Posted on 08/30/2009 9:28:04 AM PDT by SeekAndFind
In recent days, a number of prominent people have warned of the downside risks facing the U.S. dollar.
Warren Buffett argued while aggressive U.S. monetary and fiscal policy response is necessary, Congress must bring spending back under control in a timely fashion or the ensuing inflation will undermine the value of the dollar.
Joseph Stiglitz, the former White House economic advisor and World Bank economist, warned of the downside risks to the dollar and wants a new international monetary regime because the current reserve system is fraying.
Curtis Mewbourne, portfolio manager at PIMCO, warned the dollar is losing status as the world’s reserve currency. In a report on PIMCO’s web site, Mewbourne explained:
While we have not yet reached the point where a new global reserve currency will arise, we are clearly seeing a loss of status for the U.S. dollar as a store of value even in the absence of a single viable alternative.
The Truth is Out There
The problem with most of this cant about the dollar is simply and factually wrong. Stiglitz and Mewbourne confuse assertions with arguments. The IMF is the most authoritative source of information about the currency allocation of reserve holdings. The data is unequivocal. The dollar’s share of world reserves remains relatively constant at approximately 65%. There was a little bump up as the central banks prepared for European monetary union.
The euro’s present share of world reserves is roughly the sum of its original parts. In the early 1990s, the Deutschemark, French franc, and ECU accounted for about 25% of the world’s reserves, the same as the euro’s share today. This is to say that the U.S. dollar and the European currencies and now the euro account for about 90% of the world’s reserve currencies. Where is the evidence that the international reserve system is fraying as Stiglitz claimed?
The dollar remains the numeraire of the world economy. Energy, foodstuff, and fibers are priced and traded in U.S. dollars, even if Russia, Iran and Venezuela accept other currencies for their commodities. The lion’s share of world trade is invoiced in U.S. dollars. The greenback is on one side of more than 80% of all foreign exchange transactions. Most countries continue to use the dollar as the key metric for their currency and intervene vis a vis the dollar. Where is the evidence that the dollar is losing its status as Mewbourne asserted?
It is Political Economy
Adam Smith, David Riccardo, Alfred Marshall and other classical and neo-classical thinkers thought what they were studying was political economy. Yet these days, many critics seem to be engaged in crude economic reductionism. As the psychologist Abraham Maslow observed,
If all you have is a hammer, every problem looks like a nail.
The U.S. provision of the world’s chief reserve asset, invoicing currency and unit of account is supported by many factors. One of the factors is the size, depth, and transparency of the U.S. Treasury market. There is no other bond market that comes close to it. The European bond market is too fragmented. The Japanese bond market is too insular and barriers to entry are great.
The Treasury market and dollar are also backed by the world’s strongest military might. U,S. defense spending is nearly equal to the rest of the world combined. The U.S. also controls the seas. The U.S. naval tonnage exceeds the next 17 fleets together. As Josef Joffe points out in a recent Foreign Affairs essay, China, India, Russia, Japan, and the EU cannot individually or collectively conduct a major war 8000 miles from their territory. Since 1990, the U.S. has done it three times: twice in Iraq and once in Afghanistan.
The Future
Stiglitz and Mewbourne also are too one-dimensional in their thinking about the complex issue of the U.S. hegemonic status, of which the dollar as numeraire is but an expression.
The U.S. invests more in improving its human capital and research and development. The average education level in the U.S. is 12.3 years, the highest in the world. The U.S. spends around 6% of GDP on higher education, higher than China, India, Japan, Russia and Europe. Joffe cites research that places 17 of the top universities in the world in the U.S. and 39 of the top 50. In contrast, China’s top three are in the 200-300 placed rankings.
The U.S. spent 2.68% of its GDP on research and development in the first half of the decade, according to the most recent UN data. Proportionately China spent a little more than half of that, and Russia even less. The U.S. devotes a greater share than all but a small handful of countries (Israel, Sweden, Finland, Japan, and Iceland).
The idea that the U.S. has lost its innovative edge and no longer produces goods is simply absurd. Last year, one U.S. company alone received more patents than China—IBM. It takes fewer workers to produce more goods. There are fewer Americans employed in manufacturing than at any time in the past 58 years, though output has risen, only reaching a peak when the economy did in the 2007-2008 period. It is called productivity.
University of Michigan Professor Mark Perry, drawing on data from the Federal Reserve and Bureau of Labor Statistics, notes that U.S. productivity reached a record high in July 2009 with each worker producing $223,000 of output (in constant 2000 dollars). Each worker’s output is equivalent to that of three people in the mid-1970s and the output of two in the mid-1980s.
Supply and Inflation
Warren Buffett’s concern is different than those of Stiglitz and Mewbourne. He does not make unsubstantiated claims. He simply observes that the deficit spending that he approves of to address the crisis has limits. He fears that the politicians will not have the backbone to cut spending on the other side of the crisis. Getting toothpaste out of the tube is easy. Putting it back in is the difficult part.
Milton Friedman famously noted that inflation was always and everywhere a monetary phenomenon. For Buffett, inflation is a political phenomenon. It can be a politically expedient way to reduce a debt burden in lieu of the less tasteful reduction in spending or raising taxes.
While Buffett may be the most savvy investor of our time, but when it comes to macro-economics, he demonstrates a firm grasp on the obvious. That the U.S. government is borrowing an incredible sum of money and the Federal Reserve is purchasing nearly $2 trillion of long term securities has been known for months. There was no real new information or insight in his argument.
Knowing full well the facts, here is what the market has done. In the past six months, with a deluge of supply and evidence that the economy has stabilized, the 10-year Treasury yield has risen 45 basis points. New supply has been fairly smoothly absorbed by a wide range of investors.
At around 3.45%, the yield is only about 20 basis points more than the perceived to be more prudent Germany, the benchmark for the euro zone. The U.S. 10-year yield is a few basis points less than what the French government must pay. The spread between the U.S. and Germany is tighter than the spread between Germany and France, who of course share a common currency.
There are many ways to monitor inflation expectations. The five-year/five-year forward (in essence taking a five year forward of the 10 year TIPS' last five years), which has been cited as a good indicator by both the Federal Reserve and European Central Bank, is hovering around 2.5% for the U.S. This is around where it traded quietly in 2007 and most of 2008. The French five-year/five-year forward, the proxy for the euro zone since Germany’s is less liquid, is about 25 basis points higher.
It seems only prudent to be concerned with the vast amount of debt the U.S. is taking on. Between the fiscal year just ending and the fiscal year about to begin, the Obama Administration has warned of a combined deficit of something near 25% of GDP.
It should be a bit comforting for Buffett and ourselves that the U.S. government debt was a significantly smaller part of our GDP than most of Europe and Japan before the crisis hit. Japan’s gross government debt is approaching 200% of GDP, incidentally, and their problem has not been inflation but its opposite.
As of the end of the first quarter of 2009, as the stock market was forming a bottom and house prices were still falling rapidly, household net worth—that incorporates assets as well as liabilities—stood at more than 3.5 times larger than GDP at $50.4 trillion. This is a painful economic crisis but it is not existential in nature.
True, but that doesn’t mean the dollar isn’t going to lose a large amount of its present value.
We are in uncharted economic territory. The numbers are enormous and the complexity is daunting. I don’t think any of our “experts” know what happens from here.
Hopefully, things will not come crashing down on our heads.
Interesting.
Those who think foreigners will abandon the dollar seldom recognize that they have to switch to something else, and all the alternatives are generally a good deal less workable.
Gold/Silver backed “anything” would be a vast improvement.
The Fed is purchasing nothing. It is going into the back room and printing $2 trillion dollars and then giving that to the government to spend.
Never in history has a country as large and economically influential as the US done what we are doing now. Oh yes, it's been done many times on a much smaller scale and by countries with much less potential impact on the world's economy and monetary system.
A dead gerbil stinks a lot less than a dead elephant.
The weakness of most of these predictions is that no one is willing to consider the unthinkable. Worst case scenarios do happen. And in this instance, the worst case is potential economic anarchy of a scale not seen in modern times.
What concerns me is that if all these experts refuse to even verbalize this as an extremely remote possibility, what is that really telling us? It is telling me we should be seriously scared.
I do not even vaguely resemble an economist, but I would suspect the Swiss franc is far too small in volume to handle international trade.
The author ignores the very large current deficit and the unfathomable size of possible future deficits. I agree that the current state of the economy does not warrant devaluation. The current state of the economy is mostly a function of past economic growth and reasonably responsible governing. We are entering uncharted territory with nationalization of the economy and massive increases in entitlement spending. The author is foolish not to be highly concerned about future economic growth and the value of the dollar.
Here are some arguments that support a continued strong dollar. The rest of the world does not have the capacity to replace the dollar in the short term. Replacing the dollar puts their economies at grave risk especially in the short term. If the dollar plunges, the value of foreign reserves also plunges. The US would not be able to buy the world’s goods due to higher prices. Other currencies to replace the dollar have weak underlying economies. The European Union has more socialism than us even given current rat plans and desires. In addition, it is possible that the underlying conditions of economic decline will change. It is possible that entitlement promises will be sharply reduced and replaced with more economic output.
Despite these countering arguments, I remain pessimistic about the state of the US economy and value of the dollar in the long run. I doubt that entitlement promises will be controlled. Economic collapse will be the only brake on entitlement promises. I expect that the rats will continue their relentless march to nationalize the economy even with some signs that voters are unhappy.
The major question is the timing of the collapse. Will the collapse be gradual or rather sudden? I think that traders will make the collapse rather sudden. I do not think that governments will have the power to stop market forces in the long run.
True, the death of the US DOLLAR is not a fact. Also true, the US DOLLAR is going to decline in value as compared to other major currencies.
The law of supply and demand is no more often violated than the law of gravity. Large national debt means eventually more supply of US DOLLARS. Therefore, the US DOLLAR is going to be worth a lot less soon.
That’s not entirely correct. The Roman Empire had a policy for several hundred years of currency debasement/monetary supply expansion in order to pay the army. This policy was necessitated in their minds because Rome was no longer engaged in conquest and once they weren’t engaged in conquest they had financial problems.
However, when people discuss the issues of hyperinflation and deflation they need to realize some things. Currencies survive deflation and die in hyperinflation. However, one thing about hyperinflation is that it would allow for every debt in the country to be written off. It would allow everyone to start anew. Now, this is no get out of jail free card. Most hyperinflationary episodes lead to political turmoil and upheaval in the society. However, if you believe that the system is sick anyway then there is something to be said for hyperinflation because, while it would be bad for a while, most people would get to keep their property and everyone would have learned their lessons when the new order sets in.
Look at Germany, they learned their lesson from Weimar. It’s why they are the only country that is being half responsible in their policy right now
I'm continually amazed that the major markets have simply chosen to ignore the whole of it. It's irrational. I think this author does the same. Simply throw off the dangers and act like it is business as usual.
Thanks, SeekAndFind. Good posts, but I’m hearing whistling off to the west. There’s a graveyard over there....
Nice article, but it still doesn’t explain how we can continue to have a deficit that is 10 to 20% of our GNP and not, eventually, get taken down.
We will go down, but it will not be a crash to the bottom, rather it will be a slow deterioration of the dollar, probably to no more than one quarter of its value today. We will simply cease being a first-tier country and have to live a more simple lifestyle.
U,S. defense spending is nearly equal to the rest of the world combined.
Count on this being cut, big time.
Why?
All currencies float. Why would large banks buy more CHF than any other currency or commodity?
What should dollars be traded for?
Gold? That’s just a metal with emotional attachment.
Oil futures? Demand is destroyed when oil soars.
There will of course be a herd mentality into and of these types of hedges but there is no safe reserve numeraire short of owning your own farm or ranch and fending for yourself.
What strengthens a currency in the world of today is economic growth or economic stability or appearances thereof.
Where a society is prospering and growth is observed, there the currency will strengthen as such a phenomemon represents an attractive market.
Otherwise it’s just trading fuji apples for galas, or red delicious for valencia oranges. It doesn’t make sense except temporarily. The real value is who controls the market and whose markets are growing. That’s it in a nutshell.
For the best synopsis of our current deflationary cycle (a ‘D-Process’ aka depression), Ray Dalio offered the best perspective earlier this year and it will be good for the next two years at least.
Here’s the link everyone should read:
http://online.barrons.com/article/SB123396545910358867.html
Obama is attempting to enter uncharted territory with nationalization of the economy and massive increases in entitlement spending. All indications are that he will fail miserably, just as his mentor, Carter did before him. Smaller government will then be the obvious solution to the countries' ills...and a small government candidate will easily defeat him in the polls in '12.
Well, exactly. And, the nature of currency values is that they are relative. If the baseline of value keeps sinking, it's nice that the dollar sinks less, but...
But it is market driven -- the dollar enjoys a "franchise" that no other currency has. But I don't think such a franchise is necessarily eternal, and economies are in upheaval for lots of reasons now. Last year's franchise may not be next year's.
And then there's the issue of intrinsic value. The dollar's strength has come from its support by the US's market economy. That is ultimately a moral question. So, degradation in morals, are bearish for the dollar, as are any degradations in the market machinery: corruption, misguided regulation, outright nationalization, etc.
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