US Economy a Rubin-in-a-Box?

June 24, 1998

The dollar has been in a three-year bull market. It has moved massively against the yen and the exchange rates of many of the world's emerging economies. Lastly, the Asian economies it has rallied against have now entered serious recessions.

The US trade deficit is deteriorating rapidly. Given the lags in trade, much of this year's weakness in these foreign currencies and economies has yet to impact our trade deficit. Much more trade deterioration lies ahead.

The US stock market has recently shown signs of weakness because of adverse earnings reports stemming from dollar strength and economic weakness in Asia. The recent US/Japan intervention to lower the dollar against the yen and avert another downward spiral of the currencies and economies of South East Asia caused worried investors to breathe a sigh of relief and led to a reflex rally in US stocks. Investors may now favor a weaker dollar.

The Rubin Treasury has pushed for a strong dollar in order to encourage short term capital inflows into US stock and bond markets. It has feared a weak dollar on the grounds that a weak dollar could reverse this capital flow, with negative implications for US stock and bond markets.

We believe that economic weakness in Asia is setting the stage for a new currency and economic crisis in Latin America. Because the US trades more with Latin America than Europe does, such a crisis could weaken the dollar against the European currencies. A declining dollar relative to Europe and Japan is the very dollar weakness that the Rubin Treasury fears.

A strong dollar may now be bad for US profits and thereby for the US stock market. A weak dollar may generate short term capital outflows, which may also be bad for the Us stock market.

The following report sketches out a scenario. It is not a forecast. The US stock market is a bubble which will eventually burst. Collapse of the US stock market will cause a US recession. However, it is the nature of bubbles that they go on longer and get larger than any same person can imagine. We set out in what follows a dynamic path that could burst the US stock market bubble and lead to global deflation. However, all the political constituencies in the world want economic growth and reflation. It is our guess that, if this dynamic begins to unfold, policy everywhere will move enough toward stimulus to result in reflation, not deflation, and thereby postpone the inevitable denouement for a later date.

Past US Policy---Competitiveness Called For a Reasonable Exchange Rate

From the early 1970's onward, American industrialists have been concerned about competitive inroads from lower wage countries on a rapid path toward modernization. In the 1980's the focus was on Japan and its successful takeover of a long succession of consumer durable goods markets ( autos, TV's, etc. ) and some high tech markets ( semiconductors ) that were developed initially by US firms. By the 1990's concerns were rife that imports of an ever widening range of goods from lower wage countries, particularly in the Far East, would "hollow out" America's industrial base.

Past Secretaries of the Treasury in the United States conducted economic policy with an eye toward preventing a loss of US competitiveness. Faced with calls for protectionism from firms and workers whose industries and jobs were at risk, these former Treasury regimes were biased toward a low dollar exchange rate which would enhance the position of US industries in world trade without running the risk of trade wars posed by protectionist solutions. Most of these Treasury Secretaries remembered an earlier era when the US ran current account surpluses and was the world's largest creditor nation. From this perspective, US current account deficits were a source of weakness they wished to rectify. It was only a few years ago at 100 yen to the dollar that Mickey Cantor and Lloyd Bentsen were fighting to improve US competitiveness in global tradeables markets with, among other weapons, a threat of dollar devaluation.

The Rubin Treasury---A Strong Dollar Supports US Financial Markets

In recent years, the Rubin Treasury has differed from its predecessors in that it has followed a very strong dollar policy. Secretary Rubin has differed in his focus: trade competitiveness is seldom cited as an issue; instead, he emphasizes the support a strong dollar gives to domestic financial markets. We see this clearly in an interview Mr. Rubin granted to the New York Times, September 29th, 1996.

Mexico was still boiling when Rubin faced his second potential political disaster, the fall of the dollar to below 80 yen. For Rubin, this was more familiar territory: he had supervised the currency traders at Goldman, and he knew both the fiscal and political risks. "These kinds of occurrences are not without consequences," Rubin said. A declining dollar tends to drive investors out of American stocks, bonds and Treasury debt, putting pressure on the federal government to raise interest rates. "It would take a while to show up, but I'm certain it would have happened," he said.

What can one say about Mr. Rubin's approach to exchange rate policy? First, it presumes that destabilizing speculation rules the foreign exchange roost. If the dollar was deeply undervalued at 79 yen to the dollar, US trade would improve relative to Japan. Trade improvement implies an inflow of foreign exchange, which is supportive to the exchange rate. US assets become cheaper relative to assets in Japan. The cost of production of goods in the US falls relative to Japan, raising returns to investment in the US at the expense of Japan. Such considerations should draw in long term capital and thereby foreign exchange. Therefore, under such conditions, the dollar would fall only if the flow of short term speculative capital which chases price momentum rather than long run returns outweighs the exchange inflow from the trade account and the long term capital account.

Economists have long argued whether speculation in any market is stabilizing or destabilizing. In fact, in any market both exist, with predominance shifting periodically from one to the other. There are always Milton Friedman's speculators who stabilize markets by betting against a market that departs from its long run equilibrium. And there are other speculators who, by riding trends, drive markets away from such equilibria. Rubin's statements emphasize the role of destabilizing speculation. For him, it is important to have a strong dollar to encourage trend following speculative inflows of short term capital.

Encouraging strength in a dollar that is too low is constructive in that it reverses the flow of speculative short term capital in a fashion that restores long run equilibrium to the exchange rate. This is what coordinated intervention is all about when it is on the "right side of the fundamentals". This may have been appropriate on the dollar's rise from its 1995 low at 79 yen. However, once the dollar rises appreciably, such encouragement of trend following speculative short term capital becomes questionable. It eventually can become destabilizing, causing a speculative overshoot in the direction of extreme overvaluation. The dollar has risen from 79 yen to 140 yen. The threat of deepening chaos in Asia and other emerging economies and threats from China have finally forced Mr. Rubin to intervene against the dollar. Yet Mr. Rubin still contends a strong dollar is in the interests of the US and is warranted by the fundamentals.

It appears that Mr. Rubin believes that a strong dollar is always desirable to the extent that it encourages short run speculative trend following capital inflows which buoy domestic stock and bond markets and keep domestic interest rates low. The other side of this coin is that a weak dollar from any level is dangerous in that it will reverse such capital flows which can, to use Rubin's words, "drive investors out of American stocks, bonds and Treasury debt". A loss of competitiveness, a rising current account deficit, and a growing net debtor position, all associated with a very strong dollar, appear to always be outweighed by any potential risks from destabilizing capital flows out of US stocks and bonds. This would appear to be an example of the type of "US short termism" that one would expect from a trader from Wall Street. It is noteworthy that this is the appraisal of Mr. Rubin's Treasury given by the press organ of the Chinese central bank just prior to the US/Japanese intervention on behalf of the yen.

Washington could cut interest rates and intervene in FOREX markets to stop the yen's decline but feared that "a sharp fall in the dollar would very likely cause an outflow of foreign capital, causing a plunge in US stock and bond markets," it said. US Treasury Secretary Robert Rubin had often touted the benefits to the US economy of a strong dollar, it added. ( Reuters, June 16, 1998 )

Eventually, Relative Prices Matter

What, might we ask, does such "short termism" on the part of a trader from Wall Street lead to when he becomes Secretary of the Treasury. When the exchange rate is overshooting to the downside, as it may have in 1995, it admirably reverses destabilizing short term capital flows, thereby restoring long run equilibrium. But if pushed too long and too far, it fosters a new set of disequilibria. It results in a loss of trade competitiveness. It propels asset markets ever higher with unstable fuel from inflows of short term global speculative capital. In the case of the US it is now hurtling the world's largest net debtor nation toward a record current account deficit as a share of GDP. And it is helping send a stock market with an unprecedented overvaluation ever higher.

At some point, encouraging trend following short term speculative capital to support an exchange rate and stock prices at extreme points of overvaluation comes a cropper. Why? Because relative prices do matter in the long run. Trade competitiveness erodes. As the current account deteriorates ever greater offsetting capital flows are needed to support the exchange rate. At the same time, returns to investments in tradeables fall. Why would anyone build a plant in such an economy when factor endowments and relative prices make it more profitable to build it elsewhere? And, encouraged and abetted by speculative flows of international capital, domestic share prices rise to valuations which are far too high relative to long run prospective returns.

We are seeing ample signs of this in the US economy and markets. Every day US corporations now report earnings disappointments. Owing to a strong dollar, they suffer profit margin pressures. Owing to a strong dollar, they suffer eroding domestic and foreign sales. In the present instance the outflow of short term capital from the emerging world into the US has created financial and economic crises in these economies which further weaken global markets for US industries. Overall, the strength in the dollar exchange rate is now so great that US corporate profit performance is deteriorating and is falling short of expectations. As a result, the US stock market has been floundering, with weakness focused on corporations exposed to the adverse direct and indirect consequences of the dollar's strength. Now, finally, a key relative price, the US dollar exchange rate, may have moved so far from its long run equilibrium that the relative price effect on US profits may pose a greater risk to the US stock market than the possible withdrawal of the flows of short term international speculative capital to which it may have grown addicted.

A Rubin-In-A-Box?

What might Mr. Rubin do if mounting earnings disappointments threaten the US stock market with its unprecedented valuations? Like other Treasury secretaries before him, he could move toward coordinated intervention against the dollar and try to "manage expectations" by "talking down the dollar". The recent intervention on behalf of the yen was no doubt encouraged by investors' adverse reactions to earnings disappointments arising out of a too strong dollar and to pressures from US corporate interests that were adversely affected; in effect, prospects of a lower dollar were seen as a positive for the US stock market. But, alas, if dollar weakness goes too far, it might encourage the cumulative speculative capital flows of the last several years to turn tail and run. By his own words, such dollar weakness could "drive investors out of American stocks, bonds and treasury debt."

Perhaps the penchant to purchase stocks by US households is so great that even earnings disappointments will not undermine the US stock market.

(Note: We take this option very seriously. The US stock market is now driven by "bubble dynamics". Long run prospective returns no longer govern the formation of investor expectations of future returns to stocks. Rather , investor expectations formation has become almost completely backward looking or "adaptive": it is the past rate of stock price appreciation that determines expected future returns. We have witnessed a one time move in stock valuations from historical lows in 1980-1982 amid adverse economic conditions to record valuations amid unusually benign economic conditions. This one-time rise in valuation has created a rate of appreciation in stock prices that vastly exceeds trend. Investors with adaptive expectations of stock price performance assume past 1982-1998 returns will go on forever. Surveys show that 80% of US households expect 14% or higher returns to stocks forever. In fact, at today's lofty stock valuations, trend returns must approximate the growth in nominal GDP ( 4.5% ) plus the dividend yield for an overall trend return of only 6%. Today's stock valuations reflect unrealistic expected returns which in the end will not be validated. Eventually, when disappointed, expected returns will erode, which will reduce warranted valuations and the demands for stocks. Then the positive feedback loop of bubble dynamics will go into reverse, drawing stock prices to and below their long run equilibrium. But, near term, past positive stock price performance may still drive investor demands for US stocks, resulting in a firm stock market despite earnings disappointments.)

Perhaps we are wrong that the US stock market is 50% to 100% more overvalued than it has been at prior historical peaks and that it exhibits classic bubble dynamics and therefore is especially vulnerable. Then, Mr. Rubin faces no risks; neither disappointing earnings nor a withdrawal of short term capital will threaten today's lofty stock market. But if it is vulnerable, then Mr. Rubin may be caught in a dilemma. He will have encouraged an addiction to short term global speculative capital that has gone on for too long and that has gone too far. In the end, relative prices will matter. Too rich an exchange rate will erode profits. Too rich a stock market valuation will create unusual market vulnerability. Too high an exchange rate will create current account deficits that may more than offset short term capital inflows, which will in turn risk a sustained retracement of the dollar and a massive withdrawal of short term speculative international capital. There may be no way out. A sustained high exchange rate may lower earnings relative to unrealistic expectations and imperil stocks. A move to lower the exchange rate may pull the support of large cumulative speculative global capital flows. Mr. Rubin's sustained courting of short run global speculative capital at the expense of almost all else may place him in a box: a sustained high exchange rate may hurt too much and for too long, eroding the current account, profits, and ultimately stock prices, and a declining exchange rate may cause withdrawal of critical mobile global capital flows, which in turn may also undermine stock prices.

Due primarily to the California Gold Rush, San Francisco’s population exploded from 1,000 to 100,000 in only two years.