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.

Wednesday, April 27, 2011

Bernanke Press Conference

What he said…and what he didn’t

The Fed will be pleased with the Bernanke performance at the press conference. He did not send any obvious confused signals. He embellished on the policy notes in the Fed’s policy statement. He clarified that his remarks were meant to reflect the committee and to reflect divisions where they existed. He took responsibility for his own remarks. It was a stand up and professional performance. He made the Fed’s decisions to continue to maintain the size of its portfolio and to complete the QEII process the feature of this presentation. He followed that with a discussion of the Fed’s outlook. Then he took questions.

Stylized facts and the Fed’s stable inflation expectations hypothesis

The Fed’s Q&A went smoothly. But there were some issues of interest. This is always the case at a press conference. A written statement is controlled but in answering questions sometimes an undiscovered truth slips out. For example, the Chairman toed the line on the notion of inflation expectations being stable except for late in the Q&A when he let it slip that inflation expectations had risen somewhat. This of course did not get into the FOMC statement. Such an admission is the hobgoblin of all Fed fears. As pat of the Fed’s written text it would have an explosive impact. But in the flow of the Q&A give-and-take the impact is different. Bernanke admitted this in a context of an answer to a related question; he actually said that expectations are up a little and that the Fed has some limitations in what it can do. So this is something that the Chairman said and at the same he did not say it. He said it in a context that allowed it to slip by, as part of a response to a different question. But like a ticking bomb in an Alfred Hitchcock movie that the audiences sees and no one else is aware of, it is there in the background, ticking away.

What this reveals is that the FOMC statement and minutes are caricatures of the economy or if you prefer a presentation of ‘stylized facts’. The Fed does not portray each variable exactly as it is but in the way that the Fed construes it sort of Alice in Wonderland style ("When I use a word, it means just what I choose it to mean -- neither more nor less." -Humpty Dumpty). So if expectations are a bit elevated but not so much that they are a ‘clear’ problem the Fed may choose to continue to refer to them as subdued or anchored even as the moorings are loosening. The Fed has made it clear that it is not going to be as preemptive as its rhetoric once-sounded. It is willing to see expectations slip a bit because it is relatively more worried about high unemployment. For that reason it will accept the risk that is implied by the up-creep in expectations. On direct questioning Bernanke would never admit this trade off but it is implicit in what he said and the way he responded in the Q&A session. This is precisely the problem with adoption of a dual mandate, it creates dueling mandates and one keeps getting in the way of the other.

The Dollar

The question about the Fed’s role in the decline in the dollar came up; the Chairman deferred, saying that the Treasury Secretary is the spokesman for the dollar. That is correct. Then he added that the Fed was in favor of a strong dollar and a strong economy adding that to strengthen the dollar the Fed was keeping inflation low and acting to strengthen the economy.

The real fact is that the dollar is weak and that is boosting the economy. A weak dollar raises inflation risks as well. But it is true also that the dollar is in some sense not as much weak from the Fed’s actions as it is back to where it was before the financial crisis began. During the crisis a flight-to-quality boosted the dollar’s value then as recovery took place the dollar went back to where it was before the recession’s onset. It does not require any reference to the Fed’s low interest rate policy or to QE to explain it.