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Volume 1 - Issue 14
December 13, 2004
Debating the Dollar
Morgan Stanley Global Economics Team
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This week we look at the comments of one of my favorite analyst groups, the Morgan Stanley Global Economics Team, who's most recognizable member is Stephen Roach. I have been a big fan of Roach over the years and part of last week's commentary was a roundtable discussion by the group between Roach, Stephen Li Jen, Richard Berner, Joachim Fels, Andy Xie, Eric Chaney, David Miles, Riccardo Barbieri, Ted Weiseman and Gray Newman.
This distinguished group debates the dollar, deficit and other global imbalances between the US, Europe and Asia. I found it an interesting and highly insightful look at where the world economies stand today. A group as talented as this one is always able to help you think "Outside the Box."
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Debating the Dollar
December 10, 2004
Morgan Stanley Global Economics Team |
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A weakening dollar is now center stage in world financial markets. But
dollar depreciation is not the endgame of global rebalancing. It is the
means toward the end -- a long overdue realignment in the mix of global
saving and consumption. Morgan Stanley's Global Economics team has been
actively debating the currency issue and its implications for the world
economy. Below are excerpts from a recent roundtable discussion we
conducted on the dollar.
Stephen Roach: A $40 trillion world economy is woefully out of balance.
This shows up in many forms, but the most glaring sign is an unprecedented
disparity between the world's current account deficits (America) and
surpluses (mainly Asia and, to a lesser extent, Europe). The key to a
successful global rebalancing hinges critically on tempering the risks of
the world's most serious excesses. For me, that speaks of a shift in the
world's relative price structure -- namely, currencies -- in order to re-
establish a more sustainable equilibrium. That's where the dollar comes
into play. But currency adjustments can't do it alone. A weaker dollar
could also be key in forcing the interest rate adjustments that address the
asset-driven excesses of the American consumer -- quite possibly the
biggest risk factor in today's US and global economy. If the depreciation
of the dollar implies tough adjustments elsewhere in the world -- like
forcing export-led Asian and European economies to stimulate domestic
demand -- then that's not such a bad thing either. Global rebalancing is a
shared responsibility.
Stephen Li Jen: I think everyone is too sanguine about this de facto competitive devaluation by the US. To me, this is very serious, and a very
dangerous policy pursued by the US. I've never heard any central bank
telling the world not to buy their assets. But this was essentially what
Alan Greenspan said in his Frankfurt speech on November 19. We are now
talking about a gradual sell-off in US Treasuries that would take yields on
10-year notes to 5.0%. But if the world really were convinced by
Greenspan, why would bond yields stop at 5%? Why should US equities be
spared?
Richard Berner: I certainly agree with Stephen Li Jen that it can be a
dangerous and risky game for Fed officials even implicitly to talk down the
dollar. Chairman Greenspan, himself, is often guilty of believing that he
can wave his magic wand to manipulate markets to produce the desired
result. History shows that even he is sometimes humbled by the collective
wisdom of millions of investors.
I believe that Fed officials would like to promote -- if they can pull it
off -- a shift in the mix of financial conditions that will facilitate
rebalancing. That shift entails higher US rates, an associated compression
of equity multiples, a tightening of domestic borrowing costs, and a weaker
dollar. Officials must have decided that the risks of the current mix of
financial conditions, with all of its potential consequences for growing
imbalances and prospective abrupt asset price adjustments, were greater
than those entailed in a strategy aimed at letting the air out of the
dollar in a more orderly way.
By the way, while I agree that having a central banker talk down his/her
own currency can be dangerous, I think we'd all agree that it is broadly
appropriate -- nay, essential -- for central bankers to signal their policy
intentions. So Greenspan's related comment that market participants
should expect rising interest rates is certainly an integral part of
today's Fedspeak.
Joachim Fels: On Dick's last point, I have the sneaking suspicion that the
Fed's policy of talking the dollar down is part of their game plan to
create higher inflation in the US. Core inflation (as measured by the
personal consumption deflator) at 1.5% simply doesn't give you enough of a
safety margin against deflation if and when the next recession hits. And,
in highly indebted economies such as the US, a little more inflation helps
to grease the wheels. That's why I think that stagflation will be the name
of the game in America in the next few years.
Jen: The possibility of stagflation is a perfect example of what I mean by
stressing the potential pain of a competitive dollar depreciation. Yet
everyone is still insisting "it won't hurt." I think they are missing the
point. The whole purpose of the competitive devaluation of the US dollar
is that it would hurt the rest of the world. It is about taking jobs and
output from the rest of the world, and leaving the rest of the world to
find other ways to come up with alternative sources of demand.
The US is effectively exporting bubbles to the rest of the world by forcing
other nations to run a low-interest rate, strong exchange rate policy.
Look at Japan in the late 1980s: they were forced to cut their discount
rate in half between the Plaza and Louvre accords that demarcated the
dollar's descent in the latter half of the 1980s. What happened in Japan
in the late-1980s? Japan was left to deal with the bubble and its
aftershocks for the ensuing 14 years.
Roach: Stephen, your response is a classic example of what I call the
global blame game -- the notion that it's unfair for America to foist its
problems on to the rest of the world. While I have some sympathy for this
argument, I would also stress that Asians and Europeans have been asking
for trouble on this score for a long time. Unable or unwilling to
stimulate sustained growth in their own internal demand, they have hooked
their economies to the fortunes of the hyper-extended American consumer.
The idea that such a "free-rider approach" is a good way to run the world -
- Americans consume Asian goods and Asians gobble up American bonds -- was
dangerous from the start. It has led to huge dollar overweights in
official reserve positions of all major non-US central banks -- overweights
that now look fiscally reckless to America's creditors in the event of a
sustained further drop in the dollar.
I am not as worried as you that this will be a competitive devaluation that
will take jobs and output from the rest of the world. America's
manufacturing base has shrunk so much in the past 20 years that such a
dramatic turnaround is problematic at best. What I am most worried about
is that the dollar's weakness will trigger a real interest rate response
that will finally bring the American consumer to his or her knees. With
the rest of the world lacking in consumerism, this raises the distinct
possibility that we are headed for a protracted period of subpar global
growth. Rather than bemoan America's willingness to take a long overdue
adjustment -- one that the wise men of Europe and Asia have long sensed was
appropriate -- why can't the rest of the world respond with a growth agenda
of its own?
Jen: My point is not so much about blaming the US for imposing pain on the
rest of the world. It is a fact that there will be pain -- that's not a
judgment call. That's how the US current account deficit can be
compressed. That's how the US can generate (some) inflationary pressures
that prompt Fed tightening. Up to this point, dollar depreciation is a
zero-sum proposition! That is now about to change.
If it didn't "hurt" anyone, there wouldn't be any change in the US
inflation or demand outlook, and the Fed would be no more justified in
hiking rates than if the dollar did not weaken. In other words, a weaker
dollar being the trigger for a more hawkish Fed must involve pain in the
rest of the world, which is a point that the rest of the world does not
understand. The talk in Euroland and Japan is, "how much more currency
strength can we tolerate before we get hurt." That misses the point.
As you yourself have argued, Steve, it is the next step -- when the rest of
the world and the US take proper action -- that determines if we can move
on to a state that is more sustainable in the long run. Going from A to B
will not be a smooth path, because equities and bonds are being talked down
in the process: Greenspan cannot talk down the dollar without talking down
other dollar-based assets as well. Bottom line: I don't disagree with you.
I just think that the world doesn't understand that pain is a part of the
game here.
Roach: Stephen, thanks for the clarification. Your point is an important
one that I certainly do appreciate. I guess it boils down to how the world
copes with pain -- constructively (i.e., structural reforms in Europe and
Asia plus deficit reduction and increased private saving in the US) or
destructively (trade frictions and protectionism). I worry that Asia
hasn't gotten over the 1997-98 crisis syndrome -- that it holds a grudge
that may complicate the rebalancing endgame.
Andy Xie recently wrote the following: "It is in the overwhelming interest
of the region (Asia) to fight back. The global economy should not be there
just to serve the US. Everyone's interest must be taken care of offer. The
only sustainable equilibrium is a cooperative one."
My question to Andy: If all Asia does in defense is sell Treasuries, it may
end up shooting itself in the foot -- i.e., incurring huge fiscal costs of
currency losses for that portion of their dollar portfolios they do not
sell. Asia needs a backstop of balance and resilience that will enable it
to withstand the pain of a weaker dollar. If all there is to Asia is capex
and exports, then Asia will get creamed when its US-centric external demand
dries up. Talk about being beholden to the "kindness of strangers!"
America is hooked on foreign capital inflows. Asia is hooked on the
excesses of American consumerism. There is pain involved in breaking both
of these habits. I agree with Stephen Li Jen that the world is in denial
over that possibility.
Andy Xie: Steve, I am not saying that Asia is not to blame. After the
Asian Crisis, the Fed cut interest rates and Asia employed an export
strategy to come back without embarking on the fundamental changes needed
to establish a new balance between investment and consumption. The US,
however, did not ask anyone to change the strategy when it was cutting
interest rate and taxes to stimulate demand after the tech bubble burst.
That was because it needed Asian savings to stay out of recession. Asia
became complacent in living in this precarious equilibrium. Now, suddenly,
the US wants to shake it off. How is that possible when the necessary
changes are huge? All dollar devaluation would do is increase deflationary
pressure without changing Asia's export potential. The cooperative
solution involves both (1) the US reducing demand and Asia increasing
stimulus in the short term and (2) structural changes in Asia to decrease
savings and in the US to boost savings. A unilateral approach by the US
could lead us down the road to a bad equilibrium, a prisoner's dilemma.
Roach: Andy, America is like everyone else -- steadfast in its strong
predisposition for embracing the painless way out. The theory behind
finally facing the pain and getting on with the adjustment is simple -- the
longer you wait, the rougher the endgame. I think the Fed has finally
taken the leadership in this "resolution" because it has lost confidence in
the US Treasury to manage the problem. I do believe that an unbalanced
world needs a wake-up call. If that's what this dollar angst boils down to
-- all the better. Complacency and benign neglect are no longer acceptable
as policy options for a world that has become this seriously unbalanced.
You are right, of course, that the only way out is a cooperative solution.
But it takes someone to jar the world to its senses to get the major
players of the global economy all on the same page. Three (belated) cheers
for the Fed for bringing the problem out into the open.
Eric Chaney: That a very weak US dollar will inflict pain on America's
trade partners is not debatable, in my view. As I understand it, both
Steves -- Roach and Jen -- agree on that. The first Steve has long made
the point that some form of external shock is required to force Europeans
to unshackle domestic demand. I am not fully convinced of that. Apart from
monetary and trade policies, structural policies are in the hands of a
bunch of local governments, which have different agendas.
David Miles: I must confess that I am also a bit confused by the view that
if there were more structural reform in Europe this would help reduce
imbalances in the world. I thought "restructuring" was a sort of catch-all
for liberalizing labor markets and product markets designed to make Euro
area more competitive, productive and so on (i.e., a set of policies
designed to tackle high unemployment by, for example, weakening
restrictions on hiring and firing, making social security less employment
unfriendly, cutting restrictions on maximum hours and so on). If all that
works, doesn't the Euro area become more competitive? How does that help
close the US trade gap? Isn't the Euro area actually doing its bit to help
by keeping itself less competitive?
Of course, one could argue that the prospect of structural reform creating future higher wealth in Europe would boost consumption now by more than
output, so net demand for the output of the rest of the world rises,
helping shrink the US deficit a bit. But that depends on European
households interpreting reforms in a positive light and being willing to
borrow against (uncertain) future gains. All that strikes me as a bit
unlikely. It is not that I am against the position that reform in labor and
product markets in many European markets is needed. Rather I am not
convinced that this has much to do with reducing structural global
imbalances. In fact, it is even possible that it could make things worse.
Roach: Structural reform is a long and arduous process that often entails
major risk for incumbent politicians. The temptation is always to put off
the heavy lifting -- thereby ducking any potential backlash. The US saga
of the 1980s is a key case in point. A stronger dollar crushed Smokestack
America and unleashed a powerful wave of corporate restructuring. America
-- aided, perhaps, by more tenuous social contracts than in Europe -- took
the currency signal as an imperative to reinvent itself. Moreover, a
strong yen in the mid-1990s triggered aggressive restructuring by Corporate
Japan. Europe whines a lot but doesn't seem to get the old adage of "no
gain without pain."
Riccardo Barbieri: I would argue that if the EU or the euro-zone started
major labor-market reforms tomorrow morning, that would not necessarily
raise aggregate demand (and thus, imports) next year. In the medium-term,
however, a more competitive Europe would not only challenge US and Japanese
companies, but also, probably, enjoy higher rates of economic growth. In
turn, that would boost imports.
Roach: Precisely. A more competitive Europe will finally promote lasting
job creation, income generation, and domestic private consumption. That
would be the sustenance of incremental import growth that would eventually
offer opportunities for increasingly competitive US exporters.
"Eventually" is the key word here. But let me come back to something that
bears on what I believe is Europe's overly-defensive response to recent
currency adjustments: Are you guys serious in expressing the belief that
America's central bank has made a conscious decision to punish Europe for
its lagging progress on structural reform?
Barbieri: I interpret the apparent preference of the Fed for a further
weakening of the dollar and higher interest rates as a reaction to the US
election outcome. Mr. Greenspan evidently feels that the dollar will be
better underpinned once it is widely viewed as "cheap" and US interest
rates are rising.
Europe is criticized for its lack of structural reforms -- a criticism that
most of us would share. However, the euro has so far borne the brunt of
the dollar adjustment. The appreciation of the euro will drive up imports
and will cost Europe further jobs. In sum, Europe could do more on the
structural side, but is doing more than its share on the macro side. The
same holds with Japan, with the notable exception of exchange-rate policy.
Roach: Riccardo, your Euro-centric view of pain misses one important issue
-- the failure of Asia to bear any burden of the dollar's recent weakening.
Isn't that what burden sharing ultimately must entail?
Barbieri: Countries that follow dollar pegs -- either explicitly (i.e.,
China) or implicitly (i.e., Japan) are a complete or partial exception.
Roach: But isn't Chinese currency policy the real missing link in the
global rebalancing script?
Barbieri: Yes. China certainly does stick out as a critical factor going
forward. I realize that until two years ago, in a strong dollar
environment, the Chinese peg suited everyone else around the world. The
fact is that now the US, unilaterally, wants a weak dollar is a very real
irritant on the Chinese side. However, one thing is clear: Every
percentage point of dollar depreciation is also one percentage point of RMB
depreciation against third parties. This will put further pressure on
countries that do not have the flexibility and the local market size of the
US. To the extent that China refuses to change its currency regime, then
Europe will have at some point to draw a line in the sand -- if it can --
in terms of the euro exchange rate. In my view, that line is at 1.40.
That said, if China does change its currency regime, the world financial
system will no longer be the same. Indeed, a further move towards flexible
currencies could in due course bring an end to the supremacy of the dollar.
Or will it? Can the world financial system and international trade be
organized around different currencies? What will be the numeraire for the
commodities markets? In my view, the expectation that holds world markets
together is that a period of higher US and world inflation will be
followed, in the medium term, by fiscal consolidation in the US, which will
then re-establish the credibility of the dollar. But, will this come to
pass?
Ted Weiseman: I disagree with one part of Ricardo's earlier argument in
assessing the current-account implications of the US policy mix. Contrary
to what he stated, post-election news on the US fiscal front actually has
been quite positive.
Barbieri: My reasoning goes as follows: The US will continue to have a
current account deficit in coming years, but the deficit must decrease in
order to prevent an excessive accumulation of net international
liabilities, i.e., in order not to have the world awash with dollar assets.
However, if a given policy approach promises, say, to reduce import
dependency and to raise the saving ratio, that is helpful for the dollar,
because it reduces the US current account deficit in the long run and
should thus make the rest of the world more willing to hold US assets.
My bottom line: if you think that we will see significant tightening in
fiscal policy in the next four years, then this is something we must take
on board in assessing currency risks. If it also means a higher overall US
saving ratio, then I guess this should make us more optimistic (or less
pessimistic) on the dollar.
Weiseman: The argument we've been making is that the US fiscal situation is
gradually improving -- that the current budget deficit is not out of line
historically. So this is not really where the focus should be in the
debate about the US savings imbalance. The relentless downtrend in the
personal savings rate is the glaring issue. That has to start rising if
the overall national savings rate is going to go up.
Roach: America's federal government budget deficit is a very serious
problem for precisely the reason you state, Ted -- a dramatic shortfall in
private saving. Declining personal saving is an outgrowth of the Asset
Economy -- namely, aging and myopic homeowners banking on unrelenting
house-price appreciation to do the saving for them. The fact that America
is now in the midst of a housing bubble is especially worrisome in that
regard. The problem with persistent structural budget deficits -- a long-
term prognosis that is centered in the 2.5% to 3.5% steady-state range --
is that the US has no cushion of private saving to fund it. That's the
intractable current account problem in a nutshell. Nor would I be quite as
optimistic as Ted on the federal government deficit -- the peaking is
cyclical, whereas the real problem is structural. America's saving problem
is off the charts -- possibly the most serious imbalance in an unbalanced
world. Sounds to me like a classic case for a consumption tax.
At least Europe and Asia have that cushion -- much higher private saving
rates -- giving them every right, in my opinion, to be critical of the US
for its profligate ways.
Barbieri: If the US economy continues to do well, shouldn't the Fed step up
the tightening pace? It all looks like a huge bet on growth. If American
companies invest their savings in the US (perhaps with some help from a
weak dollar), then the pie grows, jobs grow, and consumers can pay off
their debt.
Gray Newman: If Administration officials made important moves on the fiscal
front, I wouldn't be surprised if we saw the dollar rally. In that case
the negative economic impacts of fiscal tightening could well be offset by
an easing of long rates. That could buy us time but it would undoubtedly
perpetuate an outsize current account deficit -- setting us up for an even
bigger problem in the future.
Roach: So here's what this aspect of this debate boils down to: Does the
US have a structural budget problem, or not? Does the US have a private
saving problem, or not?
If the answer to both of these questions is "no" then we should be pounding
the table on the likelihood of a miraculous US current account adjustment
and a related strong reversal of the dollar. If the answer to both of
these questions is "yes" -- and that is where I am -- then the adjustment
game is just beginning. The trick comes when the answers to either
question get shaded one way or another. The dollar's recent decline
reveals the collective preference of the consensus of global investors.
Again, it's not that a weaker dollar will fix all that ails an unbalanced
world. But, as I noted at the outset of this debate, it is very much the
Trojan Horse of global rebalancing -- a spark to real interest rate
adjustments and a concomitant trigger to a narrowing of global consumptions
and saving disparities.
The hope is the world finds a way to manage the dollar's decent gradually
over time. Unfortunately, given the sheer magnitude of today's global
imbalances, that may be wishful thinking.
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I hope you enjoyed reading one of my favorite analysts and his colleagues
thoughts on world economic issues. We did edit it somewhat, so for the full
debate, you can go to http://www.morganstanley.com/GEFdata/digests/latest-digest.html, click on archives and then on December 10, 2004.
Finally, a paper by premier money manager and all-around smart guy, John
Hussman (of the eponymous Hussman Funds) was brought to my attention last
week. It struck a very similar note to the work featured in last week's
"Outside the Box", but gave a more in-depth and lengthy basis for a portion
of the analysis. It is very interesting reading. You can read it at http://www.hussmanfunds.com/pdf/mixdist.pdf.
Your hoping the dollar adjusts orderly analyst,
John F. Mauldin
johnmauldin@investorsinsight.com
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