Thursday, January 04, 2007

Cato's View of the Dollar Drop A Little Oversimplified

I love Cato and have great respect for them. They have some of the best minds on earth. BUT -- sometimes they irritate me with what I'll call, diplomatically, their excessive sense of propriety.

Richard Rahn of Cato argues in an article entitled "How Far Will The Dollar Fall?"that currency value swings, and more specifically the fall of the dollar, are a bad thing. Hear-hear. The main reason, he says, is the uncertainty it creates in the minds of dollar investors here and abroad. Now, that is certainly a mild way of putting it.

(Click on the photo to see what happens.)

[Thanks to pickens.k12.sc.us/dhsteachers for the photos.]

He points out that, although a fall in the dollar may help our exports, it simultaneously makes imports more expensive, and we import a lot including a good percentage of our raw material and parts. (Does petroleum ring a bell?)

He mentions a common error:

"Some argue our large trade deficit (or current account deficit) is responsible for the fall in the dollar's value. They have it backward. It is the flow of foreign investment dollars (the capital account) into the U.S. economy that drives the trade deficit."

I don't quite agree. I would put these two factors into the chicken-or-egg category. Neither is really responsible for the other. Neither was the first force to begin this cyclone of dollars leaving the US, and the corresponding imports and foreign investment coming in. It is not the cheap goods from abroad, nor the high foreign demand for US investment instruments. There is a symbiotic relationship going on here; and after all, the dollars are coming from somewhere.

He goes on to say:

"So long as the U.S. continues to offer a higher return on capital than its foreign competitors, both foreign banks' and private investors' demand for dollars grow, and the current account deficit can be sustained."

But higher demand for dollars would normally mean a higher price for those dollars, and we are now talking about a falling dollar. Could there be an oversupply?

Secondly, since 2000 or so, American savings rates were below inflation, and only for the past year have they climbed up a bit. Surely this is because there is too much liquidity, i.e. too many dollars coming back in from abroad, satisfying the US demand for capital (even over-satisfying it, to be precise -- have you noticed the housing, the CLO and ABS, the M&A, and the corporate bond markets lately? Remember: Capital doesn't have to flow into production; and [over]supply creates its own demand...)

A third unmentioned factor: What about the Chinese and Japanese pegging and support of the dollar? On this, he does say that "[t]he export-driven economies of Asia and Europe cannot afford for the dollar to fall too much, both because their markets will dry up and the value of their dollar assets in their own currencies will decline." As indeed these latter are starting to do.

If anything, the continued foreign interest in US investments is maintaining the dollar's value above where it normally should be, not the opposite; i.e. it is preventing a total collapse of the dollar.

So unlike me, what does he blame for the dollar's fall? Recent government moves.

"[T]the U.S. government made a series of mistakes that have discouraged foreign investors." These are the Patriot Act (think back to the Arabian effort to buy the US port handlers), Sarbanes-Oxley, higher withholding on dividends for foreign investors, and a threat of a new foreign interest-reporting requirement.

I would say that even these have not prevented foreigners from preferring dollars to their own currency, through a combination of the tallest dwarf syndrome and of having to park somewhere the import dollars we are handing over to them. Remember Bernanke's "global savings glut"? I would have been a bit more grateful and called it a "global saving-grace." Without their magnanimity, our treasury would be in big doo-doo. (On the other hand, it might teach us a good lesson if they'd just take our government's doggie bowl away.)

Could it be that the dollar is falling because there are just too many of them and the global economy can't swallow any more? He makes no mention whatsoever of the Fed's recent loose monetary policy episode(s) as a contributor to the dollar's fall.

He also neglects to mention three specific dangers of a falling dollar:

1. The coming home to roost of that famous "loan without interest" represented by the 50% of our monetary base that is floating around outside our borders, which could happen if and when the whole world begins to lose confidence in it as a store of value (never mind the consequent loss to the US of seignorage rights);

2. The imperilment of the dollar reserve accounts of a number of very large and/or instrumental countries (China and the OPEC nations, for example), not to mention the other millions of individuals and corporations who hold dollar assets and who would be royally disappointed, to put it mildly -- and don't forget to include every man, woman and child of America in that group; and

3. The danger that the above actors in this global tragicomedy will reject our dollar at the same time, creating what is called "a flight from the currency" -- and we're not just talkin' any old currency.

In order to reinstate the dollar's reliability, it will not suffice for Congress to repeal S-O and soften foreign investment disincentives. Someday, someone, somewhere will have to confront this excess global liquidity mess head on, and the US is not the only culprit. It may not be the right timing for a righting (tightening) of monetary policy to reestablish the dollar's equilibrium and keep our assets from bubbling off into the stratosphere; but that time will inevitably come, whether we are ready for it or not.

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