Dollar bubble about to burst

Larry Elliott Monday May 21, 2001 The Guardian

Apart from John Prescott's bit of argy-bargy, not a lot happened in the the election last week. Labour will win by a country mile because real incomes are rising, public spending is increasing and the Tories cannot come up with a credible answer when asked how they would pay for their tax cuts.

You know that and I know that. At some point over the next couple of weeks, it may be worth returning to British domestic politics, but for the time being let's turn our attention to something that presents a rather more difficult intellectual challenge: explaining what is going on with the US economy.

The fact is that last week's really important events - and events that may impinge on Britain before too long - took place on the other side of the Atlantic. On Tuesday the Federal Reserve cut interest rates by 50 basis points for the fifth time in as many months, expressing concern about the health of the US corporate sector where investment spending is falling rapidly and stocks are run down in an attempt to boost profitability.

On Friday, the US trade figures were released showing an increase in the deficit from $26.86bn (£18.66bn) in February to $31.17bn in March. Put another way, that's $1bn a day.

Good news Now, call me old fashioned if you like, but I was always told that running a trade deficit of this size was a sign of economic weakness, and would result in a depreciation of the currency in order to make imports dearer and exports cheaper. Apparently not. According to the Reuters news wire, dealers on Wall Street see the increase in the trade deficit as rattling good news because it shows that the cuts in interest rates are stimulating consumer demand.

"While the trade report suggested the economy was weaker than earlier thought at the start of the year, economists said it augured better times ahead, with the import number indicating consumers have not been scared into snapping their pocketbooks shut."

So, because the trade figures were so "good", the dollar rose against the euro on the foreign exchanges, making life for the US corporate sector even more difficult. Dell, the world's biggest producer of computers warned that earnings in the second quarter were likely to disappoint, and no wonder.

Don't worry if you're baffled by this, because a lot of clever people in the world of economics are baffled by it as well. "The rise in the dollar since February has been puzzling", the Bank of England said in its inflation report last week, "as it has been associated with falls in US growth forecasts and short-term interest rate expectations relative to some of its major trading partners". Loose translation: all our models say the dollar should be falling like a stone but for some reason it is going up.

The International Monetary Fund cannot explain it either. It devoted a special section in last month's world economic outlook (WEO) to the factors driving the weakness of the euro and the strength of the dollar, which it said seemed "to defy explanations from conventional exchange rate models". Conventional exchange rate models treat the value of a currency as just another price that will fluctuate in order to bring a market into equilibrium.

If you are running a big trade deficit, the price of your currency will fall; if you are running a trade surplus it will rise. Economics text books say that this is what happens under floating exchange rate regimes, but in the real world the big three currencies - the dollar, the euro and the yen - are grotesquely misaligned.

The IMF has looked at all the possible explanations for the strength of the dollar against the euro and concluded that the likeliest cause is the flow of hot money out of Europe and into the US, encouraged by the perception that America offers better prospects for growth and profits. This is amply borne out by the data. Net portfolio flows into US assets, according to the IMF, have increased from $25bn a year in the early 1990s to $500bn a year in 2000. What's more, the composition of these flows has changed over time, with foreign investors spurning the safety of US treasury bonds in favour of equities, where net flows have risen 12 fold over the past decade.

So, let's recap. Here we have an economy that is running a current account deficit of 4% a year. It is one that has an overvalued currency and one where the corporate sector is showing all the classic signs of distress; falling profitability, cutting investment and laying off staff. It is an economy dependent on constant flows of hot money but which also gives investors the absolute right to leave with their money whenever they want. Faced with a similar set of circumstances in Thailand, dealers could not get out fast enough.

The US is not Thailand and the dollar is not the baht. Even so, you would be forgiven for wondering whether it is true that all the really smart people are working in the City these days rather than in the civil service, the media or education. Nick Parsons, currency strategist for Commerzbank and a man who understands the psychology of markets as well as anybody, says there are two rational explanations and one irrational one.

The two rational ones are; first, that whatever the problems of the US economy it has a central bank that is proactive. Unlike the European Central Bank, which appears to delight in stuffing the markets, the Fed has done what dealers have expected; cut often and cut big. There is something in this: the ECB has the William Hague problem; it lacks credibility.

Second, while Europe may have stronger growth than the US this year, it will still be affected by a slowdown on the other side of the Atlantic. Germany is already struggling as a result of a one-size-fits-all monetary policy and will struggle even more as exports to the US dry up.

And the irrational explanation? Simple: the only reward for being right six months before everybody else is a P45, so the safe bet is to do what everybody else does. The herd mentality is powerful and, at the moment, the herd believes that Alan Greenspan has the situation under control, or at least pretends that it does.

Dangerous

It doesn't take a genius to deduce that this is a situation fraught with danger. The dollar has appreciated by 65% against the euro over the past six years, well in excess of any conceivable improvement in US productivity relative to Europe, and at some point will fall. If it were to fall slowly and steadily there would be a gradual readjustment, but the chances of this happening recede with every week that the currency remains absurdly high.

The bubble in the dollar will eventually become as obvious as the bubble in hi-tech shares, and the market reaction will be the equivalent of someone shouting "fire" in a crowded cinema.

Can Greenspan save the day? I doubt it, because he is now part of the problem. The feeling that Greenspan is God has encouraged the belief that the US economy will snap back as a result of easier monetary policy, boosting corporate earnings and thereby justifying faith in both equities and the dollar.

In the short term this may work, but only at the expense of yet another consumer binge and a further burgeoning of the trade deficit. Far from being the "maestro", as Bob Woodward called him in his book last year, Greenspan is more like a quack doctor dispensing happy pills to the gullible.

The IMF is aware of the dangers. In the WEO it said that there must be "a proportion of the euro area outflows that would be repatriated if returns abroad turn out to be disappointing". Another way of putting it would be that the dollar is an accident waiting to happen.

It is already the case that the number of financial crises in the modern post-1973 era has been double that of the Bretton Woods and pre-great war gold standard eras and before many months are out the world's finance ministries could have another really big one on their hands.

Or rather two, for as figures out in the UK will show, Britain's trade deficit is not looking too clever either and sterling is also defying gravity against the euro. There is trouble ahead.

larry.elliott@guardian.co.uk

www.guardian.co.uk/busine...51,00.html

-- Martin Thompson (mthom1927@aol.com), May 22, 2001

Answers

http://www.guardian.co.uk/Archive/Article/0,4273,4189382,00.html

-- Andre Weltman (aweltman@state.pa.us), May 23, 2001.

There would not be a trade deficit if the dollar was allowed to assume the proper value in foreign exchange. We have trade deficits because the Fed through interest rate manipulation varies the value of the dollar. The Fed does want to pay for these imports.

-- David Williams (DAVIDWILL@prodigy.net), May 23, 2001.