[R-G] The Dollar and the Market Mess

[Yoshie Furuhashi]

<http://online.wsj.com/article/SB120105077515308369.html?mod=googlenews_wsj>
COMMENTARY

The Dollar and the Market Mess
By BILL WILBY
January 23, 2008; Page A25

Lenin was surely right. There is no subtler, no surer means of
overturning the existing basis of society than to debauch the
currency. The process engages all the hidden forces of economic law on
the side of destruction, and does it in a manner which not one man in
a million is able to diagnose.

-- John Maynard Keynes

Currency debauchment is a choice. Most governments don't want to
debauch their currency -- it's just that they don't want to take the
actions that might prevent it, because those actions are perceived to
be intolerably painful. Thus it was that last fall, the Federal
Reserve, the world's central bank, decided to "let the dollar go"
because staying the course on interest rates might threaten the
world's financial system (or so the argument goes).

Meanwhile oil prices are high, inflation is considerably above the
Fed's own stated long-term targets, and the dollar is in danger of
losing its reserve currency status. Should we care? Are saving the
dollar and saving the global financial system mutually exclusive
alternatives? And isn't a dollar decline necessary for "rebalancing"
the U.S.'s external deficits? The answer to the first question is a
resounding yes, and to the last two questions, resounding nos.
[Hourglass]

Why is a weak dollar bad for America? First of all, it directly pushes
up oil and other commodity prices by paying the producers with a
depreciating piece of paper (thus removing the incentive to increase
production), while lowering local currency oil prices for the rest of
the world (thus increasing oil demand at the margin). It is no
coincidence that the world's two great oil shocks in 1972-73 and
2004-2007 both came after long periods of off-balance-sheet global
monetary expansion and subsequent dollar weakness -- the growth of the
eurodollar market in the late 1960s and 1970s, and the SIV and CDO
expansion of the last several years.

Oil traders know this, and it is why the immediate consequence of the
Fed's earlier 50-basis-point cut was to take the dollar down and oil
prices up. One could write a separate essay on what a lower dollar and
higher oil prices do to our strategic interests, such as propping up
regimes like those in Iran and Russia.

Second, a lower dollar reduces the wealth of the U.S. consumer in
global terms, immediately through the dollar's lower purchasing power,
and longer term through the erosive impact of inflation. It hits
retirees and those on fixed incomes particularly hard, and is a
totally counterproductive policy for a potentially weak consumer.

Third, the weaker dollar accelerates the growth of our competitors.
China may be growing at 11% or more in yuan terms, but their growth in
U.S. dollars in 2007 was greater than 17%, and it is their dollar
growth rate that is relevant for the rate of their rise in the world's
economic hierarchy. Using Europe as another example, in 2002 U.S.
nominal GDP was nearly 10% larger than that of the Eurozone 15. Today
it is 14.3% smaller. Although Europe has been growing more slowly, its
global economic power has been rising more rapidly than that of the
U.S. because of our falling greenback.

Finally, if America were to lose its reserve currency status because
of a continued loss of confidence in the dollar, the cost in terms of
jobs and growth would be significant. The real economic benefit
conveyed by the right to print the accepted global currency is called
seignorage, which results in part from the lower capital cost we
derive from foreigners' willingness to hold dollar cash. This country
has taken for granted the benefits of our global seignorage for many
years, and it is one of the reasons the U.S. has maintained a higher
growth rate than the world's other mature economies.

But don't we need a lower dollar to "correct" our large trade and
current account deficits? In the first place, our accounting deficits
are largely with our own overseas subsidiaries (more than 50% of world
trade is intra-company trade) and reflect an increasingly globalized
world economy. Second, America is the shopping mall for the world.
Because our distribution system is the world's most efficient, retail
prices for the world's goods are lower here, and we have been the
shopping destination for the world's consumers even before the dollar
began its recent fall. These foreign purchases prop up retail sales
(helping to explain the resilience of the U.S. consumer), depress our
measured savings rate, and result in an underreporting of U.S. exports
and an exaggerated measure of our imports (some significant share of
our imports are actually bought by foreigners).

The ability of currency moves to correct trade deficits or surpluses
depends on the elasticity of demand and supply. Because of
increasingly specialized world trade, the elasticity associated with
our exports and imports are very low. Thus a falling dollar is likely
to increase the dollar amount of our imports (the infamous J-curve),
and force the bulk of the adjustment to currency moves into the
"income effect" that results from our higher bills (witness the impact
of higher oil prices on the U.S. consumer). Moreover, our current
account deficit for a year is equal to only a fraction of the dollar's
foreign-exchange trades for a day. To say that one is either the cause
or consequence of the other is almost laughable.

Our external deficits are largely measures of Federal Reserve and
banking-system liquidity creation, just as the dollar's exchange rate
is a function of foreign trust in holding dollar cash or near-cash
balances as a monetary store of value (these balances are the lion's
share of our so-called foreign debt). Thus, our deficits will only be
ameliorated by a slowdown in liquidity creation itself. Just such a
slowdown is likely now underway as a result of the mortgage crisis as
we enter 2008, but any attempt by the Fed to ease at the expense of
further dollar declines will likely snatch defeat from the jaws of
victory, and risk a global inflation of significant proportions over
the next several years.

Doesn't a failure to respond aggressively to the credit crisis by
cutting rates too slowly risk a recession, or a Japan-like breakdown
of the world's financial system? Unfortunately the recession risk is
high, but not because of high interest rates (which are currently
negative in real, after-tax terms). The recession risk is high because
of a breakdown in the absurd system that developed for the packaging
and underwriting of debt, and the excess liquidity that developed from
the combination of that system and a highly stimulative monetary
policy.

The Fed took a gamble on inflation to ward off what was perceived as a
deflationary threat in 2001-02. The inflationary consequences of that
gamble are now here, with the petrodollar monetary merry-go-round
fueled by the weaker dollar. Those consequences will be much easier to
deal with now, rather than later. Unlike Japan, where the
capital-markets risk was concentrated in a handful of thinly
capitalized large banks, the very growth of the credit-derivatives
market that is the source of the current crisis in the U.S. has also
resulted in a wide dispersion of risk in the financial system, and any
recession will likely be mild and short.

While we might see a number of hedge funds and some isolated banks
fail, the pool of distressed asset buyers waiting in the wings would
result in a needed consolidation of the financial-services industry,
without systemic failure. In the meantime, the systemic risk posed by
the failure of one or more of these institutions is minimal compared
to the moral hazard and longer-term inflation risks we incur from
their bailout.

Sadly, the dimensions of the Fed's great dilemma would be much less
acute had the Fed and Treasury officials not taken such a cavalier
approach to the U.S. dollar over the past eight years. Our "strong
dollar" (wink, wink) policy has never been articulated by either
institution with any real conviction, and markets have rightly sensed
that maintaining employment, growth and stock-market happiness has
begun to take precedence over maintaining the value of money. In a
world of fiat currencies, where trust is your most powerful policy
tool, dollar strength is a far better indicator as to the appropriate
stance of monetary policy than "core" inflation.

Any further loss of confidence in the U.S. currency will cost us
dearly in terms of both price stability and jobs in the long run, as
it will imply a higher level of interest rates to maintain a given
monetary stance. A convincing elevation of the dollar in the policy
priority list for both the Fed and the Treasury would be the single
greatest step that either institution could take in restoring health
to the financial system.

Mr. Wilby is a former head of equities at OppenheimerFunds.

--
Yoshie
<http://montages.blogspot.com/>