Tuesday, February 17, 2004

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The lure of the dollar

On Friday, the Associated Press reported that the U.S. trade deficit hit an all-time high, both in terms of dollar value ($489.4 billion) and as a percentage of GDP.

To finance this deficit, the U.S. needs to run a capital account surplus roughly equal in amount. The trouble is, the dollar countinues to depreciate against other currencies, and Daniel Gross argues in Slate that there's little the U.S. government can do to halt the slide, despite the wishes of the G-7.

Combined, this appears to have stoked two mutually inconsistent concerns -- 1) Foreigners are purchasing too many American debts and assets; and 2) If the dollar continues to slide, foreigners won't want to buy our assets any more.

On the latter front, the fears seem to be overhyped, as the Financial Times reports:

Foreign investors provided a vote of confidence in US asset markets last year by increasing the amount of money they invested in the US even as the dollar fell, according to capital flow data by the US Treasury.

A monthly report released on Tuesday showed net inflows into US markets totalled $75.7bn in December last year, down from $87.5bn the month before, but still far more than the $27.7bn seen in October or the $4.2bn inflow registered in September....

Net flows into US equities rose to a strong $13.3bn in December from $8.8bn the month before compared with an average inflow of $3.1bn over the year. In the bond market, net inflows into the Treasury market slipped to $29.8bn from $33.4bn but remained well above the $22.8bn monthly average....

Michael Woolfolk, currencies strategist at Bank of New York, said the December numbers were "overwhelmingly" positive for the dollar.

"It shows that the decline in US interest rates to four decade lows has not undermined foreign appetite for US securities to the degree thought earlier" he said.

As to the first concern -- foreigners purchasing too many dollar-denominated securities -- I'll leave that to the commenters. I'd say the best analogy to that situation is the conditions that would prompt a run on a bank.

posted by Dan on 02.17.04 at 11:08 AM


Is the concern really that

Foreigners are purchasing too many American debts and assets;
or that the health of our economy requires foreigners to purchase our debts? If we rephrase 1 and 2:
I am concerned that the health of our economy requires foreigners to purchase our debts. This concern has grown as the dollar continues to slide.
then I don't see any inconsistency. I have little understanding of the economic issues, so I'm not really making an economic point so much as a dialectic one.

posted by: Anon on 02.17.04 at 11:08 AM [permalink]

The tendency for American business executives and even business analysts to focus on the numbers for the next quarter only is so pronounced it's in danger of becoming a stereotype.

The reason low interest rates are not undermining foreign demand for American securities is that Asian central banks -- that is, governments -- are buying US securities to keep their own currencies weak against the dollar. Their own economies depend for growth on exports to the United States, which is something that a weak local currency promotes. It is also something that will not always be true.

At some point, Asian governments will want, or be forced to, increase the purchasing power of their own consumers. They may also at some point wish to use export earnings for internal economic development. When that happens, the market for American securities will dry up, forcing substantial increases in interest rates -- increases that will be all the more dramatic because the American government is itself a large purchaser of debt.

It is the height of complacency to assume that the reason foreigners are buying American securities is that these are the attractive investments they have always been. At least it would be if one's time framework extended beyond the next couple of months.

posted by: Zathras on 02.17.04 at 11:08 AM [permalink]

And concerns about the ability of foreign powers to wreck the US economy by selling all its debt are overblown. It's not in the interest of anyone who has an economy that's buying dollars to cause the US economy to crater. We're all too interlinked.

In some way America has the upper hand. If the foreigners stop buying enough US debt, the world economy blows up. America really doesn't have to worry about how much debt it accumulates. Everybody else *has* to buy it or watch their economies collapse shortly after the US economy expires.

posted by: Tom West on 02.17.04 at 11:08 AM [permalink]

In some way America has the upper hand. If the foreigners stop buying enough US debt, the world economy blows up. America really doesn't have to worry about how much debt it accumulates. Everybody else *has* to buy it or watch their economies collapse shortly after the US economy expires.

Well that's comforting. I'll sleep better now.

posted by: praktike on 02.17.04 at 11:08 AM [permalink]

Exactly what Tom said: the global economy is dependant upon powerhouses staying relatively stable. If China seels off all their Tbonds, and the US economy implodes -- what does that do to China's economy? It absolutely kills it, since China makes most of its money by selling cheap goods to US consumers.

G7ers want the US dollar to rise so their exports will pick up again; as long as the US dollar slips versus the Euro -- but stays stable -- our exports will be cheaper in foreign markets.

posted by: Mike on 02.17.04 at 11:08 AM [permalink]

One unexamined problem is that if we weren't putting out new debt in massive amounts, would the demand for our debt change? In other words, we're teetering on the edge of a deflationary spiral here. Inflation's about 1% and has been trending down for some time. If the bond supply into the market were lower, prices should rise and we might get into negative return territory.

The PRC doesn't care about negative returns. It just wants to avoid revolution and a leadership that is hung in the streets. They're on a very unsteady high wire and they have no net.

posted by: TM Lutas on 02.17.04 at 11:08 AM [permalink]

Just a comment - when the bank loans $1,000, you are in trouble if you can't pay. If the bank loans you $1,000,000, the bank is very likely in trouble if you can't pay, *even if* the bank is a multi-million dollar concern.

Expecting rational behavior from markets is the way to bet, but not invariant. Added to the political issues, and things get a little more complicated

posted by: Ian Argent on 02.17.04 at 11:08 AM [permalink]

And, that, Mr. Argent, is the point. Purchase of American debt by Asian central banks is primarily a political decision, aimed at perpetuating the rapid growth in employment an export-driven economic model has made possible in Asia. The export-driven model is not the only one possible (it is not, after all, the one the United States used itself) and there is some question how sustainable the growth resulting from it is.

No one is talking about all Asian central banks getting together some Monday and deciding that they will buy no more Treasury notes on Tuesday. The combination of very low interest rates here and investment opportunities offering higher rates of return elsewhere make it inevitable that they will buy fewer Treasury notes eventually, however. Foreign governments are buying American debt now because they think it helps them. When they conclude their own interests are better served by doing something else with their foreign reserves, we will have ample reason to deplore today's self-congratulation over "the lure of the dollar."

posted by: Zathras on 02.17.04 at 11:08 AM [permalink]

Ok, upon reading the title of this post, did anybody else think immediately of Kramer?

posted by: Independent George on 02.17.04 at 11:08 AM [permalink]

Allow me to ask a provocative question. The United States is militarily the strongest nation on this planet. How much does this indirectly, if not even directly, encourage other countries to trust our economy? Is it plausible that every single dollar we spend on our military budget results in economic gain?

posted by: David Thomson on 02.17.04 at 11:08 AM [permalink]

I had this argument with my late father zt'l 35 years ago. He said "They send us cars and we send them green paper. Where is the problem?" He was right.

Ian Argent quotes the old saw about large and small debts. And the trade deficit presents that in spades. Further, the central banks that hold treasury paper as reserves don't have a lot of options. There is not enough yen or pound paper available and the Euro is riding high but is very precarious.

posted by: Robert Schwartz on 02.17.04 at 11:08 AM [permalink]

Dear DT,

You ask a provacative question:
"Is it plausible that every single dollar we spend on our military budget results in economic gain?"

The answer is that market confidence will be increased so long as it is perceived that we are militarily dominant and winning. Given that we have not one, but several military escalation scenarios playing out in the next 12-24 months and we're already stretched tight then I'd saying buying market confidence by military prowess wasn't the smartest idea.

Dear Zathras,

You write:
"When they conclude their own interests are better served by doing something else with their foreign reserves, we will have ample reason to deplore today's self-congratulation over "the lure of the dollar.""

I agree. However if we look at the peso devalulation problem of the nineties we see a plausible scenario of how it might play out. Currently Foreign banks are supporting the dollar using their foriegn hard currency reserves. These dollars are then parked in treasuries, which is depressing the yield curve. What happened to Mexico is that when it tried keeping the peso from falling too far, it burned through its foreign currency reserves and then the peso fell precipitiously and Mexican debt took a dive - forcing interest rates up in the bond market yeild curve and forcing the Mexican central bank's hand. At that point, the US bailout ensued and a recession/market correction hit Mexico.

I would argue that the most likely scenario is something similar. At some point the falling dollar will suitably exhaust foreign hard currency reserves and the value of treasuries will drop appropriately, and countries like Japan and China will both find it necessary to let their currencies float versus the dollar. The pressure on the US bond market will cause the yeild curve to assume historically normal trends and Greenspan will be forced to let the Fed Funds rate rise to its long term trend - probably 4-5%. If this occurs in a short period of time look for a massive real estate and stock market correction. Along with already contracting money supply this would probably generate a severe recession possibly this fall.

posted by: Oldman on 02.17.04 at 11:08 AM [permalink]

"Foreign investors..."

this is a misnomer, central banks are not foreign investors. there's a big difference. private portfolio inflows into US assets have been small compared to central bank purchases the last few years.

this is because of purchasing power erosion, much less low returns on US assets. so foreign investors have already stopped buying. central banks will stop when they want to rein in nascent bubbles.

posted by: lobeaux on 02.17.04 at 11:08 AM [permalink]

The great fear out in the world of the capital markets is that the huge, enormous, awe-inspiring, stupendous, on-going, massive (are we clear yet?!) increase in foreign buying of US government debt by the Japanese and Chinese will eventually come to a halt. As the great economist Herb Stein once said, "Something that cannot continue won't." Knowing when that something shall stop is quite another question, but certainly Mr. Stein was correct. Trees do not grow to the sky; Bubbles do eventually explode.

The foreign buying of US securities is reaching Bubble stage. In the past two years, someone.... or more properly several someones... has bought very nearly $400 billion of US government securities (US Federal and US agencies combined). We know that because the Fed's custody account (including agencies) has gone from something on the order of $700 billion in 2000-2001 (where it was quite stable) to 1.225 trillion presently. This is unprecedented buying, but it is buying that has had to be done. Simply put, if Japan and China are the two major buyers, the Japanese are buyers as they have tried vainly to push their own currency down, have printed huge sums of Yen in the process, having sold that yen and bought US dollars with it, and have had to invest those dollars. They've created their own problem, and they have tried to accommodate their problem as best they could.

In the case of China, its huge trade imbalance has mandated that they re-invest these accumulated "reserves" in US Treasury and/or agency securities. Simply put, they've swapped goods for debt securities, and as long as the imbalance of trade persisted, US government securities were there to be purchased... and were. The problem is that earlier this week, China reported a trade deficit of US$20 million in early January, the first deficit in 10 months, as export growth slowed down after a cut in tax rebates to exporters took effect in early January.. The media only pays attention to the fact that China still runs an enormous and expanding positive imbalance of trade with the US, but it is now running an imbalance of trade with the rest of the world, and it is this figure that is paramount... and it is shifting.

I have long maintained that the Chinese, as their per capita incomes rise (and they are and they will) shall become the world's great consumers, buying better food, better and more washing machines, better and more curtains, better and more... et al, ad infinitum. The Chinese are leaping headlong into the 21st century, and they are about to have a shift in their trade figures that shall be stunning in its enormity and its effect. In essence, I fear that the recent drop in the positive balance of trade into a negative imbalance may be the first shot across the trade bow in this regard. I do not expect the next month, or the month after be necessarily negative, for this first negative turn is the result of the ending of a tax rebate as noted above. But this tax rebate's conclusion was not the only change... and if the imbalance is indeed beginning to turn, when it does turn, it will be worthy of note.

When this imbalance does turn, the buying of US Treasury securities will... if not end.... be curtailed materially. And eventually, if the Japanese chose to give up on their attempts to engineer the Yen lower, they too shall quickly end their purchases of debt securities. The Fed then shall have no choice; it shall be the buyer, and it shall be the aggressive buyer, and it shall be the relentless buyer of these securities. It must, and in the process, it shall be rather fundamentally inflationary, and egregiously so. Dollars... hundreds of billions of dollars, will be created by the Fed to buy those securities on offer and it will be obliged to buy them, expanding the monetary base at a pace we have simply not become accustomed to.

Dr. Bernanke, in his now famous speech of November of '02, made it very clear what the Fed could do as it approached what he called the "Zero Interest Rate Option." I called it then the most important speech by a central banker since the comments made by Mr. Volker over that eventful
weekend in '79 when the Fed changed its focus and became an overt inflation fighter. Dr. Bernanke and an associate later laid out the policies that the Fed could follow when necessary.

The Simplest Strategy: "Buying Other Domestic Securities."

Bernanke has made it clear that the Fed's policy shall be: it shall be what it is supposed to be, the buyer of last resort and it shall accept that role willingly. When the time comes (and it shall come...of that I am certain) for Japan to stop intervening and for China to suffer an imbalance of trade that is negative, the Fed's actions are mandated, and they shall be inflationary... overtly so... and they shall be dollar destructive. This is a problem for the future, and as we are wont to say, "A problem is not a problem until it is a problem." I have learned that trading in anticipation of a problem is a stunning waste of capital and energy. However it is good to be prepared for problems, for when they do come they tend to fall upon us like an anvil from on high. As Shakespeare said, when problems come they come in legions, and we are preparing for battle.

posted by: TG Logan on 02.17.04 at 11:08 AM [permalink]

Oldman, I'm not so concerned about the timing, and in fact I doubt that the sequence of events you predict will happen this year. The Chinese appear to be happy with the status quo for now; the Japanese, conversely would risk a major economic contraction of their own if the yen were to suddenly depreciate right now. But I agree that at some point we will be looking at a scenario with elements similar to yours -- and in addition a surge in inflation as imports from Asia become more expensive with a weaker dollar.

posted by: Zathras on 02.17.04 at 11:08 AM [permalink]

So what happens in Europe when the US economy abruptly stops (assuming the Japan/China credit crunch scenario goes down?)

posted by: Ian Argent on 02.17.04 at 11:08 AM [permalink]

Dear Zathras,

You should look at my post and TG Logan's in tandem. The reason why I suggest this year is a mere suggestion/educated guess based on several factors.

The point is that if you look at several different indicators - foreign debt speculation (See the current online Buttonwood column: the coming storm), foreign central bank intervention in the currency market, the US domestic stock market, US fiscal red ink expansion, inflation being above the reported nominal 1.1%, subtle noises of distress coming from the Fed, and real estate in the United States you see not one but several unsustainable escalatory bubbles that are all approaching a "top". All of these systems are interrelated, and what we're looking at is a convergent set of instabilities that look to produce an "economic meltdown" somewhat similar to the Asian contagion experience in the 90's. Only it is doubtful that this time that central banks will be able to stop the unwinding of the bets made.

Basically in the coming year, it will only take a small exogenous shock to any one of these systems to cause a precipitous interaction with the others. This could set off a global market correction.

Investors who have been coming to me and asking my opinion, have after hearing it nodded and said "yes, I've already decided to pull out my money ... I just wanted to hear what you had to say". One just had me over for dinner last night for that reason, and a business owner today separately over dinner had the same anxieties over his own investments (he's from Thailand). People already smell trouble in the air Zathras, it's simply that they aren't able to articulate it as well as those of us who have some familiarity with macro-economics. They won't announce their decisions, they'll just quietly sell before the top. More and more I get this kind of spontaneous feedback on the ground, and more and more I get cagey commentators remarking on various market escalations recently. You add it all up and it isn't pretty.

posted by: Oldman on 02.17.04 at 11:08 AM [permalink]

Quick comment, because unlike you all, I am actually contributing to the GDP by working.

23 years ago, I started in the stock market business and I remember clearly anticipating with all of my market comrades with great nervousness to monthly announcements of record trade deficits. The doom and gloom analyses of those deficits were the same then as they are now.

My question: Exactly when is all of this calamity supposed to happen? I'm waiting.

posted by: ken on 02.17.04 at 11:08 AM [permalink]

Well, Ken, I hope you weren't too busy working to read the posts you responded to. They laid it out pretty clearly. Oldman thinks calamity will happen sooner and suddenly; I think it more likely to happen later and be drawn out over a longer period of time.

I do not know who is right. I do know that we are headed for trouble, and that the people who think we are not just because it hasn't fully arrived yet will be the most aggrieved after it does at the idea that the government didn't see it coming.

posted by: Zathras on 02.17.04 at 11:08 AM [permalink]

23 years ago, I started in the stock market business and I remember clearly anticipating with all of my market comrades with great nervousness to monthly announcements of record trade deficits. The doom and gloom analyses of those deficits were the same then as they are now.

My question: Exactly when is all of this calamity supposed to happen? I'm waiting.

It happened, weren't you looking? If you'd not been so busy getting the coffees as desk junior, you'd have noticed that the Dow Industrials fell 12.9% between January 1981 and January 1982.

posted by: dsquared on 02.17.04 at 11:08 AM [permalink]

Ken as I noted above I have been waiting for 35 years. In the long run we are all dead.

posted by: Robert Schwartz on 02.17.04 at 11:08 AM [permalink]

It is the economic era we live in that's to blame. For years the US and Europe were more prosperous than other nations, because they made products other nations could not make. Either because of the advanced technology or because of the closed markets in the West, which took away export prospects and profitability for other nations. It took a long time, but Korean engineers can now build a technologically advanced ship as well as American engineers. With the difference in wages, this means a whole industry moves out of the country. How do you stop outsourcing? By stopping other nations from gaining advanced technology? This is impossible. By protecting our market, so foreign companies can not hope to export and regain their investments and therefore will not invest in certain industries? This is impossible. If we do not go with the time and buy the best you can get, other countries like China might get an advantage over us. Foreigners are not stupid. American power is sustained by staying on top. If you discard advancement, we will wake up one morning and find "communist Russians being the first to put a man in space", or an equivalent of that. The only thing you could do to stop outsourcing is to pay American workers less money. But how low can you go? A chinese worker gets a dollar an hour. Economists know that a country like China could manufacture all goods all the 6 billion people on Earth need. With their low wages. This might happen. What should American, European and other workers do? Nothing. Kapitalism is by it's nature, the best economic system, but also a suicidal system. Kapitalism dictates that all manufacturing jobs go to China. Other countries better start a 1 child a family population reduction policy, because not too long from now there will be a lot of unneeded workers everywhere. It's either population reduction or poverty on a massive African scale. And poverty in the US will lead to a Weimar like Republic and we know what follows after that. An American Third Reich.

posted by: Ricky Vandal on 02.17.04 at 11:08 AM [permalink]

"It happened, weren't you looking? If you'd not been so busy getting the coffees as desk junior, you'd have noticed that the Dow Industrials fell 12.9% between January 1981 and January 1982."

That's called a correction, not a calamity. Of course the year after that started the longest bull-market in history.

What people are talking about here is a series of economic events that will end up with America being permanently damaged, never to be an economic power again.

Not being quite old enough to remember what was going on economically in the early 80's (although I did know the words inflation and recession) my point of reference is the early 90's when Japan was going to buy America and we were all going to end up caddying Japanese golfers around Pebble Beach for a living. It's hard to describe today what anxiety Americans had about losing everything to Japan. It almost sounds comical to somebody who didn't live through it, but it's true. If I had a nickel for every crank consultant running around this country hawking their latest book saying that we would have to emulate Japan (since America was broken) or we would all be second class citizens, I'd be have a Ferrari for every day of the week.

The only thing that saved America from that "calamity" was reality.

My theory is that every 10 years or so America has to go through a period of serious self-doubt and self-loathing before we can get on with the business of being the greatest country on Earth. It ususally coincides with a Presidential election.

posted by: DSpears on 02.17.04 at 11:08 AM [permalink]

Mr. Ken,

Idiocy like yours is one reason the oldman has rarely trusted those who work in the financial markets - to my profit and the preservation of my principle. You are confusing long term structural issues and short term oscillations. Admittedly, this is something even Zathras has done as his summary shows his lack of grasp.

First, it is well reported that there may be a major market correction this year. This morning the oldman heard a financial advisor talking about the widespread reports of it among market participants. It's not exactly a secret.

Second, if you haven't noticed American wages are stangnant, the cost of living inflation is much higher than the CPI inflation, education, housing, and medical care costs are rising all much faster than "nominal inflation" - the trade deficit has been balanced on the back of the American worker for the last two decades. It was a long term trend, and not a sudden sharp event.

Thirdly, the dollar crises is already forcing the price of oil - denominated in dollars - up considerably (from $28 pb to $35). It will rise more. As the Buttonwood column of the Economist noted, there is a bubble in foreign debt speculation. As others note there is no support for the dollar. As market participants note, there is a correction or unwinding that needs to be done in the American stock market this year.

So there will be a market "crash" or correction, probably in multiple markets - the dollar, the stock market, US treasury debt, foreign debt, and through interest rates the US economy - and probably sooner than later. As of info recieved this morning the oldman is sending out adviseries suggesting a moved up schedule to pull back out of stock and debt markets. This isn't just going out to associates or clients, it's going out to friends, relatives, etc.

The sky isn't falling, but unless you want to be one of the "buy and hold" suckers you have to learn how to pull the trigger and operate in the black. This is the real world. These decisions have real consequences for people's lives. Saying the stock market will make you money in 50 years if you blindly trust brokers or trading specialists is for chumps. It's not like it's their money on the line. If people trust in your opinion, as people trust in the oldman, then you better be able to deliver. The oldman says ... a stretched out debacle ... probably starting in the summer. To be save, move your money out of the market within one to two months. Where? The oldman doesn't favor gold even though it may have upside potential. Just parking it in a money market account that has diversification in currencies may have some appeal. There are more complicated strategies, but the main idea is to get it out of asset classes including real estate.

posted by: Oldman on 02.17.04 at 11:08 AM [permalink]

I just checked back to this thread. I'm actually laughing so hard. I'm sitting here on a friday night with a beer in my hand contemplating whether I should reply in depth. Nyah.

But a few of the posts were really pretty humorous (ohhhh, the things I could say ). Kudos to Dresner for the forum and the stimuli.

posted by: ken on 02.17.04 at 11:08 AM [permalink]

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