Friday, 22 October 2010

A new currency war?

To students of the Great Depression, the current discussion about a currency war should come as no surprise. In the ‘30s, the world had a fixed exchange rate system, based on a US-centered gold standard. It made it obvious for all that a series of competitive devaluations were taking place as countries turned their attention to exports as a way of boosting domestic growth.

This time around it is a bit different. We do not have a global fixed exchange rate. We have dollar, we have the euro, and the yen. Until the outbreak of the crisis, we also had two currency blocs, the Euro and the US dollar bloc. By the latter I refer to the fact that a number of South American and in particular Asian exporters unilaterally kept their currencies largely stable against the dollar.

We are now in a situation where competitive devaluations are off the table, since there is no fixed exchange rate system. This has opened the floodgates for something far more insidious, quiet and discrete manipulation of the currencies. And there is a sneaking feeling that the US of A is actually the main culprit. The US allegedly want to weaken the dollar in order to redress the huge hole in the trade balance. Doing this is so not kosher.

It is very easy to come to that conclusion when looking at the weakening of the USD since in the past months. Several currencies have appreciated significantly against the USD. I talk about the euro, the ASEAN currencies, the yen. And even the Chinese yuan also increased a bit. For all practical purposes the implicit dollar bloc has gone and the USA appear to be exporting its economic trouble to everybody else.

It always makes good headlines to accuse somebody else of currency manipulation. US lawmakers are specialists in that discipline as they pound the Chinese in order to obtain a significant appreciation of the CHY.

I am sure that everybody in the US economic policy circles welcomes a weaker USD. It was the same in Euroland in the first half of the year. But I am equally sure that the current dollar depreciation is the result of what I described in my previous post. Namely the current situation of the USA being caught in a liquidity trap.

There is a near universal expectation that the Federal Reserve will resume its asset purchasing programme within weeks. Such a program increases reserves in the banking system, but so far it does not lead to an increase in the money stock. Banks do not lend money and consumers and businesses do not borrow. Banks have a tendency to increase deposits at the central banks in that situation. It could however also happen that they help finance investments in securities. In other words, the main consequence is to inflate the value of financial assets.

To the extent that investments are not made exclusively in dollar-denominated assets, this liquidity flow will tend to weaken the dollar and to drive up assets in the “host” countries. In other words, the side effect of the US monetary policy is to drive the dollar down and financial assets upwards, also outside the USA.

Obviously, there is nobody complaining about the asset inflation, since it is supposed to lead to consumers feeling better and increasing demand. Eventually, that is.

But the falling dollar is obviously provoking a lot of politicians in other countries, from China to Brazil. A lot of noise is now audible and it is fully understandable. The weakening dollar makes US exports more competitive. The country that triggered the financial crisis through a disastrous combination of private and public sector deficits, a debt explosion and a terminally weak regulatory regime are now trying to export their way out of the crisis. At least according to the critics. I am sure that US policy makers would prefer to be in a situation where they could indeed push a string – using the monetary policy to get the economy growing faster.

Eventually the US economy will pull out of the liquidity trap, but nobody knows the timing of this. In the meantime the trends in the financial markets will continue, no matter how contradictory they are.

And in the meantime, we can all marvel at the best manipulators in town, the Chinese. Following months of increasing pressure from the Western World, the crawling peg regime from the pre-crisis years was reinstated. Not that CNY has moved a lot against the USD. But the change came virtually at the same moment as the USD began to weaken against the EUR and the JPY. So the net effect has been a weakening of the CNY in trade-weighted terms. Not bad for presumed novices in the noble art of waging a currency war.

Tuesday, 19 October 2010

Helicopter Ben getting ready for take-off? He ought to

Back in the ‘80s, then-US Fed Governor Paul Volcker used some serious weapons to quell inflationary expectations in the US. Interest rates were hiked to a point where the economy went into recession, excess capacity was established and a veritable press blitz focused on the need to stop inflation. At the same time, like-minded governments in the Western world gave the same message and such a thing as inflation indexing was killed in most countries. And it worked. Over a couple of years, inflation and inflationary expectations were falling rapidly and they have remained on a falling trend ever since.

Now that deflation – or at least disinflation – is a very real possibility, the game is to create some inflationary expectations, hoping it will feed through the economy. The reason is the same as fighting excessive inflation, namely that inflation as well as deflation leads to sub-optimal economic decisions.

The question is how to boost inflationary expectations, and it is not quite as easy as one would expect. Monetarists have told us that inflation is essentially a monetary phenomenon – “too much money chasing too few goods”. But that is clearly not the case now. With excess capacity nearing 10 per cent of GDP in several large countries, including the US, and monetary policy not leading to credit growth, inflationary pressures are totally absent. No matter how much money Federal Reserve and other central banks have pushed into the banking sector, most of it has remained with the banks, deposited at the central bank. It has not led to an increase in credit, and the main effect has been to salvage the banking sector and to recapitalise it by stealth.

Economic textbooks prescribe increased public spending that directly creates demand. With governments across the Western world moving to reduce public sector deficits, this solution is not exactly on the agenda. So rumours abound that now the central banks, led by Fed, are about to introduce another round of asset purchases, also known as “Quantitative Easing”. Which is again supposed to increase the money stock.

It probably won’t work this time either. The rumours have created some minor moves in the financial markets, though. The break-even inflation rate between T-bonds and US Inflation-indexed bonds, known as TIPS, has increased to 2.20 per cent. It means that if US inflation over the coming 10 years is 2.2 per cent, an investor will receive the same real return on a TIPS as on a normal government bond. 2.2 per cent is obviously higher than Fed’s assumed inflation target of 2 percent. Thus the situation receives quite some attention in the financial press.

But bond dealers do not create inflation expectations out there in the real economy. Such technicalities have nothing to do with how the average consumer perceives of the world. He/she begins to expect inflation once everyday goods and services begin to increase. We need the price of homes, groceries, haircuts, child care and so on to increase before inflation becomes tangible. At this moment in time it appears that only food prices are going up.

So I am very sceptical that Fed’s attempts at creating inflationary expectations through intervention in the financial markets will work. Fed Chief Ben Bernanke (unfairly) earned the nickname “Helicopter Ben” when in 2002 he quoted the monetary economist Milton Friedman’s recipe on how to stop deflation: Drop money from a helicopter. In the same speech Bernanke went on to describe the monetary policy as it is being implemented right now.

The problem is only that as long as Fed buys T-bonds off the private sector, including the banks, essentially it turns some private sector savings into cash. If the cash is not spent, it will not increase demand. Friedman saw clearly that the cash money had to be aimed at people who would spend it.

Maybe Ben should begin to look for his pilot helmet and get himself ready for that helicopter drop.

Thursday, 7 October 2010

A sweet sport ... followed by?

Renowned Fed hawks believe it is necessary to expand and extend the Quantitative Easing programs in the US. Bank of Japan is doing it already. Bank of England is being strongly recommended by business leaders to do the same. And in continental Europe it is all quiet. I must admit that some of what I hear makes me rather apprehensive. Apparently there are strong worries that the current slow growth phase will last long enough to spur deflation. And deflation is the thing we do not want. At all!

In the past months we have seen some broad trends: Stronger stock markets, strong bond markets, weaker dollar, weaker yen, Stronger EUR, stronger EM currencies and EM stock markets. Market risk indicators are coming down. Credit spreads are falling.

Plainly, some of it does not make sense. I am afraid that we are setting ourselves up for a new round of market turmoil, maybe even at the level of what we experienced in May.

Since the outset of the crisis, the central banks have worked to reflate, and the asset prices have indeed recovered much of the lost ground. The loss of paper wealth should not be a major obstacle to growth. But now we have arrived at another critical junction. It is marked by a slew of new growth forecasts for 2011 from various institutions – they all represent downward revisions of growth forecasts.

The Great Recession was triggered by a huge increase in debt, mainly by households in the Western world. Households are now involved in a gigantic cleaning up of their own balance sheets. Meanwhile, the sharp recession undermined government revenue, leading to huge government deficits. Governments are now cutting back on expenditure and increasing tax revenue to fill the coffers.

Some had hoped for business investment to step in as a driver. But in terms of volume, investments do not match neither consumption nor public spending. And we have already seen an inventory rebuilding. New business investment is being delayed as final demand appears sluggish.

It means that attention turns to the original purpose of monetary policy, namely to stimulate the economy. But we are in a “liquidity trap” where pouring more money into the economy has very little effect on economic activity, since banks to not increase lending. As Keynes would have put it, we are trying to push on a string.

Several central banks have taken the step of introducing Quantitative Easing. Instead of massaging the money market they buy securities (various bonds) directly in the market, pushing money into the pockets of banks and other corporations. But the question is whether that has any effect on the economy. If we look at traditional measures, there are no significant signs that it is actually moving the economy forward. So what happens is quite simply that the reflation of the financial assets takes another step forward.

It all looks like a replay of the events following Internet bubble. This time it is not different. It is more of the same, just on a grander scale. Stocks move up, bond yields fall, commodities prices increase. We are in a liquidity driven sweet spot. It all goes well until it becomes clear that the underlying reality does not correspond to the current market perceptions.

Given that the stock markets have not yet taken to heart that growth will be slow because of the ongoing attempts to repair public and household balance sheets, this is where things may go wrong, maybe sometime in 2011. Until then, the markets look set to have quite a good time.