On Borrowed Time

August 18, 2000

What is really sustaining bullish sentiment about the U.S. stock market and, propping up the dollar? When asked, everybody pulls the same trump card: Faith in the economy's superior qualities, and faith in the unique wisdom of Mr. Greenspan. No further explanation is needed. His name stands for two tacit presumptions: first, that any signs of undesired economic weakness will prompt the Fed to instant rate cuts; and second, that the U.S. economy and the financial markets will just as promptly respond to any monetary easing.

Okay, let's assume that the U.S. economy shows more sluggishness than Mr. Greenspan and investors ( domestic and foreign ) like. The difference between desired and undesired economic weakening, by the way, may be no more than a hair's breadth. Smelling lower interest rates, the stock market may even be pleased, at first. However, there is another market of crucial importance to the well-being of the U.S. economy and its financial system where such prospects are liable to cause a shock, and that's the currency market. Slower economic growth and lower U.S. interest rates are unambiguously bad news for the dollar. And what's bad for the dollar is bad for the needed capital inflows, and what's bad for capital inflows is bad for the financial markets.

It is reported that measured bullish sentiment on the dollar is at an absolute peak, as against an extreme low in bullishness on the Euro. Considering the present attractiveness of the U.S. financial markets on the one hand, and the excessive and dangerous dependence of the dollar on uninterrupted, huge capital inflows to finance the yawning current-account deficit on the other, the U.S. currency's resilience is certainly most astonishing, if not enigmatic. Back to the question of what Mr. Greenspan will do when the U.S. economy's growth starts to disappoint. There is no doubt in the markets that he will instantly fight any threat of recession by immediately cutting rates and loosening his credit reins. In reality, he will face the catch-22 situation of his life. Prompt monetary easing may help the slowing economy and even launch a rally in the stock market, but he would take an incalculable risk on the grossly overvalued dollar. Some downward adjustment may be desirable. But with the monstrous current-account deficit looming in the background and only a minimal interest rate advantage against the Euro, the U.S. currency is vulnerable to any slight shift in market perception and psychology as never before.

The experience of 1985-88 suggest that once the dollar begins to fall, a self-accelerating bandwagon easily develops. At the time, the dollar's earlier steep rise turned abruptly into an equally steep plunge that erased its prior gain by about 100% within less than three years. Apparently a major factor behind the dollar's sudden, sharp reversal was a drastic shift in economic growth between American and Europe. While slowing in the United States in real terms from 6.8% in 1984 to 3.4% in 1985 and 2.7% in 1986, in Europe it accelerated from 1.4% to 2.8% and 3.9% during the same year.

Traditionally, American monetary policy has been strictly geared toward domestic requirements. Fending off a threatening recession has always had absolute priority, regardless of what happened to the dollar. Given the relatively small share of foreign merchandise trade in the economy, it seemed an appropriate principle. In short, the tail should never wag the dog. In this light, it seems a foregone conclusion that Mr. Greenspan, too, will act accordingly, once the economy weakens more than desired.

CHANGE IN THE RULES OF THE GAME

As already noted, a catch-22 dilemma is waiting for him. Quite possibly, the link between the falling dollar and domestic price level may still not bother him. But over the last few years, another linkage has grown to crucial, overriding importance, and that is the linkage between the dollar, capital inflows and the stability of the financial system. The problem is that the stability of both the dollar and the financial system over the last years has become singularly fated on the persistence of huge credit and capital inflows that have to finance not only the gargantuan current-account deficit, running now at an annual rate of more than $400 billion, but also very substantial capital outflows on the part of U.S. corporations and investors.

In fact, there is far more at stake than merely the financing of current outflows. An even bigger threat to the dollar looms in the existing, vast foreign holdings of dollar assets that have in particular accumulated in the last few years and are now soaring faster than ever. According to the latest official calculations, these amounted to almost $2,700 billion on December 31, 1999, of which $1,837 billion was on private account and $833 billion on account of central banks.

What few seem to realize is that this unprecedented dependence of the dollar and the U.S. financial system on uninterrupted, huge capital and credit inflows has thoroughly changed the rules of the game for U.S. monetary policy. It has created conditions under which the dollar tail could indeed would most probably would-wag the big economic and financial U.S. dog. Once lasting dollar strength begins to be questioned in earnest and people's willingness to increase their exposure to the dollar dries up, the full force of both the current-account deficit and the horrendous, existing foreign dollar holdings will, finally, impact the currency and the financial markets.

In order to get some idea of the looming risks, it is necessary to also visualize the market dynamics that are sure to come into operation once the dollar starts its definite decline. An important point to keep in mind is that any slowdown in investment and credit inflows relative to the current-account deficit and U.S. capital outflows instantly weakens the dollar. Yet, pondering potential, dangerous market dynamics, we see the incalculable, greatest hazards in the linkage between existing dollar trillions in foreign hands and the futures and derivatives markets.

Their owners may be slow in unwinding their positions by selling their dollar assets outright and converting the proceeds into euro or yen. Many of them, however, will be inclined to play at least temporarily for safety and lock in the dollar value by selling the U.S. currency forward through the futures and derivatives markets. As heavy, one-way selling of this kind develops, the institutions making these markets are, in turn, compelled to hedge their forward purchases of dollar entirety by selling correspondence amounts in the spot market.

In this way, the forward sales will immediately translate into correspondingly large spot sales of dollars. It is this reflection in particular that frightens us of a possible, it not probable sudden bandwagon effect against the dollar, once the confidence in its stability begins to wear off. There is no precedent in history where the economy of the world's major currency vehicle has been so preposterously out of balance.

A sliding dollar will, in turn, promptly close the spigot of capital inflows with dramatic effects on the U.S. financial markets, showing up in plunging stock and bond prices, that is, in rising market interest rates. The resulting crunch in the financial markets is the link through which the plunging dollar will rapidly spread recession. The hard landing has arrived.

What will and can Mr. Greenspan do under these circumstances? Slash interest rates? Before long, it will dawn on him and the markets that his freedom to pilot the economy away from the threatening recession through easier money is less than zero. As this alarming realization spreads, it is sure to precipitate the dollar's slide into a free fall. Hoping to prevent a bottomless dollar crash with inflationary implications, the Fed will probably feel compelled to raise its interest rate and tighten its monetary reins which, by the way, has always been normal policy for normal countries. The important point is that a responsible and prudent central banker will never allow such stupendous internal and external imbalances to develop.

Small amounts of natural gold were found in Spanish caves used by the Paleolithic Man about 40,000 B.C.

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