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.   

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?

Signs of the Future: Emerging Countries vs. Developed Countries

The world goes on.  Whereas the news has tended to be dominated by what is happening in Europe, with some attention going to the United States, things are still going on in other parts of the world. 

For example, “Standard & Poor’s has become the third rating agency this year to upgrade Brazil’s sovereign debt…” (http://www.ft.com/intl/cms/s/0/a1c1a890-116a-11e1-9d04-00144feabdc0.html#axzz1e48y8AYK)

“Brazil’s debt fundamentals are already seen by markets as superior to many European countries with spreads on the Latin American country’s debt trading tighter than those of many eurozone countries.”

“The move…emphasizes the growing divergence between the fast-growing large emerging markets, led by China, Brazil, and India, and the advanced economies.”

Meanwhile, the central banks in emerging markets are buying gold in the largest quantities for forty years.  The forty years is important for that refers back to 1971 when President Richard Nixon severed the tie between the United States dollar and gold. 

“The scale of the purchases was bigger than previously disclosed and puts central banks on track to buy more gold than at any time since the collapse of the Bretton Woods system 40 years ago, when the value of the dollar was last linked to gold.”  (http://www.ft.com/intl/cms/s/0/c0025500-10ef-11e1-a95c-00144feabdc0.html#axzz1e48y8AYK)

Many emerging countries, especially the BRICs, now believe that they are over-exposed to the dollar in their central bank reserves and are trying to build up gold reserves at times when the price of gold dips.  Also, there is incentive to buy as concerns grow over the role of the United States dollar as a reserve currency.

“It is a mark of creeping distrust in the unofficial reserve currency, which nervous central bankers see being printed by trillions even as America’s political leadership shows no sign of dealing with its daunting fiscal challenges.  Fiscal worries are even more acute for the number two and three reserve currencies, the euro and the yen.” (http://www.ft.com/intl/cms/s/3/59f07c7e-113f-11e1-a95c-00144feabdc0.html#axzz1e48y8AYK)

But, “Central bankers are late to the gold party.  Private buyers of ETFs alone have accumulated 15 times as much since their advent a decade ago as government bought last quarter.  But their shift should be of far more concern.” http://www.ft.com/intl/cms/s/3/59f07c7e-113f-11e1-a95c-00144feabdc0.html#axzz1e48y8AYK)

Seemingly oblivious to these happenings, the United States continues to pursue policies that will devalue its currency.  Fed Chairman Ben Bernanke appears to be focused on keeping the world abundantly supplied with U. S. dollars while Treasury Secretary Timothy Geithner continues to swear that U. S. policy is to maintain a “strong” dollar while the Obama administration continues to issue more and more debt. 

Others within the Federal Reserve System continue to back up the Fed effort to continue to inflate the world.  The President of the Federal Reserve Bank of New York, William Dudley, says that “the central bank isn’t out of ammunition “ and that “monetary policy must do its part” to support economic growth. (http://professional.wsj.com/article/SB10001424052970204517204577044481934030256.html?KEYWORDS=michael+derby&mg=reno-secaucus-wsj)

And, the pressure in Europe is intense to get the European Central Bank to engage in much more aggressive actions to save the European Union and the euro.  Is quantitative easing in the future for Europe? (http://professional.wsj.com/article/SB10001424052970203611404577042302226590104.html?mod=ITP_pageone_0&mg=reno-secaucus-wsj)

The emerging nations are seeing the “crack in the door” and are steadily moving to take advantage of the fact that the developed countries must currently keep their focus on current distractions.  By following such a policy they see “the door” opening wider and wider.

To me, the real report card is the value of the dollar.  The credit inflation of the last fifty years in the United States, first, forced the United States off the gold standard, and, second, resulted in a secular decline in the value of the dollar.  The U. S dollar still fluctuates near the lows reached over the past forty years since its value was floated.

 

Looking at the value of the dollar against twenty major currencies one can see that news lows were hit around August of this year.  One can note that the three periods of recovery from the lows reached in 2008 were periods when there was a “rush to quality”.  The first was during the “Great Recession” and the other two spikes came during the sovereign debt crises in Europe. 

The economic policies of the United States government aim at a devaluation of the United States dollar.  Still the United States dollar is the reserve currency of the world and is the currency of the country that remains the strongest country economically.  This is why the United States dollar is still the haven for others when there is a movement to “quality.” 

Since the second world war, the United States…with western Europe tagging along…has dominated the world, economically as well as militarily.  During this time, the United States has basically acted independently of all others.  It is still “Number One” in these areas but is finding that its voice is growing weaker and weaker.  Current examples of this are the position the U. S. had to take in the actions in Libya and the back seat it took in the G20 meetings in Cannes, France.  And, more and more it is finding that with its fiscal position that it just does not have the money to “throw at things” that it used to have in the past. 

One way or another, the separation between the developed countries and the emerging countries is going to be a major factor in the world going forward.  Most analysts have moved up the time they expect some of the larger emerging nations to catch up with America and western Europe.  Within this environment, the currency conflicts and the financial conflicts are just going to grow

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.

"We Don't Expect Americans to Fight Temptation"

Suggested reading for today: Gillian Tett’s piece in the Financial Times, “ECB rate rise will spark new debate about US tightening.” (http://www.ft.com/cms/s/0/e40ec032-613b-11e0-ab25-00144feab49a.html#axzz1ImD5RZZn)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Trichet Delivers: ECB Hikes Its Interest Rate!

The European Central Bank raised its policy interest rate by 25 basis points this morning and, I believe, changed the game.

Mr. Trichet, president of the ECB, delivered on his promise initiatlly given in March.

To me, this is a “tipping point”, even though the Bank of England kept its policy rate constant. Other central banks around the world have been raising their policy rates over the past year but no “Western” central bank had followed.

Now, the “West” has followed and this alters, not the outlook for interest rates, but the timing of future increases.

There are three areas one needs to focus on within the current environment.

First, keep an eye on what goes on in the Eurozone in terms of country “bailouts” and the potential re-structuring of the sovereign debt within the nations of Europe.

It was not a coincidence that Portugal asked for help the day before the meeting of the ECB. Portugal has lots of debt coming due this year; its credit rating has gone through several reductions already this year; and the country is without a government and facing an election. Even Portuguese banks were saying that they would not buy anymore debt issued by the government of Portugal.

Facing a “new” attitude in the capital markets and rising interest rates, what is substituting for a government in Portugal had to act. In essence, the IOUs were coming due.

And this means, I believe, that the IOUs are going to be collected elsewhere within the Eurozone. The day of reckoning has been advanced. People are going to have to do something now.

Second, watch what European banks are doing and are going to do. On Wednesday, two European banks announced their plans to raise new capital. The total to be raised amounts to about $19 billion and brings the total capital raisings announced this year by European banks to almost $36 billion.

Again, I don’t think that the timing of the announcement, the day before the ECB raised its interest rate, was a coincidence.

Furthermore, the Spanish government this week stepped up efforts to get its “healthy” banks to buy up a good portion of its “savings” banks in an effort to shore up Spain’s threatened banking industry. With Portugal now seeking help, a greater focus is going to be placed upon the fiscal health of the Spanish government and its banking system. Spain is going to move because it appears as if it may be “next in line”.

In addition, there still are the results of the recently applied “stress” tests on the commercial banks of Europe. Two things here: there is the question about how valid the tests are; and there is the response of the banks, themselves, to the results of the tests.

The European “stress” tests are already being questioned relative to whether they are strong enough to really be anything but a subject of jokes. If the tests are too weak to prove anything, then the credibility of the European regulators will suffer a serve blow at a very crucial time. This will not raise the financial markets confidence in the European banks and the European banking system.

The European banks may have to “act on their own” to overcome this loss of regulatory credibility. The way to do that? The banks can raise a significant amount of capital on their own and take the whole question of capital adequacy out of the hands of the regulators. This may be a part of the strategy of the European banks that are now raising capital.

Third, continue to observe the behavior of the United States dollar in foreign exchange markets. My guess is that this move by the ECB to raise its interest rate will cause further erosion of the value of the United States dollar in foreign exchange markets. This move may not be immediate, but will persist over time.

By raising its policy rate, the ECB may be forcing Europe to get its act together and resolve some of its solvency and governance issues. The movement by the Portuguese is just a starting point. The movement of the banks adds momentum to the process. If this action truly brings events “to a head” then, I believe, everyone will be better off for it.

But, if Europe begins to move in the right direction, what is in store for the United States dollar?

Europe moving to resolve some of its issues will only result in more pressure for the value of the United States dollar to decline. And, this decline will only provide additional evidence that the international community has little confidence in the current leadership of the United States to really address its fiscal (and monetary) problems.

The question then becomes…will this change the nature of the discussion within the United States?

Will this twenty-five basis point change in the policy interest rate of the European Central Bank serve as anaction that creates the “tipping point” for the direction of economic and fiscal policy in Europe and the United States?

I’m sure that the wiley Mr. Trichet would like to see this happen.

I’m not sure that the former professor of law from the University of Chicago and the former chairman of the Princeton Economics Department would agree.

The Currency Wars and the Free Flow of Capital

The foundation for the economic health of the world for the last fifty years has been the relatively free flow of capital begun in the 1960s. That consensus is being threatened now.

The extent of the problem is captured in the New York Times article by Landon Thomas, “Countries See Hazards in Free Flow of Capital.” (http://www.nytimes.com/2010/11/11/business/global/11capital.html?_r=1&ref=business)

“In China and Taiwan, regulators are imposing fresh restrictions on stock market investments by foreigners. In Brazil, officials have twice raised taxes on foreign investors. Even South Korea…pressure is building on the government to take similar steps.

As the leaders of the 20 major economic powers gather in Seoul, an increasing number of them have either imposed curbs or are in the process of doing so to slow the torrent of hot money into their markets…

Once a core policy commandment of the so-called Washing consensus and held dear by the United States Treasury, the International Monetary Fund, and global investment banks, the belief that unfettered capital flows are a boon for everyone—including the country on the receiving end—has been dealt a major blow.”

The culprit that has brought us to this situation is another one of the legs of what is called the “Trilemma” of international monetary relations. The “Trilemma” basically states that only two of the following three conditions can hold: free capital mobility; fixed exchange rates; and a country’s independent economic policy. The leg that is now causing all the trouble is the leg that allows a country to pursue an independent economic policy.

More specifically, in terms of the situation that the world is now facing, is the ability of the United States to “go-it-alone” and follow an economic policy that is independent of the rest of the world.

Whereas most other countries in the world, especially in western Europe, that have tried to conduct economic policies independent of the rest of the world, ultimately paid a price for this independence. The United States, because of its size and the fact that the United States dollar is the world's reserve currency, has never had to face the reality created by its independent economic policies.

The bill is now coming due.

The United States government, since 1946, has had one major economic goal and one minor economic goal. The major goal: to achieve low levels of unemployment within the United States economy. The minor goal: to achieve homeownership for most Americans.

For more on this assertion see the Financial Times award winning book by Rajan Raghuram, titled “Fault Lines.” (http://seekingalpha.com/article/224630-book-review-fault-lines-how-hidden-fractures-still-threaten-the-world-economy-by-raghuram-g-rajan)

Given these goals, the United States, in the past fifty years, has persistently followed an economic policy of credit inflation. This policy has resulted in a decline in the value of the dollar by more than 40 percent during this time even though there were two periods when the value of the dollar actually rose. The decline in the value of the United States dollar since January 20, 2001 has again been dramatic.

The value of the United States dollar has been able to decline as it has because in August 1971 President Nixon floated the value of the dollar due to increasing capital mobility internationally and due to the fact that he wanted to retain the independence of United States policy making.

It is very interesting that Thomas, in his article, brings up one of the conditions of the Post- World War II monetary system agreed upon in Bretton Woods, New Hampshire in 1945. A crucial part of this agreement was the presence of controls on the international flow of capital. As quoted in the article by Thomas, “Just as John Maynard Keynes said in 1945—capital controls are now orthodox.” In the 1930s and 1940s, Keynes was a major proponent of restricted capital flows. Nixon “broke” the Bretton Woods system.

Running an independent economic policy based upon credit inflation does have consequences. The value of the currency of the country running such a policy may decline. And, as we have seen, the credit inflation created by this country, especially if it is the largest economy of the world, can export its inflation to all of the rest of the world!

And, this is precisely what the United States has been doing, regardless of what is going on any place else in the world. And, this is precisely what the rest of the world is rising up against.

There have been other consequences of the United States economic policies, regardless of whether the party in power has been the Republicans or the Democrats. I have presented these consequences in many other blog posts and will just state them here. First, the credit inflation policies of the government have tended to keep unemployment lower…in the short run…but, in the long run these policies have resulted in about one in four workers of employment age being under-employed. Second, capacity utilization in the industrial sector has continuously declined since the middle of the 1960s. It is now around 75 percent. Third, the inflationary policies of the federal government have resulted in a substantial skewing of the income distribution, with the wealthier, who can hedge and protect themselves against inflation, receiving more and more of the income generated within the United States.

Still, the leaders in the United States government use an economic model that prescribes more of the same: more spending and more monetary expansion to further stimulate the United States economy. Whereas the Congress will not provide further stimulus from the fiscal side, Bubble Ben at the Federal Reserve has entered into a desperation commitment, a “hail-Mary” pass if you will, in order to try and save the game.

The problem is that a “hail-Mary” pass at this time in the game cannot do much if your team is down by 35 points!

However, this “hail-Mary” pass can do a lot of damage to the rest of the world because the international flow of capital is so open and fluid. But, the rest of the world does not seem like it will bend over and just accept what the United States has to give it.

Two final points: First, I do not believe that we will go back to an age in which world capital flows are highly restricted. For one thing, I believe very strongly in the advancement of information technology and the increased flow of information throughout the world. Regulations and controls are going to have less and less impact over restricting international capital flows in this world. Restrictions of any kind will be “gone around” if there is an incentive to do so. This is why I believe the Frank-Dodd financial reform legislation is relatively useless. Fluid international capital flows, to me, are a given for investment analysis in the future.

Second, the United States is not going to prevail in its efforts to keep inflating the world. There are three reasons for this. One, other countries will band together and more aggressively confront the United States and work against it. And, I don’t believe the United States really wants a world of controls and protectionism. Two, by following this inflationary policy the United States is handing over its assets to the rest of the world. (See my “China Buys the World”: http://seekingalpha.com/article/236060-china-buys-the-world.) Finally, the United States must ultimately stop hurting its own people through its macroeconomic policies.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Read the article.

The "New" Economic World Order

Experts tell us that one way to solve trade problems is to let the value of your currency fall. When the value of your currency declines relative to other currencies, your exports will rise and your imports will fall. This seems to be the accepted theory.

This seems to be what the Federal Reserve is trying to do. “U. S. officials are determined to push the dollar lower” we read in the Wall Street Journal Wednesday commenting on the minutes from the September meeting of the Fed’s Open Market Committee. (See “Fed Viewed as Trying to Devalue Dollar”: http://professional.wsj.com/article/SB10001424052748703440004575547553908304106.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj.)

Maybe, however, there is another part of this theory that is not being considered. Remember, in economic theory there is a “ceteris paribus” assumption attached to all models: thus we assume “all other things the same.”

One of the other assumptions made when discussing the value of a country’s currency is that the relative productive power of all the countries considered remains the same.

My question is, can we assume that the United States, over the past fifty years, has maintained its relative position in the world with respect to its productive power?

I ask this question because it appears as if the continued decline in the value of the dollar has not improved the trade balance of the United States, especially against many of the emerging nations.

The value of the dollar goes down…the trade balance…if anything…worsens.

This is not the way it is supposed to be. Thus, something else must be at work.

The United States has been on the top of the world since the late 1940s. It continues to act as if nothing has changed.

I will respond with just two broad comments on this situation.

First, the economies of the emerging nations are developing: they are developing rapidly; and they are developing in a very competitive way.

Second, the United States has followed an economic philosophy in terms of policy over the past fifty years that has weakened it in many ways. I have presented this case on many occasions in recent weeks.

“Other things” have not remained the same, yet leadership in the United States continues to assume that they have.

As a consequence, to the leaders of the United States, the problem is “out there.” The problem is China!

One of my favorite Stephen Covey quotes is this: “If you believe the problem is ‘out there’; that’s the problem.”

My belief is that as long as the leadership of the United States believes that the problem is ‘out there’, that will be the problem.

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

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

Here are two quotes:

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

and,

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

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

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

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

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

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

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

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

And in the Bloomberg article

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

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

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

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

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

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

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

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

Guess what?

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

I find it scary for someone to say,

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

and,

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

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

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

You Can't Lead Out Of Weakness: The IMF Meetings

With each international meeting it is becoming more and more obvious, the United States is dealing from a weakened hand.

The New York Times makes it very clear: “Despite loud calls from the United States; and more muted appeals by Europe, Japan and other countries, the annual meeting of the International Monetary Fund did not succeed in placing significant pressure on China to allow a prompt and meaningful rise in the value of its currency.” (See “Financial Leaders Decline to Press China on Currency,” http://www.nytimes.com/2010/10/10/business/global/10imf.html?_r=1&ref=todayspaper.)

The language in the concluding statement of the policy-setting committee of the IMF “was benign.” Everything was postponed to the G-20 meeting in Seoul, South Korea in November.

The United States took a strong position on the value of the Chinese currency and the behavior of the Chinese government with respect to this value. The United States Congress made its will known in late September. Treasury Secretary Geithner also spoke out about the need for action on the part of the Chinese. President Obama has even made mention of the issue.

But, policy-makers are “wary about pressuring China too severely.”

Right now, China seems to hold the cards and no one is willing to move strongly against their position.

Most revealing is the fact that the United States seems to be in no position to press its points with its own actions and does not seem to be strong enough to command support among the other nations that might side with it.

Furthermore, the central bank of the United States, the Federal Reserve System, appears to be on the verge of another round of “quantitative easing”, something that world financial markets have reacted to by selling dollars. The world investment community has not given the United States a very good grade in terms of how its government has managed the monetary and fiscal policy of the country over the past eight years or so and sees these additional efforts as just a continuation of the lack of foresight and discipline and will in its economic policymaking.

If this is the prevailing attitude in the world about the economic policy of the United States, then one can only project further declines in the position of this country in the evolving discussions about world financial arrangements.

The United States has dealt itself a weak hand in world economic affairs. Unless it steps back and re-assesses how it got here and what it needs to do to change the situation, it will just continue to further weaken its position. And, it is very hard for a nation to lead when it is continually hurting itself.

Federal Reserve Non-Exit Watch: Part 2

During the Federal Reserve’s Exit Watch, the excess reserves in the banking system rose by $400 billion or so. Thus, as the Federal Reserve attempted to exit it put more reserves into the banking system.

Remember that in August 2008, the assets on the Federal Reserve balance sheet was no more than $900 billion…total!

Now we are told that the Federal Reserve, still concerned that the economy is not growing fast enough, has entered into a phase of not exiting the banking system, even expanding its stance of monetary ease by the tool affectionately referred to as “Quantitative Easing.”

Well, excess reserves in the banking system fell below the $1.0 trillion level in September for the first time since late October 2009. The decline in excess reserves in the banking system has reached almost $200 billion since the peak in this total was achieved.

Does anyone understand what the Federal Reserve is trying to do? Does the Federal Reserve understand what the Federal Reserve is trying to do?

I have argued many times in recent months that I have never seen such a lack of leadership at the Federal Reserve in my lifetime.

People claim that there is so much uncertainty in the economic and financial world right now that businesses and individuals don’t know what to do!

Well, you can look at the leadership of the Federal Reserve and get a prime example of why there is so much uncertainty around in the world.

The Fed looks positively leaderless!

In looking at the numbers from the Federal Reserve release H.4.1, “Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks,” one could argue that over the past four weeks and over the past thirteen weeks the Fed has been facing some “operational” factors that have affected reserve balances and this has clouded the picture.

“Operational” factors are things like seasonal movements in currency outstanding due to cash needs during the summer months or during the Thanksgiving to New Year’s time period or in the management and payment of tax receipts on the part of the United States Treasury.

These factors usually appear of the side of the Fed’s balance sheet that “absorbs” bank reserves. For example, if the Treasury draws funds from commercial banks into its General Account in order to “write checks” this removes (absorbs) reserves from the banking system.

In the last four months, Total Factors Absorbing Reserves rose by almost $26 billion. This increase was centered in three areas. First, currency came out of circulation ($4 billion) as the summer came to an end. Second, the United States Treasury brought about $12 billion into its General Account at the Federal Reserve. And, the Federal Reserve engaged in more Reverse Repurchase Agreements with “Foreign Official and International Accounts” which rose by $9 billion.

The Federal Reserve did not offset these absorbing factors. In fact, Total Factors Supplying Reserves also fell, but only by a little more than $3 billion. This decline seems to have occurred as line items connected with the government’s financial bailout ran off.

So, “operational” factors seem to have accounted for the $29 billion decline in Reserve Balances with Federal Reserve Banks, (part of bank’s excess reserves) over the past four weeks. This is “not exiting”? At one time this amount of decline was about 3.5% of the Fed’s balance sheet!

At the same time the Federal Reserve replaced declines in its’ portfolio of Mortgage Backed Securities and Federal Agency securities by purchases of Treasury Securities. During the four week period ending September 30, 2010, the Mortgage Backed Securities portfolio declined by about $25 billion; the Federal Agency Securities portfolio dropped by about $2 billion.

The Fed upped its portfolio of Treasury Securities by a little more than $25 billion.

So the Fed appears to be replacing maturing mortgage-backed securities and federal agency securities with Treasury securities so that the overall portfolio does not decline by much. This is one thing the Fed said it “might” do.

One should note, however, that in the last 13-week period, the Fed’s portfolio of securities declined by almost $16 billion as the Fed did not replace all of the $40 billion in mortgage-backed securities that left the portfolio and the $11 billion decline in the portfolio of federal agency securities.

One should also note that during this last 13-week period $18 billion in accounts associated with the government’s financial bailout also ran off.

I don’t know what the Federal Reserve is doing. A lot of people don’t know what the Federal Reserve is doing.

All I can add to this is that the value of the United States dollar versus the Euro declined by about 8.3% since Chairman Bernanke spoke at the Fed conference at Jackson Hole, Wyoming in August and the Wall Street Journal index of the value of the United States dollar has fallen by over 6.6% since then.

A real vote of confidence.

Monetary Warfare: Is An Independent Economic Policy Possible for a Nation?

John Maynard Keynes, after 1917, wanted to achieve full employment for England, but also for other major countries in Europe and the western world. The reason for this goal was that he was afraid of the Bolshevik menace threatening his civilized world.

Thus, beginning with the time that he returned to England from the Paris Peace Conference following World War I, Keynes sought ways that would allow a country to follow an independent economic policy that would primarily focus on full employment for the nation. Before the First World War, Keynes was, like most of his liberal counterparts, a free-trader who believed in capital mobility and flexible exchange rates

Keynes, in essence, developed a policy prescription that is consistent with what is now called the “Trilemma” problem as it is applied to economics. The “Trilemma” problem is that a nation can only achieve two out of the following three policies: fixed exchange rate, independent economic policy, and capital mobility.

Keynes opted for an independent economic policy for a government in order to achieve high levels of employment. He also believed, in his later years, that exchange rates should be fixed. This was ultimately achieved in the Bretton Woods agreement in 1944. This agreement set up the current system of international financial organizations and created a foreign exchange system that stayed in place until August 15, 1971.

The third component of this, international capital mobility, was severely restricted at the time.

What occurred in the 1960s was that inflation increased in the United States due to the fiscal and monetary policies of the government and capital began flowing throughout the world. Thus, the value of the dollar had to float in world markets. Thus, President Richard Nixon set free the dollar on August 15, 1971 and we entered a new age.

Full employment remained a policy goal of the United States government written into law by the Congress. So, the monetary and fiscal policy of the government had to remain independent of what other nations did.

Capital mobility increased as the world became more and more globalized in the latter part of
the 20th century.

And, the consequence of this combination of events left the value of the dollar on its own. And, since the early 1970s, the value of the dollar has declined by about 40% against other major currencies.

The fundamental reason for the decline in the value of the dollar was the credit inflation created by the United States government. The gross federal debt of the United States has risen at an annual compound rate of about 9.5% in the fifty years from 1961. Financial innovation on the part of the United States government has been huge.

The private sector has emulated this governmental behavior as incentives all pointed to increasing amounts of leverage on family and company balance sheets. Again, following the government, financial innovation was everywhere, especially in the area of housing finance.

World financial markets reacted by sinking the value of the dollar…except in a crisis when there was a so-called “flight to quality”. The dollar continues to remain weak and will continue to be weak as long as the United States government follows its policy of underwriting the credit inflation which is undermining the strength of the economy.

But, given conditions of the Trilemma, the dollar must continue to sink as long as international capital mobility continues and the deficit of the United States government is expected to add $15 trillion or more to federal debt over the next ten years. The United States can inflate credit all it wants, but it will have to pay in terms of a falling dollar. The two parts of the Trilemma, flexible exchange rates and the independent economic policy of the government are not really compatible at this time.

For one, this seems to play right into the hands of the Chinese. They are building up enormous international reserves. These reserves are being used to buy productive resources around the world, acquire commodities which they badly need, and increase their political power and influence throughout the nations. (See my post “Monetary Warfare: U. S. vs. China?”: http://seekingalpha.com/article/227632-monetary-warfare-u-s-vs-china.) Yes, we have a major case of mercantilism, here.

And, how does the United States respond? In terms of the policy of the government, it continues to pump things up, just what the Chinese want. And, then the United States government points its finger at China as if it is the bad guy. Well, China is the “bad guy” because it is growing stronger as the United States weakens itself.

The other piece of the picture has to do with what the economic policy of the United States government is doing to its own economy. Well, the results are not good: one in four workers of employment age are under-employed; in industry, capital utilization is between 75% and 80%; and income inequality has increased dramatically over the past 50 years as the wealthy have taken advantage of the credit inflation and the less-wealthy have suffered dramatically from the massive increase in debt leverage. (See my post “Does Fiscal Policy Really Work?”: http://seekingalpha.com/article/227210-does-fiscal-policy-really-work.)

The United States must either get its monetary and fiscal policy in order or it must seek to reduce or prohibit capital mobility. The United States cannot continue to pursue a policy of credit inflation in this era of almost totally free capital mobility without serious ramifications to the strength of its economy. The evidence of this is the current status of the American economy.

The weakness in the economy is what is driving the decline in the value of the dollar. The first conclusion one draws from a declining currency is that the decline is related just to monetary factors, to inflation. However, what we are seeing in the case of the United States is that the U. S. has exported inflation to the emerging nations through the freely flowing capital in the world. The inflation has not shown up explicitly in U. S. prices. But, the inflation has shown up implicitly in terms of the dislocation of economic resources within the United States economy.

That is why I argue that either the United States must change its philosophy about what governmental policy can do or it must seek to reduce or prohibit capital mobility. It cannot continue to support both.

In this mobile global world we live in, we cannot achieve the Keynesian requirement that the monetary and fiscal policies of a country can conducted independently of the rest of the world. Economists have to move on from the Keynesian prescription. The funny thing is, I believe that Keynes would have changed his mind many years ago.

The Long View of China

“Spend enough time with Chinese officials and economists, and you will hear a story about the Japanese yen in the 1980s.” So writes David Leonhardt in “The Long View of China’s Currency” (http://www.nytimes.com/2010/09/22/business/global/22leonhardt.html?ref=business).

A few years ago, I heard something similar, only it went like this, “Spend enough time with Chinese officials and economists and you will hear a story about Russia opening up its economy and suffering large bouts of social chaos.” Here the fear on the part of the Chinese was that opening the economy up too quickly could bring on social unrest similar to that observed in Russia, when Russia began to open up its economy.

One of the best insights given to me has been the one a friend of mine gave about the future of China. He said, “The Chinese believes that they need to move in the direction of a more capitalistic society. They also believe that moving too quickly in this direction could result in societal disruption that could derail their efforts. Furthermore, the Chinese think in decades whereas Americans think within a two- to four-year horizon. Consequently, Americans will become very impatient with what the Chinese are doing.”

Just a side note: Martin Wolf, in explaining how China is achieving its remarkable growth, makes the statement that, China “is, in a sense, the most ‘capitalist’ economy ever.” This is because it is putting so much emphasis upon investment to achieve a 8-10 percent a year growth rate. However, this is a pretty dramatic generalization. (See Wolf’s column, “How china must change if it is to sustain its ascent,” http://www.nytimes.com/2010/09/22/business/global/22leonhardt.html?ref=business.)

Leonhardt makes two important points I would like to give my on. First, he writes that China and the United States aren’t the only two countries in the world producing products. But, “The entire value of the product counts toward the trade deficit between the United States and China.”

China is making itself felt in many, many parts of the world. Again, we see the article this morning, “Chinese Business Gains Foothold in Eastern Europe,” (http://www.nytimes.com/2010/09/22/business/global/22chinaeast.html?ref=todayspaper). And, we are constantly hearing about the initiatives of China in South America, and Africa, and the Middle East. And, this doesn’t fully capture the advances of the Chinese Sovereign Wealth Fund that is even buying physical assets in the United States.

China has a long term plan to obtain supply sources and build influence throughout the world. They are doing this quietly, peacefully, and continuously.

The United States is mired in the current value of the renminbi and the current trade deficit. In the meantime, the strength of the United States economy continues to slide. There have been numerous assessments recently about where the United States stands in the world economy and they have not been very favorable to the relative strength of America’s economic performance.

One of the standard arguments for a rise in the value of a nation’s currency, or, a decline in the value of a nation’s currency is that such movement will correct trade imbalances. This is only true if the relative quality of the goods produced by the countries remains the same.
The international investment community has been especially concerned about the performance of the United States economy and the economic philosophy of the United States government since the 1980s. This concern has been reflected in the continued secular weakness of the United States dollar (see my post “The Dollar and the Fed,” http://seekingalpha.com/article/226286-the-dollar-and-the-fed).

The decline in the value of the United States dollar will not automatically correct America’s trade balance problems. The problems go much deeper.

And, this gets me to Leonhardt’s second point: we should not “view the exchange rate as a cure-all” because “economies, like battleships tend to turn slowly.”

China will continue to maintain a long-term view of where it is going. The United States will continue to focus on the short-term. As a consequence, the specifics of United States policy will vary this way and then it will vary that way, attempting to maintain high levels of economic growth and high levels of employment. The thing we have learned over the past fifty years is that such a short-run focus eventually fails to achieve either higher levels of economic growth or high levels of employment. Such policies have led to one out of every four individuals of employment age being under-employed, the capacity utilization of American industry hovering under 80%, and continued growth in income inequality.

Business is in a “funk” right now concerning the future. Uncertainty about future economic policy is high. Few people place much confidence in where the Obama administration is going policy-wise and even more people have much confidence that the Federal Reserve knows what it is doing.

The Chinese have taken the road to economic power that Germany, Japan, and the United States have taken in the past. This path relies upon becoming an exporter and reaping the advancements that come from successfully becoming an important part of world trade. Now comes the hard part, building up “a thriving domestic economy. Leonhardt argues that China is now moving slowly to achieve this.

My belief is that the Chinese will continue to travel along this path. Some of the bumps along the road, however, are going to come from sources like the United States that have created their own problems and now want others, like the Chinese, to bail them out from the weaknesses they have created for themselves. This situation will not change until the United States stops pointing fingers at others and takes a very hard look at itself.

The Dollar and the Fed

The foreign exchange markets seem to have some of the same concerns about United States monetary policy that I do. See my “Oh, No! The Fed Has More Ideas for the Economy”, http://seekingalpha.com/article/226091-oh-no-the-fed-has-more-ideas-for-the-economy.

Yesterday the value of the United States dollar in foreign exchange markets fell. According to the Wall Street Journal, “The dollar fell against most rivals Monday as worries about a new round of economic stimulus prompted investors to adopt a defensive stance ahead of Tuesday’s meeting of the Federal Reserve.” (http://professional.wsj.com/article/SB10001424052748703989304575503301526427136.html?mod=WSJ_Currencies_LEFTTopNews&mg=reno-wsj)

The value of the dollar has been trending downward since early 2002 as the fiscal deficits in the United States piled up and the Federal Reserve kept interest rates down around one percent for an extended period of time. There was a respite from this trend as investors “flew to quality” during the financial collapse of September and October of 2008. As the environment calmed in the middle of 2009, the trend downward began again. In late 2009, investors once again came to the dollar as the situation in European bond markets deteriorated. This last “flight to quality” ended in early June 2010.

It is ironic that the basic “bet” in foreign exchange markets is against the dollar, yet in times of financial crisis investors flock to the dollar because of its “quality”.

Yet, once more we are facing a falling value of the United States dollar.

As readers of this blog know my “bet” is for the value of the dollar to continue to trend downwards. The reason for this is the fiscal and monetary disarray of the United States government. Fiscal deficits continue to rise in the United States. The last fiscal year produced a deficit of about $1.4 trillion. The latest estimates for this fiscal year is another deficit of about $1.4 trillion. My guess is that the cumulative fiscal deficits of the United States government over the next ten years or so runs around $15.0 trillion.

As for monetary policy we have a Federal Reserve that has pumped over $1.0 trillion of excess reserves into the banking system. Financial markets seem to be holding their breath waiting to see what the Fed will come up with next. Within the Fed there is concern over the strength of the recovery; there is fear of deflation; and there is an unspoken fear about the solvency of the banking system.

The consequence of all this is that market participants are concerned that the Fed might throwing “stuff” against the wall once again to see what sticks! Except for the time that Bill Miller (remember him) was the Chairman of the Board of Governors of the Federal Reserve System, I have never seen confidence in the leadership of the Fed at such a low point.

The current leader of the Fed was all in favor of the extraordinarily low interest rates in the 2002-2003 period. He totally missed the economic collapse because of his concern that inflation was the major issue in 2007 and 2008. Then once the financial collapse was upon us in the fall of 2008 he threw everything thing he had against the wall to see what would stick. He was hailed as a savior because the economy did not go into another Great Depression. Yet, now “helicopter Ben” seems to be wandering around in the dark once more.

The foreign exchange markets seem to be responding to this mis-management and uncertainty.
As mentioned, the last move into the dollar came in early June. The Wall Street Journal dollar index peaked on June 7, 2010 as did the Federal Reserve’s Trade Weighted Index of the dollar against major trading partners.

These measures dropped into early August when there was a slight rebound until…. Well, until Chairman Ben gave his talk at the Federal Reserve’s conference at Jackson Hole, Wyoming.

Guess what? Chairman Ben said that the Fed was considering how it could continue “quantitative easing” using funds running off from the Fed’s portfolio of mortgage-backed securities to buy more United States Treasury issues.

The value of the dollar reached it’s near term peak on Friday, August 24 in both the Wall Street Journal index and the Federal Reserve index. Monday, August 27, Chairman Ben spoke. The value of the dollar has declined in both of these indexes ever since.

And, foreign exchange markets are now showing concern over what might come out of the meeting of the Fed’s Open Market Committee meeting today.

The United States government doesn’t seem to get it. Although investors will flock to the dollar when there is an international financial crisis, the basic trend in the value of the dollar is downwards. This has basically been the case since the United States went off the gold standard in August 1971, with two relatively short interruptions. And, it has declined in both Republican and Democratic administrations.

The basic trend in the value of the dollar is downward because the international financial community finds the fundamental economic philosophy of the United States flawed. I happen to believe that the international financial community is correct. For some of my reasoning on this, I refer again to my post from yesterday.