Tuesday, November 29, 2011

Europe..again the trade-offs

Europe: Irresistible farce meets the immoveable subjective

As we look at the assessments these are the polar opposite arguments. One group argues that Europe cannot come apart. The other holds that Europe must come apart. The euro-unity camp argues that it is nothing short of the future of Europe that is at stake (they are right but for all the wrong reason). The EMU-breakers argue several facts ranging from the high and different debt levels, cultural differences, differences in work ethic, the inability to make austerity work and the severe loss of competitiveness that has been suffered within the Zone.

As we look at these two cases and consider some of the arguments about how painful a break up would be, we need to look only at the Greek episode to see how little thinking has gone into the e-Zone analysis. There are many more than two possible cases here.

In the recent case of Greece, it negotiated a default that was not a default and did not trigger credit default swaps to pay. Granted Greece is now back at it, asking for an even larger haircut, but that is a separate issue (as well as part of the main issue, of course). The point is that when push comes to shove the rules change. It’s like the final seconds of a basketball game when the referees all but swallow their whistles (and with the NBA is set to play again we may get to witness more of that). Suddenly, you are playing under different rules. We should have no misconception that if the Zone is under stress and needs to blow out a few members that it will be done under existing rules without any changes. That, in fact, seems the least likely result to me.

What we may need to consider is a break up that keeps Europe together. That is a novel concept.

First of all if a nation goes bankrupt it is not certain that it would have to leave the Zone. But in a number of countries the problem is not only debt, it is competiveness. Let them declare bankruptcy and write down their debt and they are still uncompetitive. I see a lot of proposals for EMU-bonds and other financing devices but these are putting the cart before the horse. Greece has lost some 25% in competitiveness to Germany, Spain has lost about the same. Portugal has lost a bit less. Italy has lost about 10%- all since EMU has been formed and the outlet of currency depreciation has been removed.

These are competitiveness losses that would be hard to make up if the Zone stays together. If it breaks up, then countries could form a second block and try to regroup within that framework and to maintain a link to the rest of the zone depreciate their currency and restore their competitiveness.. They might even get assistance since they could all remain in the same EU mechanism and thereby have a split that is in currency terms only.

The countries that left the Zone would then be able to regroup, try to reestablish their competiveness under a new currency basis and possibly reenter the Zone at a later date. Greece and Spain and Italy and Portugal could issue a new common currency or each could to retreat to its own former unit.

It is important is to realize that all these arguments that are made about the Zone are less than resourceful – some are made by ideologues rather than argued from the facts. It is highly likely that once faced with the eventuality of break up that the Zone rules would change to allow the dead weight to leave on modified terms. It is also likely that the countries that left would get some aid and would leave on ‘good terms’ with either an option or a mandate to return to the fold in due time.

Ironically, a break-up may simply be the best vehicle for Europe to stay together.

It may not be too tidy and it would cause some trouble and legal issues. Imagine contracts written in terms of euros in a country that adopts its own and former unit. What are the grounds for altering that contract or not? Magnify that thousands of times. You might not be able to keep the contract in euros but neither could you redenominate it ‘as is’ since a local currency did not previously exist and one could not assume that two parties would have agreed to the same deal on different currency terms. For example, one assumes that there would be more inflation, at least initially, under a new unit as debt problems were inflated away and as the new unit sunk to a point that reflected the true parity for the new currency relative to the euro (since we are assuming here that the least competitive countries leave EMU).

So yes break up has a lot of technical issues that will become clearer if Europe goes down that path. If it does not, maybe it is not the end of the world either, despite all those arguments to the contrary.

Maybe the lost competitiveness in the South is not an issue because they simply will have industries that will not compete with Germany, the low cost EMU member. Maybe the Zone will come to specialize more. The US, after all, does not have the same industries uniformly spread across the nation. We have farming states, natural resource states and industrial states and all sorts of specialization. We also have high-cost states and low-cost states. If Europe is willing to reorganize itself along those lines maybe ‘not coming apart’ can work.

But I do not see how Europeans stay together and pretend that the lost competitiveness regions are going to catch up. Economics rules out miracles.

If Europe becomes more of a single economic unit we will not have to worry about the structural trade and current account imbalances that have developed within the Zone. Italy Spain, Portugal and Greece are running persistent balance of payments deficits; that will not be an issue when/if EMU finances are blended with the countries that run chronic surpluses. In this view Europe will move to a model of regional specialization instead of a model of free-standing countries sharing a currency but with independent financial issues each trying to run a balanced economy.

It should be clear that the choices Europe is about to make will have far reaching consequences.

This is why having a new treaty with voting makes sense. Most euro-leaders do not want to do it because there are factions at home that want to claw-back rights from ‘Brussels.’ But Angela Merkel has pushed for a new treaty vote for good reason. As the above discussion demonstrates, what is being contemplated- whatever road Europe takes- has far reaching consequences. It is important that all members are truly on board. It would be a really bad choice if the ‘euro-leaders’ were to gin together some deal that would bridge the financing issues without coming eyeball to eyeball with the broader socio-economic issues which lie at the bottom of the Euro-imbroglio.

Let me emphasize that coming up with a check to fund Europe near term, as difficult as that has proved to be, is a much easier thing than having Europe come face to face with what its identity will become. Pretending that you can stretch out financing and not dealing with what that time will buy is absolute nonsense. And that is why the German position has been so hardline. Germans want their money to buy results: a harder reality.

The Germans are the most solvent of the European nations and Germany has the most solid bond market. Germans are in the euro-cat-bird seat. But they are not out of danger. And that is why they shoot down one harebrained scheme to finance things after another. The Germans want financing to lead to a stable end game. And most of the financial schemes do not do that because many of them take a lot of the pain out of the process and without pain there will not be the kind of enduring progress that is needed.

I think this is a much more productive way to think about Europe, than heads it’s unified, tails it’s busted up. Europe needs to decide its identity that is the issue.

It is not about financing. It is about Europe deciding what it will be when it grows up. Heck people get divorced and then remarry! What can’t the Zone break-up over currencies and keep other common elements and plan to relink under better-understood circumstances in the future? What is so sacred about keeping the currencies fixed when it is so clear that the fix has gone bad? Who is looking at this and thinking about what it means to stay fixed in one zone instead of being flexible in one union?

In a piece on the future of the euro-Zone written by Niall Ferguson, the British historian, he, interestingly, has the UK pulling out of the EU and being joined by Ireland. He has Greece staying in. Then, years on, Greeks would still be undergoing high unemployment and still muddling through with huge transfer payments to support their lifestyle underwritten by Germans! Science fiction is one thing, but Greek political fiction is something else.

It’s not a result that I can see happening (sorry Niall); but it is consistent with what could happen if the Zone is kept together without a clear view of what that means for everyone. Would the Germans give in and support high unemployment in an uncompetitive Greece? Or would they force a long, long, period of austerity on Greece? And if that were done, would Greece have the staying power to stick it out within the Zone or would it choose to leave? This is why a treaty vote is so crucial and why those who would change the game must also change the vision so people know the consequences of their vote.

But Europe is also a place where leaders are used to leading their people by herding them into certain situations. Some it seems would prefer to kick the can down the road in a certain way to make the eventuality of a certain decision more likely. This is contrivance and manipulation. I am opposed to this path for Europe. Horse first. Cart second. It should not do it the other way around. The choice and its implication should be made clear.

Those are the thoughts that lurk behind any analysis of where the Europe is going. Europe must decide first what it wants, then arrange to finance that identity. It should not finance staying together for a while longer while they all try to figure it out. That time has passed.

Euro-procrastination makes no sense to me. It’s not buying time, or renting time; it is squandering it. Time to step up and pick your future.

Sunday, September 18, 2011

WSJ Blunders over Romney smack-down on Free Trade

Open letter to WSJ over Romeny free-trade put-down

Dear sir,

Your asserting that Romney has made a blunder ( WSJ September 17, 2011 “Romney’s China Blunder”) is supported by the most vacuous logic.

You take Romney to task for not assesses the facts you then address those facts then dismiss them.

You say:

Any serious argument that China is running a mercantilist trade policy needs to look at the Chinese trade surplus with the rest of the world. That has grown dramatically over the last decade, due to policies that we have criticized. The crux of the issue is not the value of China's currency—every country has the right to pursue exchange-rate stability, and dozens of countries peg or somehow adjust their currencies to the dollar.’ (Emphasis added)

This is the warped logic of ‘free trade’ that actually undermines free trade.. For trade to be ‘FREE” and for the good things that flow from FREE TRADE to occur, exchange rates must be at their proper parity values not arbitrary or self-selected levels. Countries really DO NOT have the ‘right’ to choose any stability system they wish to choose or to peg to the dollar. This notion is sheer folly. It may be current practice but it still is folly. How can a competition-loving paper like the WSJ endorse national ‘price fixing’ as a means to free trade? What more important price to ‘fix’ than the exchange rate? The international trade literature is replete with papers about the damage from misaligned exchange rates and yet you dismiss it with a few taps on your keyboard and proceed to ignore all the evidence that misaligned trade is causing damage..

I’m sure after a few nanosecond of thought this is a position you will want to ‘re-think.’

Want more facts to support Mr. Romney? Exchange rate fixing is why developing nations own three-quarters of the world’s foreign exchange reserves. They buy dollars and other currencies to keep their own currencies competitive. This is why the US Current Account averages a deficit of 2.1% of GDP since 1971 when Bretton Woods collapsed, and why the US current account has not been in surplus in any quarter since 1991. If you believe in markets how is such a result consistent with exchange rate equilibrium?

Romney has a Tiger by the tail. Your lot would be better cast by getting on his side. The argument that China’s own domestic monetary policy has to blow up to get the Journal to realize that China (and others) are engaged in anti-competitive practices that WTO does not even address - practices that have helped to prevent the US current account from ‘ever adjusting’ - is an idea that stretches the limits of credulity. Free trade and exchange rate alignment are worth thinking about especially by a candidate for the office of president..

So many want to ‘perish the thought’ (actually, perish any thought) about the dollar because at the end of the day it leads to the conclusion that they do not want to make: that the dollar is STILL too strong. Or, put another way, US productivity is not high enough for the dollar to stay at this level. But these persisting current account deficits are signals from the marketplace. Do not ignore a lump in your breast or a persisting hacking cough or sustained current account imbalances: they all are valid signals of something gone wrong. Moreover, do not deny all the investment in China and the rest of Asia over the past twenty years that clearly has raised their productivity and should therefore raise the values of their respective currencies (and lower that of the dollar by implication).

This language that the WSJ uses that is dismissive in nature about how US firms have subsidiaries abroad to get the lowest prices is all just an end run around reality. Why aren’t those operations instead in AMERICA? That’s the real question! That they have to be overseas is the exact thing that is at issue here. That is not a part of the argument to ‘take for granted.’

Why do US firms have $2tln on their balance sheets they will not spend with US unemployment over 9%? Why do they invest overseas instead of in the US? Why does China have $3trln of foreign exchange reserves? And why did they raise those reserves by 30% over the past year all the while complaining about the dollar? SNL had some great skits about their dollar-investment angst yet they pilled on more dollars. Why doesn’t China, a poor country, spend those vast reserves at home and raise living standards? Why do countries pour $500-$600 bln into the US as capital flows each year while US banks have billions in excess reserves they can’t find borrowers for? What do foreign investors ‘know’ that our banks do not?

Give up the fantasy that the dollar is properly aligned ( and the yuan and so on…) and these question begins to have answers. Do that and many of our ‘vexing problems’ have solutions.

The drop off in US manufacturing output is the start of severe crisis. The US needs to pay for its foreign exchange and we will never do that even if services jobs come back. The US needs to export to earn its foreign exchange (that’s how it’s done) and that means manufacturing. Pretending that trade restrictions are the only impediment to better US trade performance just stands in defiance of the sorts of huge numbers we need to marshal to solve our current account financing problem. The real problems is competitiveness.

If the Journal really supports free trade it needs to support the formation of a world environment in which truly free trade can blossom- not a system in which China and other developing nations suckle at the teat of US wealth until it runs dry. Because it will run dry. No country can run current account deficits forever. Foreigners are not running up what may prove to be a stack of ‘worthless IOUs’ instead they are starting to OWN us. And that can’t be good

America needs to be competitive. Let’s BRING BACK free trade!

Mr. Romney is much more right in this debate than he is wrong. You, sir, need to look closer at the arguments that you make to dismiss him - and to look harder at the facts, even when that is uncomfortable. Intellectual honesty is not about comfort. It is often painful. But in the pain is often wisdom and that, too is a lesson from markets.

Thursday, September 8, 2011

Trade, the real fool’s game

Trade, the real fool’s game

I would like to underline one aspect of the trade report that is not getting much attention- well ANY attention.

Although the deficit fell this month, at $44bln it can be annualized to a deficit of $528bln.

When we have a deficit in our trade account (more correctly, the current account) we obtain an equal amount of capital inflows to finance that deficit.

So here is the question:

So,why, when US banks have billions and billions of dollars in excess reserves, empowering them to make billions and billions of dollars in loans which they DO NOT MAKE are foreign investors pouring capital into the US at a pace of over $500 bln per year?

How do you reconcile that paradox?

We argue that there is no great attraction that 'pulls' foreign funds into the US. Instead we view capital flows as being 'pushed' by foreign investors who have other objectives.

That is we do not think that 'high US interest rates' are sucking capital in or that 'high rates of return in business investment' or in 'real estate' are attracting inflows.

We see the inflows as the result of foreign government's decisions to accumulate dollars in order to support the dollar at a relatively high level so they can pursue a policy of export led growth by keeping their currencies relatively weak and exports cheap.

These policies have caused the US current account deficit to persist. Developing countries have amassed the build-up of world foreign exchange reserves an action that can only be regarded as one that supports them in achieving their objective of keeping their respective currencies 'too cheap' and the currencies that they buy 'too strong'. Developing countries do not need FX reserves as much as they need to put those monies to work in their own countries to further their development. But they don't do that...

China's FX reserves rose 30% over the past year and stand at $3trillion. How does that accumulation not act to keep the yuan too weak and to perpetuate the US-with-China trade deficit? How else can it be interpreted?

By 2007 China had comprised over 30% of the annual US trade deficit and in 2009 and 2010 that percentage has moved up to 44%. Despite the US need to buy oil at high world prices China takes up 44% of the US global trade deficit.

A proper functioning exchange rate system would not keep a country's current account in a state of perpetual deficit. Yet, since 1971 the US current account has been in deficit for all by 24 quarters (24 out of 159; or 15%). The current account has averaged since 1971 a deficit that is 2.1% of GDP. The US has not seen a current account surplus since 1991Q2 a twenty year span. Currently, the current account deficit is 3% of GDP after reaching a peak percentage of 6.5% of GDP in in 2005. Interestingly the US had shrunk is current account deficit to 2.4% of GDP by the end of the recent recession, but in recovery even with GDP growth at 2.2% the current account deficit relative to GDP is rising again.

Since 1982 the US current account has been in surplus only two quarters. The ONLY progress in shrinking the deficit has come as the economy has slowed either just ahead of a recession or in a recession. For example from Q3 of 2006 to Q3 of 2007 when recession started, the US current account deficit shrank because GDP growth slipped below 2.5% and then the economy fell into outright recession. That caused the current account to shrink much faster. But it remains in deficit and a larger deficit than what has been normal. Since the last US current account surplus in 1991 the summation of the current account relative to GDP is 65%- no compounding.

Clearly this international monetary system is not working. It may not need to equilibrate the US current account immediately but we do need some signs of progress and improved fundamentals to support progress in that direction. The US current account deficit is huge and is hardly getting better; at 3% of GDP it is 50% above its average since 1971. Pumping the US economy full of debt is not helping. Even S&P can see the risk. The danger is that only debt saturation will stop this madness (bankruptcy). That is what happens if a well-functioning exchange rate system cannot be imposed on this dysfunctional process that perpetuates US debt accumulation (current account deficit). No wonder gold bugs are trying to push a gold standard. It would stop this madness, but would create and entirely new madness. Imagine moving to a gold stand and losing $500bln of gold reserves a year (the current account deficit). What sort of recession would you have to run to eradicate that and to stop losing gold? And with unemployment already at 9%?

Many economists reject this analysis and blame the US for its 'addiction' to debt but I see the US being force-fed debt because foreigners will not let the US mount any consistent export growth. In short the US does not enforce its exchange rate, on the markets. Markets do the ‘enforcing’ and right now markets are being manipulated by foreign governments. The foreign capital inflows (debt accumulation) by the US and the accumulation of massive foreign exchange reserves by foreign exporter countries far in excess of needs are the forensic evidence, the finger prints, of this ongoing currency manipulation.

The excess bank reserves are evidence that those flows are not being attracted by an insatiable US appetite for debt. We could slake that thirst at home with the banks.

If this were CSI I'd be ready to go to court.

Root of all evil (well, most of it anyway...)

In other words, this is not free trade. This is not fair trade. This is a fool's game and it is coming to an end one way or another. It is a process that is responsible for many other Ills in the economy that the fiscal deficit folk and the monetary mavens are trying to solve. It is at the root of our many and varied asset bubbles. But we are unlikely to fix either US fiscal policy or monetary policy until we deal with international monetary problem because it greatly exacerbates the other problems. Don't look for the G-7 to go there because no one seems to have a clue.

Tuesday, August 30, 2011

New CEA head and more...

Lots of criticism over the new Obama head of the council of economic advisers (CEA). People say he is too far to the left...

so did you expect Obama to appoint a Republican's economist to the post?

We have a BIG budget problem nothing should be off the table- no not even a national sales tax which Alan Krueger supports (a tax, by the way, that Democrats hate, Republicans despise and State Governors (and many mayors) abhor-all for different reasons. To Democrats the tax is too regressive, to Republicans it is too powerful, to Governors and mayors, sales taxes have been their exclusive province for 'fund raising')...

Cutting entitlements is 'job one' to get the deficits in line. But not job one through 'n.' All this Republican whining about taxes is misplaced. Tax reform and more taxes are almost surely part of a real workable solution. But enlightened tax reform, not vicious now-you-are-going-to-get-yours tax reform. America does not need class (or classless) warfare, Everyone should be paying taxes, everyone should pay their 'fair share.' The tax code already is progressive. suck it up and write the check but pare the obligation down to a workable profile that is American in nature. We are not the social welfare economy that Europe has become and is struggling to maintain.

Europe is no role-model for American

There is all too much spin doctoring about our problems and our dilemma and not enough willingness to take the bull by the tail and look the situation square in the err...'eye' and deal with it.

Deficits did not spring fully born out of the head of Obama as in some tale of Greek mythology. 'W' -remember him? ran TWO unfunded wars (cha-ching!) added a large drug benefit to medicare (Cha-ching!) and added a new cabinet post, Homeland Security (Cha-ching!). He handed over to the O-man an economy that was losing jobs at a pace of nearly 1-million PER MONTH ( Kur-Plunk!) in the early months of his nascent Presidency. The economy was not just weak, it was spiraling out of control. (here take the wheel I'm outta here....) While I do not give Obama good marks for his fiscal plans (or results!) I think we need to be careful where we put the blame and to whom we ascribe the bulge in the deficits. Hey is that a big deficit in your pants or are you just happy to see me? Let me be clear. Deficits emerge in response to something-something done or not done. They do not spring forth out of nowhere. The Obama deficits merged the context of great stress on the economy.

The Bush contributions to the deficit were all policy-induced and not executed in the midst of a crisis. His famed tax cuts propelled the economy to nowhere but are staunchly defended by the faithful. Choose the altar where you plan to worship carefully...Bush's tax cuts based on results were no success story. Still, this is no defense of Obama who, based on his current body of work, does not deserve reelection. (Has any Nobel Prize winner ever failed to be elected the very next time he faced the public?)

Only look to Europe to see what I call the quadriplegic strategy: Cutting and cutting will not really get you anywhere but stuck some place from which you cannot move. It's medicine is slow-acting. It is structural not counter-cyclical. We do not need to shrink government to free up up resources for the private sector: what to you call 9% unemployment if not free resources? We need enlightened minds in both parties and instead we have friggin ideologues ON BOTH SIDES OF THE AISLE.

We need to focus not on policies that will add former government workers to the ranks of the unemployed but on policies that will spur growth, add to output and add to job rolls. We do need hard core nonthinking redistribution plans from the Democrats or shrink-o-nomics from the Republicans.

So, here is an appeal to the religious right: God help us.

Monday, August 29, 2011

Learning from Irene

Irene good night,

Irene good night

Good night Irene

Good night Irene I’ll see you in my dreams (nightmares)

About Irene and what we can learn from her passage…

While Irene was a bust of disaster in most of Manhattan it did wreak some havoc in the surrounding areas, some very real property damage and five deaths are being reported. The New England States appear to have gotten hit hard.

The more general disruption of business from airlines to trucking to package delivery business and much more has been enormous. But some of the losses will be made up. Some will not. The storm’s hitting at month-end could mean August activity is reduced and September’s is boosted. Coming so late in the month we may still be seeing come recovery effects extended to the week of the 12th of September, the week that serves as the survey basis for the nonfarm jobs report. It could be artificially boosted. Municipalities, already short on funds, will be forced to spend monies they don’t have for needed repairs, tree removal and repair of damaged infrastructure and so on.

From my vantage point on the Upper Wet Side (former Upper West Side) of Manhattan, it was a lot of rain and not even that much wind. It might have been too much wind to fly a kite but it was not blowing of a worrisome sort. All my neighborhood stores closed and the subways did not run. I was officially stranded. I took pictures both up and down West End Avenue with NO TRAFFIC at all, just like in a Sci-Fi movie. It was Sci-Fi except no Zombies- just rain. My local grocery store (soon to be renamed Wet-side Market) did more business on Saturday as the storm approached than it may ever have done ever before (in my estimation). Going through the store when it managed to open with a bare-bones crew on Sunday morning I had never seen such bare shelves. Moral: some kinds of businesses benefited.

I was amazed on Saturday as stores were shuttering ahead of the pending subway shut down, that a high end women’s shoe store in the neighborhood was still open… Never underestimate the need for more shoes (with very high heels) as rain and the threat of flooding gets real. Fashion is never to be discounted (except at Loemann’s).

The church on the corner of West End Ave and 77th put up notices on Saturday that there would be no Sunday service. Meteorologists scared the Hell into people that day; that is the moral of that story. In the end, Sunday was a fine day on the Upper West Side of NYC despite the fact the 8AM was supposed to be the time of the storm’s closest reach to my neighborhood. By 10AM the sun was out and instead of disaster we had a very fine day.

We cannot say the same for the states North and East of us or for the economy as a whole. This was a very odd event. Is this more of the effects of ‘global warning’ that many seem to not believe in? On balance is it another warning shot (a warming shot?) about the future? And it is another blow to property and casualty insurance companies. Have the winds of change really shifted so much?

If nothing else it is a good lesson of the role that expectations play. I do not criticize the Mayor or the Governor for their actions. NY it seems was ‘spared;’ the storm’s true severity has been amply demonstrated tough its impact on the suburbs. As it went through our area and did worst damage North and East of us as well as south of us. And the greater NY area took enough of a pounding for it to be a real wakeup call about future prospects. But people acted as though and were forced to act as though things would be worse. My local church sure could have held services. Few people in the neighborhood take the subway to their local church. But no one knew. So when you look at the economy let this be a lesson about how people act on their expectations and how risk aversion interacts with those expectations.

The economy’s poor performance since Barack Obama has been President stems in no small measure from his decision to have run as the ‘Yes we can candidate’ but to govern as the ‘what the heck was that’ President. I believe his desire was to see that Republicans were blamed for the bad economy he inherited (knowing full well that that was what he was getting). He even set himself up as an economic know-it-all in contrast to John McCain who admitted he was not an economic expert in the campaign for office, so don’t cut Barack too much slack here. Meanwhile, Obama has been out-maneuvered by savvier Republicans who saw he was President and knew where the buck would stop for a too-weak economy. Economists were pessimistic from the get-go forecasting a double dip before we had even a single–scoop. We had a perfect storm of soured expectations and it has played out that way in the real world, almost as it did on the Upper West side of NY this weekend when the subways were closed. Doing that killed it even for the optimists as well as for those who were in in denial. People could not get to work; stores were closed and it was a ghost town.

This economy as been an example of what partisan politics can do to the economy when each side pursues its own agenda at the expense of the economy and at the expense of the welfare of the American people. It’s as though our politicians shut down the subway without the threat of a storm. Our government can isolate us. It can also help us. Ronald Reagan made the phrase, ‘I’m from the government and I’m here to help you, into a laugh line. Government is powerful. It needs to be mindful of its power when it flexes its muscle. Now government itself is in the middle of the debate about the economy. Has IT been the problem? As it been new policies and restrictive rules that have hammered growth, or has it been mostly the conduct of public officials killing off optimism? How much of it is still the lingering effects of financial crisis with tis complex bi-partisan causes? Unfortunately, this debate is not like tropical storm, It does not pass and the sun does not automatically come out. There is still a bitter taste in the mouths of politicians from both sides. Each side still smells the other’s blood in the water- not even the storm washed that away. And there is so much more politicking to do. Yet the economy is need of near term help. What will it be? More government or less? Who will win? The answer is not an easy one. Neither side will capitulate. So be afraid, Be very afraid. ‘This' is not over, this political storm has more damage yet to wreak.

Sunday, August 14, 2011

Deficits turn policy upside-down and calls for hard choices

I have two recent articles published elsewhere you may wish to read:

CNBC on the pluses and minuses of a national sales tax

Thursday, July 14, 2011


I do not mean this to be hyperbole. There is no greater danger than the one that comes from within. And it is in play.

No Give and take- Democrats and Republicans can have their spats; it is part of the game. But the ballet in Washington now puts the nation and its finances squarely at risk –and over what? It seems that a number of Republicans ran for office on the pledge of no new taxes, but when push comes to shove and deal making requires taxes they are more concerned about their own necks than about the fate of the country. Such is the stuff that patriotism is not made of.

The obscure prize- And what of taxes, that powerful elixir that drives this insanity? Let’s look at a seven year moving average of the top margin tax rate Vs real GDP growth:

OOPs the chart does not want to print, you'll have to request that from me

Surely THIS can’t be what they are fighting over? The correlation between high tax and high growth is 0.46. That’s right. In the post-war period the higher the top margin tax rate the stronger was growth.

Now I know blood is going to start to boil over this. We know it’s the taxes you pay that matter but the tax rate you avoid is pretty important too. And the simple point here is that the simple tax rate is not a powerful predictor, is it? So what is this tax debate really about? It’s about re-election. Period.

That is not to say that I think high taxes are ‘good.’

It’s all about MEEee - It is simply clear that taxes are not the end of life for growth like drinking poison. It may be the end of the line for those who overpromised to get into office, however. And we should not mortgage our future for their sake. They are now putting the country under extraordinary stress because they have set up huge spending cut targets and want to give nothing in return. Has politics ever worked like that? No. Only if you have really big leverage can you do such a thing. And they are holding hostage the United States of America.

Cartoon Economics: Ron Paul is the real character is this whole charade that I would most like to eject from the discussion. He may not be so influential but he is spewing the most incredible lies about our country. He gets paid his deference as he is a senator and he chairs the all-important Senate banking committee. How did a guy with such warped views of the US economy get to hold such an important position? His economic statements and knowledge are severely wanting. In a recent interview (click link below)

Ron Paul tells it like it ain’t:


Mr. Paul was asked about the importance of the US AAA rating. His response was evasive and then he made outrageously false statements. He first says that ratings lag and the US has not been worth that rating for some time. Then he says the US is bankrupt. Then he says that the rating could be kept in the short run but that it would eventually be lost.

None of this is true.

Still numero uno- The US is still the wealthiest most productive nation on the plant. When its leaders tell lies like this it depresses the American people and makes them feel helpless. Some may even believe it. And if they do it’s not surprising that they go for Mr. Paul’s idea which is to not defend our rating; he has even said that the US should repudiate its debt! And he is a financial leader of this country. Why has his own party not locked him away in a closet somewhere?

Uncle Scrooge? - Why should the richest county in the world not pay its bills? What is to be gained in doing (not doing) that? What would happen to the rest of the world if we did that? And what would happen to our own most conservative institutions if treasury debt were to go into a true default, not a technical one, which is Mr. Paul’s idea?

It’s hard to go down that road but the Great Depression might seem like a picnic in comparison. The great recession would be known as the minor precursor.

Hard deadlines/soft thinking- The game being played about the August 2 date not being hard deadline is a real fool’s game. And as such only real fools should play it. As the Fed Chairman points out, that is a dangerous thing to do. Just think about it: here is what is being proposed- To prioritize debt payments for tax revenue and then pay other bills as the treasury ‘can.’ It does not take much of a financial expert to see that this would lead to cascading lay-offs first in government and then spreading elsewhere. Other kinds of payments ‘defaults’ and would weaken the economy and future tax revenues to the point that the government cuts would have to get even deeper. This is not a plan it’s a guarantee of a severe recession and worse. I don’t think Aug 2 is a drop dead data in the sense that if we do not lift the limit on that date the US will default and the world will come to an end. But it’s an important date and the legislators/politicians should respect instead of trying to ‘fool’ with it.

Whose deficits are theses? - Republicans blaming the Democrats for the weak economy is just not reasonable since both parties were responsible for the financial excesses that led to the financial crisis and the economic recession. Both parties are failing in getting the economy in gear. I do fault the Obama administration for a poorly constructed stimulus plan but that is only one part of it.

Desperation demands grow- On balance we have little balance. As the impasse has dragged on the Republicans seem to up their demands. The recent one: Boehner’s call for a balanced budget amendment. The Fed Chairman has come out against such a thing because it would be too inflexible. As upset as you are with current policy imagine if such a rule were in place today and the recession was causing not just state and local governments to pare down activities and fire people but the Federal government as well.

The debt ceiling BELONGS to Republicans too- Republicans keep getting heated up about cutting as much spending as we hike the debt ceiling. But that is a huge target. Democrats clearly want something in return after all Republicans act as though the debt ceiling is a Democrat objective and should compromise all sorts of stuff to hike that ceiling. The Republicans have vastly misjudged their leverage and position and are struggling to find a way forward.

Debt is a legacy- The nation’s debt simply reflects all the spending that has occurred that Congress, both Republicans and Democrats, has authorized in excess of revenues. What now is this opposition to hiking the debt ceiling? Is it bait and switch on the part of those who oppose the hike? Is this some cruel trick by Congressmen and women who voted vote for all these spending programs now want to vote to not fund them and blame Democrats? Apparently tax hikes and closing tax loopholes are not on the table either. With what are the Democrats supposed to bargain? Obama seems to have been quite flexible in trying to get some revenue raisers in compromise but not calling them tax hikes.

In my view this is the Republican’s gambit.

Their risk- They are the ones talking about shutting down government and about not hiking the debt ceiling. If anything bad happens they will be blamed. Their tactics already may have cost them dearly among moderate voters. One thing these newbie Republicans do not seem to understand is that the voters want spending cut but none of their benefits cut. So Republicans may yet see a backlash from their single-minded interpretation of their election mandate which, on close inspection, is much more complicated then they admit.

In all of this I fear for the nation. We have some real kooks in positions of power and I fear that the Republican leadership is not in control of its own forces as the newbies are driving the leadership to a hardened position that could prove fatal.

Saturday, June 4, 2011

The story behind the debt eight-ball

The economic data have been weaker in recent weeks than their counterparts for the year to date. This past week the degree of weakness became exaggerated. It does not point to declines in output (yet?) but it is very weak and disturbing. If you are not wary or confused about the outlook you are not paying attention.

With actual negative events in the mix we have reason to think that this week’s data reflect more than simply volatility-the economy is being pushed by something. The degree of weakness is extreme with the two ISMs each making falls of historic proportion over the past two months. The drop off in job growth is large. The unemployment rate trend which was moving lower has been stopped and set in motion in reverse. Consumer attitude surveys are not uniform on the month but all are clearly very weak – they agree on the big picture if not on the details.

Events in Washington really are worrisome.

Let me repeat something here that I think is important and worth saying AGAIN. The deficit and debt problems are not economic problems as much as they have solutions that have become political issues. We could put in place a VAT tax (think national sales tax) to raise money to narrow the budget gap. Easy as 1% 2% 3%. Even Alan Greenspan is calling for higher taxes. The Tea Party types continue to stone-wall as if any tax hike is like the Ebola virus… Painful? Yes. Deadly? No. There are simple solutions out there but none without some pain or repercussions.

I continue to wonder why, in a nation with such varied costs of living and varied housing costs/prices the income tax continues to be the centerpiece of tax policy and the rhetoric of ‘tax the rich’ is used in conjunction with income flows that have such differing purchasing power from state to state. Will we ever learn or wake up? Or is this sort of class warfare based on a fundamental falsity just part of the American way? Way? No Way! In America $100K ≠$100K. It depends in what state you live when you earn it how well you would live on such an income. So what base tax policy on such an uneven benchmark?

We know that with longer life expectancy we must push back the retirement age for Social Security. A fifth grade math class could demonstrate that to you. A fixed date for retirement makes no sense when every successive generation is living longer. Yet we can’t do this…

Finally, medical care simply cannot be offered for free any more than can any other service or good without demand for it being abused. Is medical care something different or special? To some extent, yes, still you can’t make it free without real financial consequences. AARP be damned.

Moreover if the government is going to subsidize or provide medical care it must use its clout to get reduced costs. Medical lobby be damned.

The economic logic here is clear. But the political will is splintered because each party has a different idea of how to make change and each wants to use this time of conflict as a springboard to more political gains.

So no one wants to alienate old people (AARP). No one wants to alienate the drug companies (use government buying clout) or the medical lobby or the insurance lobby- so nothing gets done. We kick the can down the road until it kicks our cans back and we are getting closer to that. At some point, it’s THEM OR US. WHO WILL IT BE?

You can see this at work with the financial crisis having come and gone-well maybe not yet gone-and the power of the financial lobby whereby real reform just can’t be had.

Oh, by the way…I have invented a new glue much stronger than ‘Super Glue.’ I am going to call it ‘Financial Lobby’ because nothing in the world is stronger than that…

As far as I can see much of the hoo-ha about the debt/deficit is largely being done by the two political parties that run things here in America. We voters are just the baubles they redecorate with every two or four years. They call it ‘democracy’ but after the election is over and we see the actual ‘pig’ we bought in that poke it feels much more like ‘hypocrisy’.

Right now the two parties are wrecking the economy with their various threats instead of fixing it. The cynic in me wonders if Republicans would push so hard to cut spending if they were in the White House and running for re-election this time around. Would the need to cut spending so much so soon, seem as compelling if their administration were on the line?

I don’t know if any of that makes you feel any better about what is happening. Having politicians who claim they are willing to let the US default on its debt when it could well afford to pay it may be worse than finding that you do not have the means to pay it at all. A politician unwilling to pay a bill to achieve his political end is a danger 100% of the time not just when times get tough.

This is not an argument for not doing debt and deficit and spending reform, just to put the tactic and need in context. Doctors too can stop the spread of disease and ‘cure’ patients by letting them die. It’s a simple solution and not really very effective when you think about the end result Vs the goal. Similarly, how does wrecking the US economy fix it? Riddle me that Bat man…

Monday, May 23, 2011

EMU takes a new hit; frazzled outlook

Main EMU sectors hit major air-pocket- The EMU MFG and Services indices are sharply lower. The MFG index fell by 2.9 points while the services index fell by 1.43 points. Those drops are huge in the histories of those respective series. For MFG the drop ranks as the fourth largest in the series’ history. For services the setback was the 14th largest. This ranking makes the MFG drop an event that occurs only about 2% of the time; the services drop is an event that occurs only about 10% of the time, a little more than one a year. The services sector last saw a drop larger than this is in September of 2010. Still it’s a large drop, but the MFG drop is enormous. MFG last fell by more last in November of 2008.

While we have seen the EMU metrics on growth show setbacks in recent months, the step-back this month is severe.

Level readings for sector as not a problem- Still at 54.85 the MFG index is still showing growth and is well above its average value of 51.62. Services at 55.40 also are still showing growth and are above their average mark as well. The dividing line between growth and contraction on this metric is 50 and both are well above that so it’s not a growth setback we worry about, at least not yet. The values still sit in the 79 percentile and the 69 percentile in the MFG and Services high-low ranges, respectively. These are still adequate-to-firm readings.

NO recession worries…yet - The levels of their headlines are not a problem at this time but the momentum of the sectors is an issue and the severity of the one-month drop is as well. Both indices still seem to be on the same growth plateau that they reached early in 2010. We have even seen somewhat similar losses of momentum in this recovery period and we have seen the sectors rebound from that weakness.

Escalated debt crisis worries? - But this time there are new factors in the mix. Europe’s debt problems are emerging again, this time a warning to Italy is in the mix. That is an escalation of the threat. A week ago the IMF warned that the debt problems in the Zone could spread from the periphery to the core. Is that now happening?

Euro-politics- Spain, a large EMU member country that has fought off further attacks after some rough spots early in the year has just had a big election set back. In Germany Angela Merkel, banker to the EMU-bailout schemes, lost support sharply in a small state election. The German electorate is not pleased with its role backstopping Europe. The economic situation remains difficult in Europe as the political situation becomes even more confused. In Italy Silvio Berlusconi has been under his own cloud of mistrust for some time, due his own sex scandal. In France Nicolas Sarkozy who was lagging in the polls now finds himself free of his most potent challenger due to a sex scandal involving the former IMF director who was to be his nemesis. Let’s not forget Finland whose new government is against any more bailouts in the Zone. Finland is one of only six AAA-rated sovereign states in the 17-nation euro zone

Can’t make this up- Quite honestly you can’t make this stuff up. If you look at the political map in Europe it is in chaos. The ECB itself is due for a changing of the guard later this year and it appears to have selected an Italian to follow in the footsteps of Trichet. Right now it’s looking like a tough time for transition.

Like Post WWI...again? All of this reminds me a lot of the financial strains that emerged in the wake of World War I. At that time Germany had lost the war and the reparations placed on its back were too heavy a load for it to bear but the victors wanted to make Germany pay. This time around, it’s not a war but a financial crisis and there has, one again, been misdeeds. This time it is the Germans with the financial muscle to help and yet they do not really want to. Then again if they do help, they want their pound of flesh from the Greeks and anyone else that has gone astray. This is one ‘safety net’ that you don’t want to fall into.

Muddles interests and a complex blame-game- Asking for too much penance to eliminate the risk of moral hazard can backfire and it has done so in the past. Will Europe wake in time to see the risks? Or are Europeans so set in getting revenge or in making those who strayed pay, that it will cut off their own nose to spite their face? This is a risk, a real risk. What makes this more of a muddle is that Germany is not simply being asked to be altruistic or to turn the other cheek to help out the already too cheeky. If euro-sovereign finances go sour en mass, it is the German, French and UK banks that will suffer the most. The Germans do have skin in the game and yes, it is their own. But in Germany this is not the way German financial involvement is being portrayed. That is probably because, like Americans, Germans get little satisfaction from a policy to take expensive steps to protect the interests of their own banks.

Get a CLUE! And so the Euro game will continue to play out like a giant game of Clue™. If EMU goes down, or is clobbered with debt and refinancing issues, who will be to blame? The Greeks, at home, in the overpriced Olympic stadium? The Germans in their beer garden by their unwillingness to help? The German bankers, with their troubled portfolios by the means of bad loans sprinkled everywhere? Who is your candidate for blame? How did they do it? Where was the ‘crime’ committed? It’s a fun game. Play it.

Saturday, April 30, 2011

Dizzying dollar dip or delightful drop?

When clubs are trump - Donald Trump doesn’t like it, so maybe it’s good after all. Trump, with a focus on real estate and the value of his holdings, while battling other real estate groups wants his dollar assets as strong as possible to keep him high on the global scale of wealth rankings. But a declining dollar does more than just redenominate the value of ‘The Donald’s’ wealth. It sets our prices in other currency terms and as our prices drop US workers become more competitive and foreign goods become more expensive; this is the process by which the trade gap narrows. Is it really so bad?

The weak dollar: how weak? - The broad dollar index is presented the in the chart above. The dollar is dropping to just about its lowest point since exchange rates were set to ‘float’ in the early 1970s. This chart shows a more compressed recent history. One thing it reminds us of is that the dollar had been weak ahead of the financial crisis and a flight to safety cut the dollar’s drop short.

Dollar reverts to pre-crisis path - But now, as the recovery continues to spread, the dollar has been unwinding its rise and is back to its pre-crisis neighborhood which is a very weak point of valuation.

Benefits and risks of a strong dollar -As the dollar falls, imports become more expensive and Americans have to work longer hours to afford to buy the same goods made abroad. That is a reduction in US welfare. Meanwhile, foreigners can more easily afford US-made goods. In welfare terms the dropping dollar has ‘bad’ consequences as we are giving our goods away for less and paying more for what we buy abroad. That it is why economists generally ‘like’ a strong exchange rate and why a strong exchange rate is more than just a ‘symbol’ of American power. But, at the same time, if the exchange rate is ‘too strong’ while we continue to reap the benefits of exaggerated purchasing power in trade we also begin to erode the basis for the exchange rate’s continuing strength by running progressively larger trade deficits which is also what the US has done.

Too-strong dollar/temporary benefits- In seeing that you can appreciate this period of an overvalued dollar as creating conditions akin to a special sale, like the old-fashioned K-Mart blue-light specials. These ‘specials’ were temporary sales that came and went. K-Mart’s managers would erect a blue light in the store and switch it on; it would pulsate like a light on top of a police car and announce to everyone in the store that the items under the light were subject to special temporary discounts. The policy was meant to bring people into the store since you never knew what would go on sale or when. Of course K-Mart has since been relegated to a much lower tier on the retailing scale and has been replaced by Wal-Mart that advertises ‘everyday low prices’. But for Wal-Mart to deliver on this policy it needs the dollar to be too-strong every day as well. The drop in the dollar (to the extent that it involves a drop Vs China’s yuan) will cause Wal-Mart’s everyday low prices strategy to reflect higher prices than it did before.

Foreigners finance our excess- And so it is with the dollar. When it was ‘overvalued’ we could buy things cheaper, but only temporarily. Since we have run a huge trade gap foreigners have effectively been lending us the funds to make all these great purchases. Now they are beginning to balk. We all know that the period of running up the credit card is a lot more fun than the period in which we pay down the balance, but here it comes. Well, not literally; we are going to continue to ‘run up the balance’ but at a slower pace as the US current account deficit should get smaller but will remain a deficit.

If a high exchange rate is so good why do countries pursue weakness? There are great ‘welfare’ reasons for wanting the exchange rate to be overvalued, but, as we look at history, we find so many cases of countries being involved in the opposite strategy of pursing policies of competitive devaluations. In fact the one clear example of a country trying to fix its exchange rate ‘too high’ is a story of economic failure. It is the case of the UK trying to return sterling to its pre-war parity to gold in the inter-war period. Instead, of this sort of tact we find most countries pursing the strategy of making their currencies weaker to promote their own exports even though that approach makes imported goods more expensive and reduces their wealth in foreign currency terms. Why do that?

Benefits of a lower-value currency- A weak currency approach is a pro-growth strategy that is largely without clear domestic cost or opposing constituency (except for a price-stability-loving central bank, perhaps). It is a relatively effective way to tap into foreign demand and to divert foreign production from satisfying that demand by making your own country’s production cheaper so it can supplant foreign producers in their home market or in sales to ‘third’ markets. The trade-off for a weak currency is to gain output and therefore employment at the cost of having consumers pay higher prices. Consumers pay more for their imported goods and for ‘domestic-made’ goods using foreign-sourced inputs. When growth is hard to attain, a cheaper currency is a vehicle to attain it. This is why the strategy of using ‘competitive devaluations’ is called a beggar-thy-neighbor policy.

Attraction for developing economics -With this insight we can see the repercussions as the US has run a series of huge balance of payments deficits. We have been afforded the opportunity buy stuff from abroad that was cheap to us. In turn exporting nations have been able to grow faster and ride the tide of their strong and rising exports to the US to improve their development. Since some of these countries were not as developed as the US many of them found the expanding jobs market more than ample compensation for the fact that workers there were not being paid fully what their goods were worth. Indeed, some of these countries were so underdeveloped that their domestic wages still rose sharply and despite that remained well below the wage level that exists in the US. Such is the magic of development

The financial angle- Various US trade partners used the technique of acquiring massive quantities of foreign exchange (dollars) to keep their surpluses in trade from creating a dump of dollars on the market that would have reduced the dollar’s value and would have short circuited their export boom. Now some of these same countries bemoan their huge stash of dollars as the dollar’s value has dropped. But all of that has been their doing, just as the weak dollar is an eventual consequence of a too-strong dollar policy.

No sense of pain for developing economics- The strategy of a keeping your currency cheap seems to work best in less developed countries. There the domestic work force does not know what its currency is worth and the spread of jobs creates a boom. That boom results in the increase in wages to levels that will still not pay those workers properly for their services but nonetheless represents a better place than they previously were. To them a cheap currency seems to be a win/win situation as jobs expand and wages rise.

Pain to be felt in the US- But the US is going through this dynamic to a cheaper currency with a bit more pain. We have been used to having an overvalued dollar and to having great purchasing power. We are just finding out what reduced purchasing power means as foreign prices rise. Since we know what prices used to be we feel the drop in welfare more than do workers in a developing country whose ‘welfare shortfall’ created by their undervalued currency comes about relative to a hypothetical situation they never had experienced. But since we in the US have experienced the greater purchasing power of the dollar we will notice when it when it goes away as the dollar drops.

Adjustments all around- The challenge for the countries with less undervalued currencies will be to redirect output toward serving their own now-larger domestic demand in order to keep from losing the employment gains made by their export boom.

One paradise lost but the paradise gained is more growth- And that reveals the benefit that the US will get for giving up some purchasing power. As we have documented in previous reports the US economy is now experiencing the second –strongest revival in GDP goods in this recovery compared to any recovery since 1960. The goods sector is flying and the weaker dollar is one reason why.

Weak dollar is no panacea- The services sector is still lagging, however, and since that sector does not compete with overseas workers the weak dollar is doing nothing to make service sector workers seem cheaper. They sell their output to a domestic audience that is fully encapsulated in the domestic economy except to the extent that these workers may toil in a sector that sells increasingly expensive goods that were made abroad. A weak dollar has not encouraged hiring in services.

The marked STUPIDITY of the double-dip thesis - Ironically, all of the time that the US economy has been in recovery the dollar has been off its cycle peak and this has provided an ongoing boost to output that has been completely misread by the US growth pessimists who have continued to harp about the risk of double dip. Meanwhile, the prospect of a double dip has been becoming more remote with each drop in the dollar’s value. More curious has been the assertion that the drop in the dollar (a drop that extends and cements US competitiveness and stimulates exports as it deflects imports and therefore further stimulates domestic output) has in some way enhanced the prospect of a double-dip! This, of course, is lunacy and has the whole process backward/upside down.

Short circuit thinking- The situation of our enduring balance of payments deficits (which are referred to as a big risk to us) and the condition of the dollar’s strength and ‘over-valuation’ are quite clearly linked. They are part of the same process. And people who bemoan deficits but want the dollar to remain strong simply don’t ‘get it.’

China wants to have its egg-foo-yung and eat it too - This is part of the same puzzle in which China threatens to commit the economic paradox because it wants to have its cake and eat it too. China wants the US to mop up its deficits but it wants the yuan to remain undervalued… Huh- how does that work? Doesn’t China ‘know’ that its import penetration of the US market is due to its extremely low prices made possible by an undervalued yuan and enforced by a policy of continuing to bulk up on FX reserves (i.e. dollar buying). That’s why China’s rants are so toothless. China cannot pursue its development (commercial policy) strategy if it makes good on its financial threat to sell or stop buying dollar assets. In the end China is jawboning and trying to confuse the situation buy making the US seem responsible for what has been China’s foreign exchange-commercial policy of using export-led growth driven by persistent currency weakness. Of course, when China buys these dollars it is expanding the stock of yuan in circulation and to the extent it over-buys dollars it also over-stimulates the yuan money stock. That creates inflation. It explains why China has an inflation problem which it’s not the fault of US policy, despite Chinese protestations. The US has warned China for years that this inflation side-effect was coming while China ignored the warnings.

The good, the bad; avoiding the ugly - So as we consider the dropping dollar and what effect it has, compare it to the period of having had a strong reading. I hope that the interested reader can now see why the strong dollar is ‘good’ but also why a ‘too-strong’ dollar is ‘bad’ and how a period with a ‘too-strong’ dollar takes a toll on the US economy and how that process creates stimulus for competitor economies that must eventually be withdrawn. The dollar–valuation and BOP-deficit issues are both part of the same knotty problem; these are not separate issues.

Pot calls Kettle ‘Black’ -- While China usually presents the situation of large US trade deficits as an issue of US ‘over-consumption’ and of insufficient savings, Fed Chairman Bernanke has presented it as evidence of over-savings and insufficient consumption on the part of China and other counties (the Chairman has not singled out China that I am aware, but I will stay with this example). The effect on the US savings rate occurs partly through the relative price effect because as imported goods are made too cheap relative to ‘true value’ that stimulates consumption causing it to become preferable to savings and crowding saving out. Meanwhile, imported capital makes the excess spending possible without causing interest rates to rise as savings fall. And since an overvalued exchange rate creates a temporary condition of goods that are ‘too-cheap’, over-consuming actually makes sense for a while. But at some point all this excess must find equilibrium again. We can’t keep over-consuming and under saving with an overvalued exchange rate and with China and others on the ‘under-side’ of all these measures where we have overages. At some point the chickens come home to roost and macro-economic policies have to be altered. So our current obsession with cutting the fiscal deficit is becoming linked to this exchange rate issue through the fiscal/international deficit linkage which again is being put in a common spotlight.

Strong dollar policy=wrong dollar policy - At the end of the day I like to remind people that in economics linkages are, in some sense, everywhere. Disturb equilibrium in one place and you will create disequilibria ripples in another as markets to try and deal with the original disturbance. We have been in a dysfunctional persistent disequilibrium for some time. Now, as we are in the process of trying to heal the distortions from our past policy mistakes, try to understand the process that is in train. The polemics of the gold standard or of ceaseless pursuit of a ‘strong dollar’ do not do us any good here. What will do us some good is to understand the right policy and to pursue it without the ceaseless threat of how imperiled the economy has become to a double dip. Nothing in fact could be further from the truth. What would jeopardize the US economy would be to pursue a policy of a persistently misaligned exchange rate, like one that is persistently too strong.

Not all equilibriums are created equal - Economists like to have things in equilibrium, not too-strong and not too-weak. But reality is a bit like dieting in that a period of over-eating sometimes has to be followed by a period of under-eating to restore balance. To follow a period of over-eating by a period of balance is only to make the new weight gain permanent. An overvalued dollar creates that same sort of excess; consider the deficit as the undesired ‘weight-gain’ side-effect. Now we need to put the dollar on a diet to solve our deficit bulge. It’s way too soon to talk about equilibrium because one ‘disequilibrium’ breeds another and we may have to stay in this new disequilibrium mode for some time to work off the accumulated debt excess. And, this ‘diet’ will have consequence for other countries and will impact their policies. Some of them already are screaming with pain. But that is part of their process as well. All who have been part of this process will be part of the new solution and its growing pains as well.

The dollar’s true value- some perspective - We can see this point about equilibriums being different in the chart above (contact me if you want to see this chart) . There we define the dollar’s proper value, or its purchasing power parity level (PPP), as the mean of the real trade-weighted dollar index since exchange rates stopped being fixed rates in the early 1970s. The idea here is that while the float has been ‘dirty’ (with exchange market intervention) exchange markets should get the dollar’s value right over time. Although with persistent foreign exchange accumulation there could be an upward bias to where this chart puts dollar parity. Still what is clear is that the the dollar is now is about as far below parity as it has ever been. Also we can see that the dollar gets to be much more overvalued than it gets to be undervalued. Its peak of overvaluation is +35% while its peak of undervaluation is -15%. Because of this the equilibrium calculation for PPP requires that the dollar stay undervalued for a longer period to make up for its shorter periods of extreme overvaluation. If this history is a guide to the future it is suggested that this is GOOD place to buy dollars since the dollar has not in the past eroded faster than its inflation differential when it has been this weak. On the other hand, maybe the dollar will reach a new lower low in the period ahead since the balance of payments misalignments are huge in the world economy. Moreover, this chart is multilateral and it does not address this issue of against which currencies the dollar might fall and against which it might yet rise.