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You Can't Have It Both Ways   (August 30, 2006)


A great conundrum now faces the Federal Reserve. Should they continue to raise interest rates to quell inflation and support the dollar, or should they begin to drop rates to counter the slowing U.S. economy? There are good reasons to want both-- a low-inflation, strong-dollar economy and an easy-money economy where virtually anyone with a job can borrow lots of money cheaply.

Ah, but you can't have it both ways. Either way the Fed goes, they will get the same result--recession. Wait a minute--how is that possible? Read on.

Just for laughs, let's say the Fed is under tremendous political pressure to keep this debt-based, housing-based, asset-bubble-based "prosperity" running at least through 2008. (As to why this might be so, I'll let you fill in the blanks: to stay in power you must win elections. To win elections, you must fatten the wallets of voters and provide them with a happy story about the golden future just ahead.)

The Fed has only one hope to accomplish this--begin dropping rates from 6% back down to 3% or less. We all know a quarter point here and there is meaningless; to re-inflate the housing bubble and re-ignite consumer borrowing, the Fed has to pump heavy steroids into the economy--massive liquidity, easy borrowing standards, and low rates.

But hey, don't they already provide the first two? Yes, they do. And if that's not working, then the only stimulant left is much lower rates. But will there be any consequences to lowering rates? Maybe this time there will be. Our exporting trading partners, Japan, Europe, China and the OPEC oil producers, have willingly (or unwillingly, who knows) entered into a devil's pact with us akin to the pusher and the drug addict. They buy our bonds (that is, our IOUs or debt) to keep the dollar afloat and their currencies weak, and in exchange we buy about $1 trillion more of their exports than we can afford (the trade deficit). They sell all this stuff to us to support their economies, and to enable all that borrowing, they pump their profits back into the dollar and bonds.

We're both addicts, actually, and both pushers: they need our market to keep going, and we need their cash/savings to keep our debt/borrowing/spending raft afloat. But observers such as Warren Buffett have long feared that this imbalance will come to a bad end, and that the dollar will at some point suffer a serious devaluation.

What could trigger such a devaluation? An abandonment of the dollar by foreign investors who suddenly realize even their massive buying can no longer keep the dollar high. Or perhaps Venezuela, Iran and Russia announce that they're pricing their oil in euros. The final straw is unknown, but the risks, at least to people like Buffett, appear to be growing. (Correspondent Wayne D. has posted Buffett's comments on his board, Warren Buffett on the dollar.)

For more of Buffett's views, go to the Berkshire Hathaway annual report and scroll to pages 18-25
But as I argued in a November 10, 2003 article in Fortune, (available at berkshirehathaway.com), our country’s trade practices are weighing down the dollar. The decline in its value has already been substantial, but is nevertheless likely to continue. Without policy changes, currency markets could even become disorderly and generate spillover effects, both political and financial. No one knows whether these problems will materialize. But such a scenario is a far-from-remote possibility that policymakers should be considering now. Their bent, however, is to lean toward not-so-benign neglect: A 318-page Congressional study of the consequences of unremitting trade deficits was published in November 2000 and has been gathering dust ever since. The study was ordered after the deficit hit a then-alarming $263 billion in 1999; by last year it had risen to $618 billion. (note: it has since risen to over $800 billion.)
Some observers believe the dollar is fundamentally more valuable than competing currencies (for instance, Mish), but there are technical analysis reasons to suspect the dollar could drop from 83 on the DX index (click here to see the chart) all the way down to 52--a 37% devaluation.

Were this to occur, what would happen? To start with, imports from everywhere but China would rise by that 37%, and our exports would get a 37% discount. There are all sorts of consequences of such a massive currency adjustment, consequences which interact in unpredictable ways.

For instance, since we import so much, then a big jump in import prices would feed inflation: we're paying more for the same goods. Except from China, of course, which pegs the yuan at 8 to the dollar. A dollar devaluation would be a boon to China, as it would discount their goods in Europe and Asia while leaving exports to the U.S. untouched. In that sense, a dollar devaluation would be favorable to China, and not something they would fear. Perhaps they would even welcome it as a support to their exports and a "tax" on imports from Japan and Europe.

Meanwhile, the oil exporters would suffer a 37% haircut--a haircut they are unlikely to enjoy. Since oil is priced in dollars, they would get 37% less for their oil--unless, of course, they spent that money in the U.S. Then their purchasing power would remain the same.

One could easily make the case that the U.S. would welcome such a move, as it would bolster our sales to the oil-exporting nations. Japan and Europe would welcome such a devaluation as well, as it would immediately drop the cost of oil in their currencies by 37%--a very hefty discount. Again, the devaluation would be neutral to China, as long as its currency remained pegged to the dollar.

But in another way, Japan and Europe would certainly not welcome such a devaluation, as it would impose an instant 37% "tax" on their exports to the U.S. Which is more important--cheaper oil or exports to the U.S.? That is yet another sticky wicket.

If, however, the oil exporters are unhappy with their haircut, they could decide to price oil in a basket of currencies rather than the dollar--a move which would instantly raise the cost of oil to the U.S. That move alone could trigger a recession in the U.S., even if the 37% increase in the cost of imported goods failed to do so.

The consequences of a dollar devaluation are uncertain, as they are negative for some global players and positive for others. Such a dislocation carries high risks for the U.S. and the global economy.

One way to avoid this mess would be to support the dollar with higher interest rates. But if the Fed raises rates, it will likely tip the U.S. economy into recession. Ah, but you can't have it both ways.


For more on this subject and a wide array of other topics, please visit my weblog.

                                                           


copyright © 2006 Charles Hugh Smith. All rights reserved in all media.

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