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Insight: US debt puts strain on dollar
By Chris Watling
Published: November 26 2008 18:34 | Last updated: November 26 2008 18:34
http://www.ft.com/cms/s/0/9790f1ba-bbe0-11dd-80e9-0000779fd18c.html
The outlook for the dollar is poor.
In the short term an expected equity market rally, quite plausibly the beginning of a cyclical, although not secular, bull market should bring an end to the dollar’s recent “repatriation rally”. The inverse correlation of the dollar and the S&P 500 is well established and not expected to break any time soon, given the global macroeconomic backdrop. The short term trend should be further reinforced by the broken financial system which impairs the US economy’s ability to releverage and mutes the strength of its cyclical recovery. The inability to releverage precludes the US from leading the global economy out of this recession. That also reinforces the dollar’s short term unattractiveness.
In the medium term, the US economy faces significant, albeit not insurmountable, structural problems. In particular the interaction of a heavily indebted economy with a broken financial system suggests a decade of poor domestic economic growth as savings are rebuilt and trust in the system restored. The US is a debtor nation and owes the rest of the world more than $2,000bn (up from $750bn as recently as 2000). Indeed both the household and the government sectors have been dis-saving in recent years – a trend that now needs to reverse. All of which suggests an extended period of sub-par domestic economic growth.
There are two distinctive policy choices for an overly indebted economy when confronted by a breakdown in the financial system. Which is chosen can have a significant impact on the long term outlook for the currency.
Policy choice 1 – do nothing and allow the economy to work itself out with a severe recession or even depression, with a cleaning out of the system as weak companies fall into bankruptcy, leaving strong companies and a base from which to build recovery.
Policy choice 2 – use all policy tools available to attempt to stem the downturn.
Choice 1, not surprisingly, is considered politically unpalatable as millions of people lose their jobs and many companies go bust. Choice 2, while seemingly more palatable, carries far greater risk. If it doesn’t work it sows the seeds for a decade or more of disappointing growth as savings are rebuilt slowly and the pain of the adjustment prolonged. If it does work it sows the seeds for significant inflation.
Ineffective policy results in a Japanese style “lost decade” accompanied by a weak currency. Effective policy combats debt deflation and offsets the worst of the immediate recession but creates a real risk of eventual significant inflation. For a debtor nation such as the US that creates a real risk of a major currency crisis as investors shun dollar-based assets (because their real value is undermined by inflation and a falling currency). Either way, the dollar goes down.
Currently, US policymakers are halfway through policy choice 2. Interest rates have been cut aggressively and are now almost zero. Politicians are about to embark on their second fiscal stimulus. The banks have been recapitalised. The government has started buying and guaranteeing distressed debt. Finally, the Federal Reserve has begun in earnest to use its balance sheet (in a sterilised manner) to step into the absent shoes of the private sector in the financial system. The Fed’s balance sheet has expanded from $900bn just three months ago to $2,200bn today.
A failure of the initial set of policies to reflate the economy is likely to lead to the next, more risky, set of policy choices – those involving unsterilised intervention. Given the breakdown of trust in the financial system, the lack of savings by the US and the continued deleveraging of balance sheets, however, those initial policies, aimed mostly at supporting the economy through creating credit (rather than increasing savings) seem destined to fail.
As the US embarks on the next set of policy choices for curing deflation, as outlined by Ben Bernanke, Fed chairman, in his 2002 speech “Deflation – Making Sure it Doesn’t Happen here” – inflationary risks will begin to rise. With that comes the risk of sustained medium term dollar weakness and the risk ultimately of the demise of the dollar as the world’s sole reserve currency.
The writer is chief executive of Longview Economics
By Chris Watling
Published: November 26 2008 18:34 | Last updated: November 26 2008 18:34
http://www.ft.com/cms/s/0/9790f1ba-bbe0-11dd-80e9-0000779fd18c.html
The outlook for the dollar is poor.
In the short term an expected equity market rally, quite plausibly the beginning of a cyclical, although not secular, bull market should bring an end to the dollar’s recent “repatriation rally”. The inverse correlation of the dollar and the S&P 500 is well established and not expected to break any time soon, given the global macroeconomic backdrop. The short term trend should be further reinforced by the broken financial system which impairs the US economy’s ability to releverage and mutes the strength of its cyclical recovery. The inability to releverage precludes the US from leading the global economy out of this recession. That also reinforces the dollar’s short term unattractiveness.
In the medium term, the US economy faces significant, albeit not insurmountable, structural problems. In particular the interaction of a heavily indebted economy with a broken financial system suggests a decade of poor domestic economic growth as savings are rebuilt and trust in the system restored. The US is a debtor nation and owes the rest of the world more than $2,000bn (up from $750bn as recently as 2000). Indeed both the household and the government sectors have been dis-saving in recent years – a trend that now needs to reverse. All of which suggests an extended period of sub-par domestic economic growth.
There are two distinctive policy choices for an overly indebted economy when confronted by a breakdown in the financial system. Which is chosen can have a significant impact on the long term outlook for the currency.
Policy choice 1 – do nothing and allow the economy to work itself out with a severe recession or even depression, with a cleaning out of the system as weak companies fall into bankruptcy, leaving strong companies and a base from which to build recovery.
Policy choice 2 – use all policy tools available to attempt to stem the downturn.
Choice 1, not surprisingly, is considered politically unpalatable as millions of people lose their jobs and many companies go bust. Choice 2, while seemingly more palatable, carries far greater risk. If it doesn’t work it sows the seeds for a decade or more of disappointing growth as savings are rebuilt slowly and the pain of the adjustment prolonged. If it does work it sows the seeds for significant inflation.
Ineffective policy results in a Japanese style “lost decade” accompanied by a weak currency. Effective policy combats debt deflation and offsets the worst of the immediate recession but creates a real risk of eventual significant inflation. For a debtor nation such as the US that creates a real risk of a major currency crisis as investors shun dollar-based assets (because their real value is undermined by inflation and a falling currency). Either way, the dollar goes down.
Currently, US policymakers are halfway through policy choice 2. Interest rates have been cut aggressively and are now almost zero. Politicians are about to embark on their second fiscal stimulus. The banks have been recapitalised. The government has started buying and guaranteeing distressed debt. Finally, the Federal Reserve has begun in earnest to use its balance sheet (in a sterilised manner) to step into the absent shoes of the private sector in the financial system. The Fed’s balance sheet has expanded from $900bn just three months ago to $2,200bn today.
A failure of the initial set of policies to reflate the economy is likely to lead to the next, more risky, set of policy choices – those involving unsterilised intervention. Given the breakdown of trust in the financial system, the lack of savings by the US and the continued deleveraging of balance sheets, however, those initial policies, aimed mostly at supporting the economy through creating credit (rather than increasing savings) seem destined to fail.
As the US embarks on the next set of policy choices for curing deflation, as outlined by Ben Bernanke, Fed chairman, in his 2002 speech “Deflation – Making Sure it Doesn’t Happen here” – inflationary risks will begin to rise. With that comes the risk of sustained medium term dollar weakness and the risk ultimately of the demise of the dollar as the world’s sole reserve currency.
The writer is chief executive of Longview Economics