. Financial leverage is going to increase once again and financial innovation, spurred on by advances in information technology, is going to this future.

This is what people do in a period of strong credit inflation.

Chairman Bernanke says he doesn’t see any signs of a buildup of inflationary expectations.

This analysis comes from a man who has been late for every economic event during his ten-years of leadership in Washington, D. C.

Inflationary expectations may not be showing up significantly in bond yields, but inflationary expectations continue to dominate the markets for the U. S. Dollar.

Inflationary expectations are not showing up to any extent in the government bond market because of the pressure kept on this market by the Fed’s quantitative easing efforts. The Fed, given the magnitude of its actions, can keep even long term interest rates lower than they would be otherwise.

The Federal Reserve cannot achieve the same success in the foreign exchange market, especially if it is flooding the financial markets with liquidity.

Foreign exchange markets look for governments that are “out of control” in terms of their fiscal affairs. Large deficits and growing levels of debt contribute to an environment of credit inflation. That is, not only does the government debt increase in such an environment, but the incentives are established by the government so that private debt levels also increase. If such credit inflations are observed by foreign exchange markets to be excessive relative to what is occurring in other countries, the value of the currency in the country that is least disciplined will decline relative to these other countries.

The last time the foreign exchange markets appeared to believe that the United States government was managing its budget in a relatively prudent way was in the late 1990s. Beginning in early 1995 when the Clinton administration began bringing the fiscal deficits of the country under control, the value of the dollar against major currencies (Federal Reserve series) rose by almost a third until January 2001 when Bush 43 took over as President.

The value of the dollar reached its near term peak in February 2002, just after 9/11, after the “flight –to-quality bid up the currency during this uncertain time. However, the budget policies of the Bush 43 administration became clearer to foreign exchange markets as the spring of 2002 progressed and the value of the dollar began to decline.

The credit inflation begun during the Bush 43 presidency continued into the Obama administration. From February 2002 through February 2011, the value of the dollar declined by almost 36%!

Some recovery took place in the value of the dollar last year as a result of the turmoil in the sovereign debt markets in Europe. However, to me, when United States credit inflation surfaced again in the late summer of 2010, it was very obvious that the focus of foreign exchange markets turned almost immediately toward selling the dollar.

The event of the late summer was the speech by Chairman Bernanke which introduced the forthcoming QE2, the second round of quantitative easing. The value of the dollar has fallen since then, indicating that the attention of foreign exchange markets was still on the lack of fiscal and monetary discipline in the United States government.

Since the summer of 2010, the value of the dollar against major currencies has declined by about 9%.

Furthermore, foreign exchange markets are showing no confidence in the fights now taking place in the United States Congress concerning the “battle-over-the-budget.”

To me, foreign exchange markets are saying that there is no leadership on fiscal matters (or monetary matters) in the United States government. Everything is the same as it has been for the last fifty years. And, we see no evidence that anything will be changed in the foreseeable future.

In addition, the rise in the price of oil due to the turmoil in the Middle East seems to raise further questions about the United States economy and this is adding to the downward pressure on the value of the dollar.

How much more will the dollar have to fall?

Barry Eichengreen, an expert of the international monetary system, gives us his estimate in the Wall Street Journal this morning. He argues that “the dollar will have to fall by roughly 20%.” The time frame seems to be over the next five years or so. (See http://professional.wsj.com/article/SB10001424052748703313304576132170181013248.html?mod=ITP_thejournalreport_0&mg=reno-wsj.)

Given this scenario, Eichengreen also sees the role of the United States dollar as the world’s primary reserve currency declining. Besides the lack of fiscal discipline in the United States and the proliferation of financial innovation in the world, he argues that there are now some legitimate alternatives to the dollar in global trade. The euro and the Chinese yuan are being used more and more in world trade and given the further decline in the value of the dollar this trend for the euro and the yuan will continue.

This outlines the picture that I am working with when I take my bearish position with respect to the long-run value of the United States dollar. In a world where capital flows very fluidly throughout the world, even a country as powerful as the United States, a country that possesses the globe’s reserve currency, cannot operate as if the rest of the world doesn’t exist.

Yet, that seems to be the view of the leaders of the United States and I don’t see that attitude changing anytime soon. Thus, the value of the dollar will continue to decline.

Deficits, Credit Inflation, and the Dollar

Over the past decade, but especially over the last year or so, there has been a concern over when the “deficit sharks” are going to turn against the United States bonds and the United States dollar. This question has certainly arisen in the minds of many as the Eurozone has been attacked and the Chinese make moves to make their currency “more international.”

My answer to this is that the debt of the United States will not really come under attack until the United States dollar ceases to be the one reserve currency in the world. And, the United States dollar will continue to be the one reserve currency in the world for a relatively long time.

It has been the status of the United States dollar that has allowed the United States government to “get away” with its fiscal irresponsibility for the past fifty years and it is this status that will allow the United States government to “get away” with its fiscal irresponsibility for a while longer.

Since the United States debt can always be paid off with United States dollars people and nations will hold the American debt and will rush to it when there is a “flight–to-quality.” This is just what we have seen over the past fifty years, especially during the worldwide financial crisis 0f 2008 and 2009.

The United States government took on a new philosophy in the 1960s, a philosophy that allowed that it was alright to run fiscal deficits, not only in periods of recession but also in “good times” so as to achieve higher rates of economic growth and keep people employed. This philosophy was inaugurated by the Kennedy administration and was absorbed by the Nixon administration and became the backbone of the economic policies for both Republicans and Democrats continuing into the present.

This “philosophy” achieved the following results: a decline of 85% in the purchasing power of its currency; under-employment in the economy reaching at least twenty percent of the workforce; and an income distribution that is highly skewed to the wealthy.

The philosophy called for a “credit inflation” in the United States economy that would result in prices rising on a regular basis which would put people to work and with a special emphasis on home ownership for almost all Americans which provided these citizens with an asset that constantly rose in price and which became the “piggy bank” of middle classes.

The debt of the United States government has increased at a compound rate of about 7% since 1960 up through the beginning of the Great Recession.

Prices rose at rate just below 4%, as measured by the implicit price deflator of Gross Domestic Product, during the same time period.

The rate of growth of real Gross Domestic Product rose by slightly more than 3%.

During this time period the value of the United States dollar declined.

The period started off with the price of the United States dollar fixed according to the Bretton Woods rules for international finance. By the end of the 1960s, sufficient inflation had been created along with rapidly increasing capital flows throughout much of the world so that the fixed exchange rates could no longer hold. As a consequence, the United States dollar was floated on August 15, 1971 by Richard Nixon and the race was on.

Dollar indices have only been in place since about 1973 because the dollar only began floating in late 1971. But, since then the value of the United States dollar measured against major currencies has declined by about 25%. (Remember the other major countries inflated their economies as well. And, many had currency crisis as well during this time period.) Against a broader range of currencies the dollar has declined by closer to 70% over the same time period.

There is no question that the “rest of the world” believes that the economic policies of the United States government are flawed. Just look at what the market is telling us!

However, the United States dollar is the one reserve currency of the world. Thus, the United States can get away with a lot of “stuff” that other governments cannot get away with.

And, the United States government has constantly argued that it is for a “strong dollar.” And, by the United States government I mean both Republicans and Democrats.

The United States government has lived off of its privileged position of having the one reserve currency in the world. It continues to live off of this privilege because it is still going to be a while before the United States dollar loses its position as the one reserve currency in the world.

This privilege has meant that the United States government does not have to conduct a “disciplined” fiscal policy because any consequence of its lack of discipline is sufficiently far off in the future to not really matter.

I presented my response to the current budget proposal of the Obama administration and the Republican posturing in my blog post of February 15. See “The Obama Debt Machine,” (http://maseportfolio.blogspot.com/). My conclusion is that we will have more of the same…more credit inflation.

So, that is my forecast for the “alpha” investor: the economic philosophy of the United States government has not changed.

Oh, there will be interludes in which “prudence” is popular. These will be like the “Volcker interlude” in the late 1970s and early 1980s when monetary policy was used to try and stop inflation, and the “Clinton interlude” in the 1990s when the federal budget was brought into balance. But these were just temporary diversions from the trend.

Maybe Charles “Chuck” Prince, the former chairman and chief executive officer of Citigroup, will have the last laugh. Prince, who made the remark that captured the attitude of the early 2000s, stated that “as long as the music keeps playing, you’ve got to get up and dance.”

In periods of credit inflation, taking on more debt, taking on more risk, mismatching maturities, and aggressive financial innovation pays. As Prince admitted, Citigroup got up and danced.

Dancing pays during a credit inflation. However, you need to be agile enough to sit out the intermissions when the musicians take a break as they did during the Great Recession.

All indications point to the fact that the “music” will continue on. The name of the dance is “credit inflation” and this dance will continue, with some periods of intermission, until the United States dollar ceases to be the one reserve currency of the world. Until then there seems to be little or no way to discipline the United States government for its profligate budgetary ways.

How Long will the United States Dollar be a Safe Haven?

“The U. S. dollar is recapturing its role as the primary safe-haven currency, eclipsing the yen and the Swiss franc, as tensions in Korea and Europe escalate.

That re-emergence as the ultimate sanctuary for those fleeing risk will likely result in continued strength against major rivals in the next few weeks, analysts expect.

‘Recent events just reinforce the underlying message that during times of turmoil, almost no matter what the source, the U. S. dollar is seen as a safe harbor for investors,’ said Doug Porter, an economist at BMO Capital Markets in Toronto.” (http://professional.wsj.com/article/SB10001424052748704008704575639022158300444.html?mod=ITP_moneyandinvesting_1&mg=reno-wsj)

The question is “how long will the U. S. dollar remain a safe haven?

Twice in the past three years, the United States dollar has served as a “safe haven” for the world. Once, following the financial collapse in the fall of 2008, the value of the United States dollar against the currencies of major currencies rose from a trough in March 2008 of 70.3 to a peak of 84.0 in March 2009.

The next trough came in November 2009 at 72.2, but the sovereign debt crisis in the Euro-Zone in early 2010 caused the value of the dollar to rise again as a “safe haven”, peaking at 79.0 in June of that year.

After June the dollar, once again, continued to decline, falling to 71.0 in the first full week of November 2010. As mentioned above, the value of the United States dollar is now climbing.

Most analysts, including myself, believe that the long term trend in the value of the dollar is down. The United States government is basically un-disciplined with little or no self-control. This is not a slam against the Democratic Party because I believe that the Republicans have acted in a similar way. Fiscal deficits have led to mountains of federal debt, and the example set by the federal government has been emulated by the public at large over the past fifty years building up more-and-more debt over time. The Federal Reserve has supported this credit inflation and has even underwritten a large portion of it…and promises to underwrite a whole lot more.

The consequence of this lack of discipline and self-control has been reflected in the decline in the value of the dollar over the past forty years, since President Nixon floated the dollar. The chart below just shows us what has happened over the past ten years where the primary culprit has been the Republican Party.

From the peak value reached in February 2002 the dollar reached a trough in March 2008, 37.3 percent below the earlier peak. The dollar became a “safe haven” in the fall of 2008 and moved from its March trough to a short-term peak in March 2009, rising by 19.4 percent. Once this move was over, the value of the dollar dropped once again, this time by 15.5 percent.

The point is, the long-term pressure on the value of the United States dollar is to decline. This can be observed very clearly in the accompanying chart.

Since the value of the dollar was floated and the current data series began, January 1973, the dollar has declined by about 34.4 percent. So, the general trend of the value of the dollar since it was set free has been downward. Over the longer haul, nothing has really changed much in the way of American economic policy.

The bottom line to all of this is that nothing has changed in the past fifty years as far as the fundamental philosophy behind the economic policy of the federal government. The long run prospect for the value of the dollar is down!

There will be upswings, flights to the “safe haven”, but the basic trend will be downwards.
But note, the 2008 recovery in value of the dollar went on for about one year before the decline set in again. Therecovery in value associated with the euro-zone sovereign debt crisis lasted only seven months before the movement down began once more. The short-term peak reached in 2010 was 6.0 below the previous peak in 2009.

How long will this move into the dollar “safe haven” last and how high will the value of the dollar reach?

My guess is that the value of the dollar will move upwards for several months. The peak will be somewhere in the neighborhood of the March 2009 peak and the June 2010 peak. But, the decline will begin once again.

And, the longer run? As the periphial countries in the euro-zone get their acts together and become stronger over time, attention will look for other countries that need to be chastized. After Greece, Ireland, Portugal, Spain, Italy, and possibly France…will the focus of the financial markets turn to the Unitred States…and not as a “safe haven”?

The Euro is "Bad News" for Spain!

Paul Krugman says it all this morning in the New York Times: “If Spain still had its own currency, like the United States—or like Britain, which shares some of the same characteristics—it could have let that currency fall, making its industry competitive again. But with Spain on the euro, that option isn’t available.” (http://www.nytimes.com/2010/11/29/opinion/29krugman.html?_r=1&hp)

It’s that Trilemma thing again!

The Trilemma problem in international financial theory is that a nation can only achieve two out of the following three objectives: it can participate in the international flow of capital; it can have a fixed exchange rate; or it can conduct an economic policy that is independent of every other nation.

Spain, and other nations in the Euro-zone, is constrained by the first two of these objectives. Being a part of the Euro-currency-system, Spain has, in effect, a fixed exchange rate with all other nations in the Euro-zone. Spain also benefits from participating in the international flow of capital.

Given that these two conditions exist within the Euro-zone, Spain, and all other nations within the Euro-zone, cannot conduct its economic policy independently of every other nation within this currency area.

If Spain could conduct its economic policy independently of every other nation within the Euro-zone it could inflate its debt and currency all it wanted to and just suffer the injustice of seeing the value of its currency decline in the international financial markets. But, this would be “good” according to Krugman because the falling value of its currency would make its industry competitive again.

The problem in Europe, according to this fundamentalist Keynesian preaching, is Germany. Germany is the most disciplined country within the Euro-zone and hence is causing all sorts of problems for Greece, Ireland, Portugal, Spain, and possibly Italy and France. And, when times get tough, discipline wins.

This situation highlights the difficulty in attempting to build a currency area. A currency area has a single currency. So, by definition, a “fixed” exchange rate exists within the area. Unrestricted capital flows are very desirable within a currency area because everyone benefits when capital can flow to its most productive uses.

That leaves one prong of the Trilemma hanging…independent economic programs.

This has always been the “hidden bump” along the road to the formation of a currency area. Governments within the currency area need to conduct economic policies that are consistent with one another. But, governments don’t like to give up this independence.

And, if you have a nation like the Germans who believe in self-control and fiscal discipline, it becomes hard for nations who chaff at self-control and believe in credit inflation to continue upon their path forever.

Keynes realized this problem in attempting to construct his economic model in the 1920s and create the post-World War II international monetary system. Keynes knew that his proposals for debt inflation depended upon nations having the ability to conduct their economic policies independently of one another. And, he was, during this time period, very adamant about having a system of fixed exchange rates. Thus, Keynes advocated controls on the international flow of capital.

Unfortunately for Keynes’ view of the post-World War II environment, international capital flows increased, particularly in the 1960s and have accelerated ever since.

What then has to give? Fixed exchange rates or the ability of a nation to conduct its economic policy independently of other nations?

The United States, in August 1971, chose to do away with fixed exchange rates. The Euro-zone came into existence in 1993 and on January 1, 1999 opted for a one-currency system by introducing the euro to the world. The Euro-zone created a single central bank for the area, the European Central Bank which began business in 1998, but allowed national governments to still conduct their budgetary policies independently of one another.

Thus, countries in the Euro-zone could maintain self-control and discipline, if they so desired, or, they could creates mounds of debt and live way beyond their means, if that was what they wished to do. Governments did not want this choice taken away from them.

Times went well for the Euro-zone and most seemed happy with the existing arrangements. Then, the bond markets got antsy. And, we had the first “debt crisis” in the Euro-zone earlier this year. Band-Aids were felt to be appropriate.

Now, we are in the second “debt crisis” and the bill is coming due. Wouldn’t it be nice, as Krugman suggests, to keep on inflating and just let the value of the currency declining? Remember in the economic model Krugman uses there is no debt and no penalty for piling up more and more debt. No harm, no foul!

Therefore, Krugman believes, Spain should be as fortunate as the United States: “The good news about America is that we aren’t in that kind of trap: we still have our own currency, with all the flexibility that implies.”

America can create debt and inflate its currency all it wants to and no one else can do anything about it!

Yet, there is a conspiracy afoot. Now, Krugman has joined Oliver Stone! The “bad guys” are trying to stifle government spending and constrain the Federal Reserve System. These “bad guys” are trying to “voluntarily put (America) in the Spanish prison.”

Does Krugman advocate the demise of the euro? Krugman doesn’t really see this happening because of the disruption it would create. Therefore, Spain must remain in a prison of its own creation.

Germany has contemplated this move. But, Germany really doesn’t want the Euro-zone to fall apart. (See “Crises Shake German Trust in Euro-Zone”: http://www.nytimes.com/2010/11/27/world/europe/27germany.html?scp=10&sq=michael%20slackman&st=cse.)

Maybe the continuing efforts to provide rescues to member nations may lead to a more unified Euro-zone that realizes and accepts greater coordination of national economic policies. The road to such a solution, however, has many, many bumps and potholes along the way. Countries that have established overly-generous social policies may not be able to reconcile their demands with that of the more controlled nations, like Germany, that support greater fiscal and monetary discipline.

The conclusion to this story is far from over.

China Plays the Game

The Chinese central bank has announced that it will raise the one year lending and deposit rates by 25 basis points. This has been a major surprise to international financial markets.

One can assume that this move was done very deliberately and very intentionally. The Chinese do not make policy decisions unless they are well thought-out.

The immediate reason for the move at this time: later this week there will be a meeting of the G-20 finance ministers. Next month in Seoul, South Korea there will be a meeting of the G-20 leaders.

The move is not an accident!

The International Monetary Fund just completed meetings earlier this month in Washington, D. C. Before that meeting, the United States took a strong stand on the value of the Chinese currency and the behavior of the Chinese government with respect to this value. The United States made an effort to get other nations to criticize the Chinese position.

The result of the IMF meeting? Little to no pressure was put on the Chinese giving indication that the United States was having no luck in its campaign to bring the Chinese “into line” on the value of their currency. The United States looked weak. (See my post on this: http://seekingalpha.com/article/229388-the-imf-meetings-you-can-t-lead-out-of-weakness.)

If China’s action on interest rates is followed up by China allowing for a faster climb in its currency, the yuan, the Chinese will strengthen the position of their government within the G-20. It would also strengthen the role of other Asian nations as well as other BRIC nations in negotiations concerning the future of the dollar as a reserve currency.

Thus, the Chinese would build on the exhibited weakness of the United States at the meetings of the IMF in Washington and help to consolidate other nations around its leadership in world economic affairs.

Is the United States and China at war?

In one sense they are. Martin Wolf at the Financial Times of London has written, “In effect, the US is seeking to inflate China, and China to deflate the US. Both sides are convinced they are right…” (See http://seekingalpha.com/article/227632-monetary-warfare-u-s-vs-china.)

How has this situation developed? Well, in a real sense, the world has bifurcated. Part of the world, generally the developed countries, are struggling to restart their economies from the Great Recession, while many of the emerging countries are doing just fine, thank you.

The Federal Reserve System in the United States and the European Central Bank seem intent upon buying massive amounts of bonds to carry out a “Quantitative Easing” in an attempt to “jump-start” their economies. The prospect of this has resulted in a weakening of the dollar. This has not been looked on favorably by the emerging nations who are experiencing economic growth and even a potential threat of inflation.

As a consequence, several of the emerging nations have already taken actions to protect the value of their currency from the weaknesses seen in the American position. These nations have already considered control techniques to protect themselves from the fall in the dollar exchange rate. They are considering the possibility having dual exchange rates, one for trade payments and one for non-trade payments.

The threat here is that world will break into two currency areas, one that is dollar/euro dominated and one that is dominated by China and the other emerging nations. And, certainly, the possibility of some kind of financial controls on foreign exchange is not a settling thought.

The reigning problem to me is the failure of leaders, especially leaders in the United States and in other developed countries, to appreciate the changes that have taken place in the world. The continued focus of the leadership in the United States on stimulating internal demand so as to achieve something, full employment of resources, that they really can’t achieve, is leading them down the path of isolation. By continuing to follow an economic philosophy that has proven itself to be ineffective (if it ever was effective) is only creating a fissure within the world.

In effect, the United States, by pursuing the same type of policy it has followed for the last 50 years, is not only weakening itself but is providing the stage for the Chinese to exert its own leadership to those the United States policy is hurting.

The Chinese are moving to achieve a position of prominence in the world of the 21st century. What they are doing is very intentional and when they do things, they do them in their own time and for their own reasons. They are not always right, but that is not the point.

The point is that the Chinese are very deliberate in promoting themselves and their country. The United States, however, seems to be helping them achieve what they want to achieve. This cannot continue.

Economic Recovery?

The front page of the New York Times reads, “Why So Glum? Numbers Point to a Recovery.” (http://www.nytimes.com/2010/04/09/business/09norris.html?hp) The economic recovery is at hand, yet, to many, even to many economists, something seems to be missing.

Unemployment remains high, but it is a lagging indicator. Consumer debt remains high and home foreclosures and personal bankruptcies continue to stay near record levels, but these tend to be lagging indicators. State and Local governments are on the edge, apparently faced with becoming the “next Greece.” (For example, this morning see “Los Angeles Faces Threat of Insolvency”, http://online.wsj.com/article/SB20001424052702304830104575172250422355156.html#mod=todays_us_page_one, and “Next ‘Big Crisis’ Is Unfolding in Muni-Bond Market”, http://www.bloomberg.com/apps/news?pid=20601039&sid=aKj_LXH6zUrw.) But, these problems are related to the condition of the consumer and hence will not recover until the consumer recovers. Commercial banks are not lending, small businesses are not getting bank loans, and there are still concerns about the value of bank assets and the impending loan problems.

Floyd Norris, in his New York Times article, speaks about slow economic recoveries and attempts to put the current situation within the context of other post-World War II recessions. Within this context, he argues, the prospects for the current recovery are not that bad. When the economy is turning around, current data tend to be revised as more information becomes available and the recoveries, historically, appear to be “less slow” than they were during the time they were actually being experienced.

I believe that Norris is correct in his interpretation of where the United States economy is at the present time and how the data we are now receiving compares with the data relating to previous
recoveries.

What this misses, as I have tried to present over the past six-to-nine months, is that there are other factors at play in the economic developments of the past fifty years and this has created a situation that is not favorable to a strong economic performance in upcoming years…unless some things change.

One of those changes that are necessary relates to the inflationary bias of our government’s monetary and fiscal policies. As I have mentioned many, many times before, inflation is not helpful over the longer run and, in fact, over the longer run tend to hurt the very people the inflationary bias is aimed to help. The fact that the purchasing power of a dollar has declined by over 80% in the last fifty years has left the American economy is a very weak position. Long-term inflation has had an impact on the economy.

For one, inflation is supposed to help existing manufacturing industries. Yet, we have seen that over the past fifty years, the capacity utilization of United States industry has continuously declined with each peak reached in a subsequent period of economic recovery lying below the level of the previous peak. (See my post “The Trouble with Recovery,” http://seekingalpha.com/article/192713-the-trouble-with-recovery.)

Inflation is supposed to help labor, yet the level of the under-employed has risen almost constantly during the last fifty years. As capacity utilization has declined, the “mainstream” laborer has found him- or her-self less and less trained to do something outside “mainstream” industry. Hence, the growing number of those that don’t “fit” into the twenty-first century industrial structure. It will be very difficult to put these people back-to-work on a full time basis.

The economy of the past fifty years has also relied on the strength of construction, especially the construction of houses. This area has received special attention in that the government has created many, many financially innovative ways to support this industry which has led to an inflation in real estate prices that has out-stripped those in other areas of the economy.

A consequence of this has been that most personal saving over the past fifty years was tied up in the value of a person’s home. People saved by investing in a home and then watching the value of the house continue to appreciate. This appreciation of home prices also allowed their owners the opportunity to borrow against the increased value of the house to maintain higher and higher living standards. Now much of this “wealth” has been destroyed.

And, the inflationary bias has led to a hurricane of financial innovation. The creation of debt and financial innovation thrive in an inflationary environment. The last fifty years has been a treasure-trove for those in the financial industry and the financial innovation that has resulted exceeds that of any period in the history of human-kind. The economy may seem unbalanced with the growth of the finance industries relative to the manufacturing industries, but that is what you get when you have fifty years of consumer and asset price inflation.

The theoretical underpinnings of the policies that have resulted in the inflationary bias of the last fifty years were built on two primary assumptions. The first is that the labor force must be kept employed in order to avoid revolutionary unrest. The second assumption is that foreign exchange rates would be fixed in value. (See my book review: http://seekingalpha.com/article/167893-john-maynard-keynes-and-international-relations-economic-paths-to-war-and-peace-by-donald-markwell.)

The model derived from these assumptions is “short-run” in nature. (Remember Keynes is quoted as saying “In the long run we are all dead.”) Policy making within this paradigm, therefore, focuses upon achieving short-run goals even if the long run consequences, as presented above, are detrimental to the people that are, hopefully being helped. Since the world is a series of short-runs, the problems resulting from previous “short-run solutions” will be offset at a later date. As we have seen, this does not happen.

In addition, since 1971 most of the world has been operating within a regime of floating foreign exchange rates. A country cannot isolate itself from other countries, in terms of the fiscal and monetary policies it follows, without repercussions. In the case of the United States, we have seen during this period of inflationary bias the value of the United States dollar has declined. The two periods in which this was not the case were those of the late 1970s-early 1980s, when Paul Volcker was the Chairman of the Board of Governors of the Federal Reserve System, and the 1990s, when Robert Rubin was an influential member of the Clinton Administration. Overall, however, the value of the United States dollar has declined during this period and is currently substantially lower, relative to other major currencies, than it was in the 1970s.

The policy focus of the United States government must change. To me, Paul Volcker had it right when he argued that “a nation’s exchange rate is the single most important price in its economy.” Consequently, he argued that a government cannot ignore large swings in its exchange rate. A country’s exchange rate reflects how international markets interpret the inflationary stance of the monetary and fiscal policy of a government. In the future, more emphasis must be placed upon this price in making policy decisions for the United States no longer dominates the world the way it did in the past.

Second, the policy focus of the United States government must move away from employment in legacy industries. A recent research paper by Dane Stangler and Robert Litan, “Where Will the Jobs Come From?”, published by the Kauffman Foundation, emphasizes that “nearly all” of the jobs created in the United States from 1980-2005 were created in firms less than five years old. By focusing on legacy industries in determining its economic policy, the federal government is just fostering an environment in which under-employment is going to continue to grow. This is not healthy for the future of the American economy, especially as emerging nations around the world are focusing on the future and not the past.

Mr. Geithner Goes to China

Treasury Secretary Tim Geithner will meet Thursday with Wang Qishan, the Chinese Vice-Premier responsible for economic affairs. The agenda of the meeting is unknown. At least one probable subject of discussion is the exchange rate policy that has been followed by China in recent years.

The word of the street is that China may widen the daily trading band for their currency and allow the renminbi to trade over a wider range. This could allow the currency to gradually appreciate against the dollar, present China as a cooperative partner in global trade, and help to build for more open world trade going forward.

It is reported that “The Chinese foreign ministry would adhere to three principles on currency policy: any change must be controlled, it must be Beijing’s own initiative and any shift must be gradual.” (See “Geithner heads to Beijing for talks”: http://www.ft.com/cms/s/0/64c4bd04-4193-11df-865a-00144feabdc0.html.)

This points to the fact that the major issue here is a political one, not an economic one. China is on the upswing in the world and is playing out its options “close to the vest.” It is bargaining for the long run, and those that see the world only as a series of “short-runs” fail to understand the Chinese mind.

In a recent post, “Why should China Change,” http://seekingalpha.com/article/193689-why-should-china-change, I wrote: “One piece of advice some people gave me several years ago about the Chinese has proven to be very perceptive. They said that whereas people in the West have very short time horizons, generally in the three to five year range or less, the Chinese have a much long perspective of history. They think in decades rather than years.”

As a consequence of this the Chinese do not want to rush into anything, any new arrangement, without a full consideration of the implications of what they are about to do. Again, from my earlier post, “My guess is that China does not plan to overdo it for they have more to gain in the future if trade is more open than not. I believe that the Chinese know that they will be better off over the longer run if world trade is more open rather than more restricted. Hence, they will not go far so as to create a trade war that will be detrimental to achieving a more open world trade. China’s investments in natural resources and companies throughout the world underscore this bet.”

And, the United States? “The United States is in a weakened position. Thus, the Chinese can achieve more now by taking advantage of this weak position and still achieve the longer-term goal of more open trade. The United States is in no position to resist this and will not be in a position to resist this for some time. And, it would hurt us more to act aggressively at this time to introduce more trade protection than it would China. Hence, advantage China.”

Yet, China does not want to “overplay” its hand.

The meeting this Thursday is a positive sign. The word is that “The secretary and the vice-premier have been working together to find an opportunity for some time,” according to a spokesperson for Secretary Geithner. Geithner, being right next door in India, found it very convenient to arrange a side trip for such a meeting.

As stated above, no agenda was reported for the meeting and there is no expectation that a statement will be issued when the meeting ends.

Still, leaders at this level don’t just agree to meet unless there is something going on. Furthermore, in recent months “conciliatory gestures” have been made by both sides. And, there was the April 2 telephone conversation between the presidents of China and the United States, a conversation that “reached an important new consensus” between the two parties according to the Chinese minister for foreign affairs.

Stephen Green, an economist with Standard Charter in Shanghai, was reported by the Financial Times to have said that “Some grand bargain between the US and Beijing appears to be in the works, if it hasn’t already been struck.”

As a prelude to the meeting, Geithner stated on television on Tuesday that the decision to revalue the renminbi was “China’s choice”. He also added that he believed that China would see that it was in their long run interest to work with a more flexible exchange rate policy in the future.

So, it seems that the pieces are in place and the meeting is at hand.

The bottom line is that it is in the interest of the United States to take a longer run view of things. For the past fifty years or so, the emphasis of the United States economic policy has been on the short run. As a consequence, the United States has focused undue attention on current levels of unemployment, short-run growth projections, and temporary fixes to markets and industries and, in the process, has established an inflationary-bias to monetary and fiscal policies that has produced more than an 80% decline in the purchasing power of the dollar. Individuals and families found that in such an environment the best way they could save was to buy a home and watch the value of the house appreciate. They didn’t need savings because their net worth was rising with the price of their home.

This short-run focus produced mounting deficits that had to be financed off-shore since Americans, themselves, were not producing the savings necessary to fund them. Thus, the rest of the world helped to finance the inflationary binge and now we in the United States have to bear the burden of this myopia.

We can see now that a nation with a longer-term focus can trump a nation that just focuses on the short-run. If the United States is going to match up with China, and with other rapidly emerging nations in the world, then it, too, will have to lengthen its perspectives to the longer-run. Perhaps we are seeing this change in the progress that has been made leading up to this meeting.

And, maybe this gives us another picture of the underlying operating process of the Obama administration. In the current issue of Time magazine, Jon Meacham comments on “The New Book on Barack Obama,” titled “The Bridge” by David Remnick, the editor of the New Yorker. Meacham writes that Obama has a recognition that “politics (and life) is in the end more about the journey than the destination, since no destination is ever really permanent.” And, he argues, the president is “a patient man because journeys require patience” and this “helps explain his understated doggedness.”

If this administration is truly working from a longer-run perspective, maybe this is one reason that many of his critics, who have just a short-term myopia relating to policy and achievements, are so unhappy with him. We shall see.

The United States Dollar, Europe, and England

I have been a “Dollar Bear” for most of the 2000s. For the long run, I continue to be a “Dollar Bear”, at least with respect to many currencies in the world. Right now, against the Euro and against the British Pound, the investment community is telling me that Europe and the U. K. are in worse shape, fiscally and politically, than the United States and therefore I need to alter my stance with respect to these currencies.

The play in international currency markets is, of course, a relative one. How is XYZ nation doing relative to LMN nation? So, one country might be doing miserably, yet another country might be in even worse shape, and, hence, the price of the currency of the latter relative to the former will decline.

This relative price, to Paul Volcker, “is the single most important price in the economy.”
Consequently, “it is hard for any government to ignore large swings in its exchange rate.” Or, at least, it should be!

Right now, the price of the Euro and the price of the British Pound are saying that the governments in Europe and the government in England should be concerned. Things are not going right and it is costing them and their people.

Of course, there are many monetary and fiscal problems that exist in the United States. But, the markets seem to be saying that, currently, attention needs to be focused elsewhere. And, in Europe and England, the problems are both economic and political.

In Europe, the major focus has been on Greece and the unfolding soap opera that is taking place in the European Union over how the fiscal problems that Greece faces will be overcome. Verbal recognition has been given to the problems faced by Portugal, Italy, Ireland, and Spain, but until yesterday they were being put to the side.

Then, Fitch Ratings reduced the credit grade of Portugal’s debt. The problem, according to a spokesman from Fitch, was that Portugal would struggle to meet its debt commitments in the face of “macroeconomic and structural weaknesses.”

This downgrade, others said, just reflected the concern over “the underlying problems in the European Union. People are worried about the fiscal situation in the southern European economies and the prospects for those economies.”

The difficulties, however, go deeper than that. What has surfaced over the past few weeks is the political problems of running a single currency in a region where there is no single government. This situation could be workable if all the countries within a currency area followed the same fiscal policies.

As is now apparent within the EU, this is not an easy thing to do. Different countries have different national make-ups. They have different histories and experiences. And, they have political parties that are at different places in the political spectrum. The chance that all the countries will follow similar paths with respect to economic policy is “slim” and “none.”

Currently, Germany is getting bashed for the disciplined and prudent policies that it has followed in recent years. No one is doing a better job at bashing the Germans than is the columnist Martin Wolf. (See “Excessive virtue can be a vice for the world economy,” http://www.ft.com/cms/s/0/924b4cc0-36b7-11df-b810-00144feabdc0.html.) The logic of this is beyond me. Germany has worked hard, kept up its discipline, produces high quality goods, and has an export surplus and should now give up what it has worked so hard for because others have over-promised, over-spent, and mortgaged their future? As Wolf argues, the virtue of Germany is a vice in a world economy? Come on, Mr. Wolf!

The European Union is facing a political crisis resulting from its adoption of a single currency. To the most pessimistic, this was always in the works. Paul Donovan, the deputy head of global economics at UBS Investment Bank, stated that Greece “is going to default at some point” because of the political problems of the EU. He goes on: “If Europe can’t solve a small problem like this, how on earth is it going to solve the larger problem, which is the euro doesn’t work.”

England is also facing economic and political problems. First of all, it has a serious budget problem and very little is being done about it at the present time. This is because of the second problem which has to do with the upcoming election. The Prime Minister, Gordon Brown, doesn’t want to do anything relative to the budget that would further upset the electorate right before the election. However, the Conservative candidate seems to be so inept that he cannot seem to be able to forge some kind of sensible budgetary policy in order to overtake a very unpopular Mr. Brown. World markets seem to have very little confidence with what is going on in the United Kingdom at this time.

The consequence of all this? The Euro is trading around $1.33 per Euro this morning, down from around $1.51 toward the end of 2009, almost a 12% decline. The British Pound is trading around $1.49 per Pound this morning, down from around $1.68 in November 2009, about an 11% decline.

The odds seem to be in favor of additional declines in these currencies until some satisfactory resolution is reached on both the economic and the political fronts.

United States officials can enjoy having someone else being in the spotlight for a while. Still, nothing has really changed for the good in terms of economic policy for the United States. Fiscal deficits are large and are expected to remain so for the upcoming decade. The monetary authorizes still have to “undo” what they have “done”. The political situation does seem to be a little more stable in the United States than in either Europe or England.

The value of the United States dollar does continue to decline against the currencies of other trading partners, especially against those currencies in the “emerging nations.” Here the trend seems to be for the dollar to continue to decline. The near-term declines continue against the Brazilian Real, the Canadian dollar, the Japanese Yen, the South Korean Won, the Swiss Franc, and the Australian dollar.

The United States dollar is not “out-of-the-woods”, by any means. And, as we have seen, world investors can turn on a country very quickly. Six months ago, the Euro and the British Pound were doing quite well, thank you. Government officials need to beware that they still have a long way to go before the investment community can look on the United States dollar with real confidence.

Right now the dollar gets a respite. How long this will last is uncertain at the present time. It is still my belief that over time the United States dollar will come under selling pressure again. It would be best if the Obama administration used this time to re-establish some form of discipline in both monetary and fiscal policy. But, I am not assuming a very high probability that this will happen in the near future, especially with the direction Congress seems to be heading.

Excess Capacity and the Slow Economic Recovery

Ben Bernanke spoke in New York yesterday and, depending upon which paper you read this morning, he basically said one of two things. First, he said that the Fed was interested in a strong dollar and would continue to keep the value of the dollar in mind in deliberations concerning monetary policy.

Chuckle, chuckle.

Second, Bernanke said that the pain in the labor market was going to last for a long time and that we shouldn’t expect the unemployment rate to fall anytime soon.

That is, don’t expect interest rates to begin to rise in the near future.

Remember, the number one policy goal of the Federal Reserve (and the federal government) is full employment and don’t you forget it. Put inflation, commodity prices, and the value of the United States dollar on the back burner.

So much for an independent Fed!

But, we knew that.

The problem with the economic recovery and unemployment is captured by an article in the Wall Street Journal, “Auto Industry Has Room to Shrink Further,” (see http://online.wsj.com/article/SB125832250680149395.html?mg=com-wsj.) Although the article focuses upon the auto industry, the situation that is described can be extended to many other major (and minor) industries throughout the world.

“Over the past two years, the global auto industry has endured one of the worst downturns in its century-plus history. Auto makers around the world have consolidated, restructured and slimmed down—and yet they still have too much of just about everything, especially too many brands and too many plants.”

“According to CSM Worldwide, the auto industry has enough capacity to make 85.9 million cars and light trucks a year—about 30 million more than it is on track to sell this year, the equivalent of more than 120 assembly plants.”

Furthermore, an auto analyst is quoted as saying, “government intervention to save auto-related jobs has forestalled the inevitable—broad and deep restructuring that would shut down unneeded plants and close loss-making enterprises. Not as much capacity has come out that should have.”

This is just talking about the auto industry. But, it is true of industry in general. The United States and the global economy have become leaner due to the current contraction: still, much excess capacity remains.

Even though capacity utilization for all industry is up in the United States (note that capacity utilization for manufacturing in October did not change from September), giving further indication that the recession is over, the problem of too much capacity lingers. As I have mentioned many times before, every economic recovery since the 1960s has seen a pickup in capacity utilization as economic growth increased, but the peak reached in each cycle was no higher, and was generally lower, than the peak reached in the previous cycle.

That is, capacity utilization rose during the expansion phase of each economic cycle since the 1960s but the trend in the United States was for more and more plant and equipment to remain idle.

In addition, this contributed to the under-utilization of labor as is evidenced by the rising trend in those of the population that are labeled underemployed .

Also, as the federal government, and the independent Federal Reserve System, tried to pump up the economy so that fuller employment could be achieved, the pressure was always on for inflation to rise. Since January 1961, the purchasing power of the dollar has fallen by about 85%. This is not a coincidence!

Furthermore, these policy efforts just put people back to work in the jobs they had been in and reduced the incentive for companies to innovate and change moderating productivity growth.

The performance of industrial production in the United States carries with it the same story. (Industrial production is up in October, but at an anemic 0.1% rate.) The growth rate of industrial production rises and falls through the swings in the economic cycle, but each rebound does not bring with it the same expansion as was achieved in previous cycles. This is just another indication that although recovery takes place, the overall trend in the productive utilization of resources in the United States continues to wane.

This fundamental weakness resource utilization is resulting in changing attitudes throughout the world. David Brooks writes in the New York Times about the underlying optimism that seems to be present in China these days, an optimism that used to be present in the United States. Simon Shama writes in the Financial Times about how China is now “wagging its finger at the United States about it wayward monetary and fiscal policies, as yet, still unaccustomed “to being the strong party in the relationship.” Clive Crook, also in the Financial Times, writes about the looming political battle in the United States concerning the “big questions” that voters have to answer “about the entitlements they demand and the taxes they are willing to pay.”

The United States is strong and will continue to stay strong. But, its relative position is changing. And, the way its leaders go about attempting to resolve problems is missing the point.

The United States economy is recovering. But, unless policy prescriptions change, there will continue to be an under-utilization of capacity, a weakness to productivity growth, a bias towards inflation, further declines in the United States dollar, and the threat of protectionism.

It is said that people and a nation do not change their habits until there is a real crisis. Right now it looks as if we have wasted a pretty significant financial crisis in returning to our old ways and old policy prescriptions and will just have to be content with an economy that produces mediocre results. No one seems anxious to change how we attack our problems.

"Europe's Plot to take over the World"

There is an interesting article in this morning’s Financial Times (10/6): “Europe’s plot to take over the world” (see http://www.ft.com/cms/s/0/a47079b2-b1e6-11de-a271-00144feab49a.html.) It was interesting to me because it has always seemed to me that the one who controls the writing of the agenda for a meeting is the one that most often ends up controlling the results that come out of the meeting.

And, according to my reading of Gideon Rachman’s comments, this is exactly what Europe is trying to do.

The thrust of Rachman’s argument ties in with my post of October 5 (see “What’s the dollar’s place in the new financial order”: http://seekingalpha.com/article/164848-what-s-the-dollar-s-place-in-the-new-financial-order.) where I discussed the changing nature of the world’s economic and financial relationships as observed in the changes occurring within the G-20 (and the lessening of importance of the G-7) and the jockeying of nations for position within the World Bank and the International Monetary Fund.

Whereas so much attention has been given to the rising strength of the BRIC countries of Brazil, Russia, India, and China, Rachman focuses on the bureaucratic reality of the evolving organizational structure of the G-20 itself. There are three points the author makes that I think are worthy of consideration.

First, Europe dominates the leadership of the G-20. Whereas Brazil, China, India, and the United States are represented by one leader each, the Europeans had eight positions at the conference table: Britain, France, Germany, Italy, Spain, the Netherlands, the president of the European Commission and the president of the European Council. Furthermore, the primary international civil servants at the meeting were Dominique Strass-Kahn, the head of the IMF, Pascal Lamy, the head of the World Trade Organization, and Mario Draghi, the head of the Financial Stability Board and these are all Europeans. The only other civil servant of similar weight was Robert Zoellick, the President of the World Bank, and an American.

Second, the Europeans seem to have a grasp of what is going on in the world than do the other participants at the G-20 conference. Rachman ties this back to the experience of the Europeans at European Union summits. The Europeans seem to be well advanced in the techniques of “bureaucratic paper-shuffling”, a process of introducing issues that they never let go of and which have important political implications in the upcoming years. Rachman argues that the European Union “advanced” from the very start “through small, apparently technical, steps focusing on economic issues.” The method used was to build the union through “the common management of common problems.”

Third, Rachman states that “the kernel of something new has been created. To understand its potential, it is worth going back to the Schuman Declaration of 1950, which started the process of European integration. ‘Europe,’ it said, ‘will not be made all at once, or according to a single plan. It will be built through concrete achievements, which first create a de facto solidarity.’”

The agenda is bigger than forming a G-3, a group of the United States, China and Europe. The world of the future cannot be organized by just these three territorial giants. The world of the future is either going to be integrated in a way that many might conceive of as inconceivable, or, the world is going to collapse into separate blocks with limited international trade and cooperation.

The model for this last scenario is the world at the start of the 20th century. World integration was discussed then for the world was open in the early 1900s in a way that has not been equaled since. Yet, the world conflict taking place in the 1910s split the nations apart leading up to conflicts of the 1920s and 1930s and the second world war that followed.

For the G-20 to help the evolution of the world into something approaching the first scenario the United States is going to have to adjust its attitude. Yes, the United States is still going to be the most powerful nation in the world, both economically and militarily, but it is going to have to change its belief that it can act, either economically or militarily, independently of the rest of the world.

If Rachman is even close to being correct on his view of how the G-20 might evolve, the United States is not going to be able to get away with continually allowing the value of the dollar to decline. The United States cannot have it all! Other countries must adjust their behavior as well (for example, the savings rate in China must fall), but the day is coming when the United States is going to have to accept the consequences of the irresponsible fiscal and monetary policy of the last eight years. And, the current administration cannot continue to add to these policy blunders going forward as they now seem to be doing.

Something new is happening. And, Nicolas Sarkozy and Angela Merkel, and other leaders in Europe are not going to let this opportunity pass them by. They will talk about cooperation with the United States, internationally, but they want the United States to get its shop in order. France, and Germany, and Britain, all went through the economic wringer in the last half of the 20th century as international financial markets took their governments to task for irresponsible fiscal policy and extremely loose monetary policy. They certainly are going to ask for the American government to exhibit a little more discipline going forward.

For people interested in the value of the United States dollar, my view is that the value of the dollar will continue to decline until the United States government stops talking about achieving a strong dollar while running up trillions and trillions of dollars in deficits and actually begins to act to achieve a strong dollar. How long this will take depends upon how much pressure is exerted in organizations like the G-20, the World Bank, the IMF, and elsewhere. This pressure will only continue to grow as the G-20 achieves more influence and these other international organizations are given more and more responsibility to oversee international financial markets. This is not going to happen, however, overnight.

A Market Grade for the Obama Economic Policy

There is a brutal way to grade administrations on their economic policies: look at what foreign exchange traders do to the currency of a country. This has been a test of political administrations around the world since the world removed itself from the gold standard in August 1971.

If we use the movement of the value of a country’s currency as a grading mechanism then this is how the Obama administration stacks up since it took office on January 20, 2009. The value of the dollar against the Euro from January 20 through July 31, 2009 has dropped 9.3%. Using early morning figures registered today, the drop has been 10.1%. The value of the dollar against Major Currencies has dropped 9.5%.

These are not very good grades!

What are the underlying factors behind this decline? First, the administration is proposing a huge deficit for this year, $2.0 trillion, a deficit that dwarfs all other deficits in United States history! And, some experts are projecting deficits that will continue to average around $1.0 trillion per year for the next ten years or so. Second, a monetary policy that is keeping short term interest rates extremely low, and it has been stated that these rates will be kept that low until possibly 2011.

Any comparisons?

The Bush administration saw the value of the dollar peak in March 2002 and then decline about 40% into 2008.

What were the underlying factors behind this decline? First, the administration created huge deficits by historical standards, deficits that continued throughout the entire Bush administration. Second, there was a monetary policy that kept short term interest rates extremely low, and it kept them at an extremely low level for two years or so.

Let me quote Paul Volcker once again. He has written that “a nation’s exchange rate is the single most important price in its economy.” This is from the book “Changing Fortunes: The World’s Money and the Threat to American Leadership,” by Paul Volcker and Toyoo Gyohten (Times Books: New York), page 232.

When are we going to learn?