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ANOTHER ERA OF POSITIVE SHOCKS: NOT IN OUR LIFE TIME
Share / Recommend - Comment - Print - Saturday, Nov 27 2004, 2:53PM
In January 1998, Federal Reserve Board Deputy Governor Laurence Meyer gave a talk at the Economic Strategy Institute titled "The Economic Outlook and Challenges Facing Monetary Policy."
Commenting on the what some then called America's 'miracle economy,' Meyer said that the country's phenomenal economic strength over the last decade had been the result of "an era of positive shocks." He presciently warned that it was beyond the bounds of reason to expect a never ending spiral of positive circumstances and that negative events were probably on their way.
Today, with an unraveling dollar and other nations' central banks flirting with a reshuffle of their dollar-denominated holdings, America may be soon feeling the economic pain resulting from irresponsible economic policy management and the "dependence" part of global financial interdependence.
Stephen Roach in the New York Times welcomes the decline of the dollar as something that will discipline American overconsumption and compel other nations to loosen their labor markets and take measures to spur their own domestic demand. He may be right, but I see the declining dollar as more the manifestation of the absence of strategy and policy than the result of one.
If he sees the dollar's decline as a welcome shock that will compel better economic housekeeping in Washington, I'm not sure I feel the same sense of relief. Rather, I have the instinct that the plummeting dollar, China's positioning that it may be less interested in purchasing treasury bonds, and general global disdain for American foreign policy and President Bush are converging, gathering speed, and becoming economic forces beyond control.
Alan Greenspan's comments about the dollar recently are several years too late and appear to be more political, cover-his-ass moves than prognostications regarding wise policy.
I hope that Roach is right and that the decline in the dollar will order our accounts in such a way that there is not a destabilizing financial quake along some of the world's most seriously imbalanced economic fault lines. I fear, however, that this normal economic pessimist is far too optimistic.
Even if his scenario takes its best course, many in America and abroad will lose jobs and feel more poor tomorrow than they do today. To some degree, standards of living will fall as the dollar is less able to pay for the lifestyles Americans enjoy.
Major currency tsunamis may hit some developing economies, particularly in Southeast Asia, as American purchasing capacity dries up, and financial positions held by hedge funds and other global investors may rapidly unwind as the unexpected scenario of the collapse of American demand becomes a real nightmare.
And what is really scary is that this could all get much worse than even imagined.
-- Steve Clemons
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I too believe that we are heading for disaster. I give Congress and the President only next year to work out any solutions but the people in charge have no "mandate" to do this.
I notice that China and Japan are trying to keep their currencies level with the dollar which is causing problems with the EU. I wonder if the EU will try to force the EURO down in the short run before everything explodes.
Here is an interesting piece about this very subject by W Joseph Stroupe, editor in chief of Global Events Magazine.
Oops, html slip up somehow. Looking at the source code for the page seems to indicate that the html I wrote was not included. Is it disabled now? Anyhow, good piece along similar lines.
Choose your own Roach.
Version 1.0 - Mr. "economic armageddon:"
http://www.moneycontrol.com/msgboard/viewfullmsg.php?topicid=159995&usr_msgid=661830
Version 2.0 - Mr. "maybe-a-dollar-devulation-won't-be-so-bad-after-all:"
Steve, which SE Asian countries in particular do you think will be hard hit? Thailand? Indonesia? Vietnam? Or do you think all of them, except for maybe Singapore, are in for trouble?
And then there are all those dadburn derivatves to consider...
What I would be most interested in is to the hit the average family would take in the various earning brackets.
Also, things like investing my family has no idea how to do but wants to, or buying Gold or Euros.
The real (negative) shocks may as some economists have suggested still be a few years down the line, but I don't think many of these analyses properly factor in what may well the initial catalyst, which is to say another massive terrorist attack on American soil.
In which case the person who called it was everyone's favourite Cassandra and 'far left' columnist one
Paul Krugman
famous chronicler and analyst of Latin American and Asian currency crashes. Who warned of this (like about everything else that the GWB Administration has gotten up to) about 2 years of anyone else, but is endlessly discounted as 'bitter' and 'partisan'.
See Unofficial Paul Krugman website for a complete archive of his warnings. No one likes a seer and a prophet is never honoured in his own time.
The problem is as long as the Asian countries hold their currencies down against the dollar, they suffer domestic asset price inflation (unsterilised holdings of currency with nowhere to go but domestic asset markets) and the dollar has to move further against the remaining the free floating currencies (the Euro).
The net outcome of all this may be to break the Euro. The Central Banks of each nation still exist: it can be done. There is precedent: the demise of the Franco-Belgian Gold Bloc in the early 30s.
We are once again in the era of competitive currency devaluations (see Paul Krugman 'The Age of Depression Era Economics' and also CHarles Kindleberger 'The Great Depression').
The Euro may wind up taking the pain.
The net effect of a plunging dollar is probably inflationary, at least until world bond markets take fright. James Carvill 'I want to be reborn as a government bond trader'.
Much of the world right now is reminiscent of the lead up to the early 1930s.
PS for investors the best way to play this is a global equity or bond mutual fund that does not hedge currency back into US dollars.
I think American Century has a European bond fund. Vanguard has various global equity funds (check the currency policy under 'Risks' in the prospectus). Causeway has a global equity fund and this is some very clever people (ex Merrill Lynch). Also Dodge and Cox whose international fund is still open (I believe).
On Gold, I don't know the US funds. There is a closed end fund on London SE: Merrill Lynch world mining fund, but it is only about 30% Gold stocks, last time I checked.
I would invest in gold mining companies (diversified portfolio) than gold directly. The costs of buying and holding gold tend to be prohibitive for the small investor.
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PPS the asset classes to avoid in all of this are long US treasuries (more than 5 years to maturity) and Japanese government bonds (a bubble waiting to bust, they only yield 1.5%).
US TIPS or I Bonds are probably the safest place to be in a dollar collapse scenario. No credit risk, and purchasing power protected against inflation. If interest rates shoot up, there will be a hit, but the protection is much greater than with a straight bond.
If you look for bubble markets out there, the Anglo-Saxon property markets are the ones to watch. Residential clearly but increasingly commercial (record low yields). In Canada they have something called an Income Trust, which largely look like disasters waiting to happen (with the exception of some very conservative ones).
Which countries outside the United States will most likely bear the brunt of a major contraction of the U.S. economy?
“Major currency tsunamis may hit some developing economies”, writes Steve, “particularly in Southeast Asia”.
This was certainly true the last time around. Southeast Asian governments had an incestuous relationship with their financial institutions that created intense “moral hazard” (the risk that one party to a contract can change their behavior to the detriment of the other party once the contract has been concluded). In the aftermath of the Asian financial crisis, considerable financial reform has abated, albeit not eliminated, much of that moral hazard. So I am going to differ with Steve in guessing where the gloval impacts of American recession might be most severe.
In thinking about the potential international impacts of a major American economic recession is may be useful to look back to some of the international impacts of the Depression of 1929. The contrasting cases of Japan and Germany are instructive.
The Japanese economy and Japanese financial institutions in the late 1920’s and early 1930’s were tightly managed by a conservative Finance Ministry. Japan had very modest debt exposure to the global economy. As a result, the Gaimusho (MinFin) was able to respond rapidly and robustly to the global economic contraction with a steep devaluation of the Yen, ensuring Japan’s trading competetiveness in a contracting world market. Overall, Japan weather the Depression period better than any other major industrial economy.
The German economy, by contrast, was saddled with enormous foreign currency debt. Some it it the result of WWI reparations and some of it the result of external financing of industrial expansion. The German finance ministry could not afford to aggressively devalue because to do so would have run up the cost of debt-servicing to an unsustainable level. Germany was, in consequence, among the world economies most devastated by the global depression.
Using the Japanese and German examples as heuristics for predicting where the worst international impacts of an American recession might fall, I would suggest that it may not be in Southeast Asia. The combination of financial reforms and reduced external indebtedness in this region should give it some insulation from the worst of the spillover from contraction in the US economy. Latin America, where the overhang of external FX debt is enormous and where financial reforms are far less will probably be the hardest hit.
Following Latin American economies would likely be the economies of South Asia (especially Pakistan) and the non-oil Middle East.
The strategic implications for American national interests of simultaneous desabilization in parts of South Asia, the Middle East and Latin America could be non-trivial.
John Stuart
Strange if billions of enthusiastic humans who are ready, willing and able to work are kept idle or are wrenched from their communities because people were playing games with the financial currencies involved.
Separate currencies seem like tectonic plates. If they aren't allowed to adjust continuously, slipping smoothly past one another, we wind up with these dang devastating quakes.
I've seen, but don't have at my fingertips, some other blogs speculating that an Argentina-style economic crisis could plausably hit the US.
The rabbis at my parents' congregation are both from South America and the synagogue did some fundraising to send relief to people in Argentina when it happened. Most Americans are not aware of how bad it was, and it's a little scary to think of the potential consequences.
I'd love to try to take some preperatory steps but really have no clue where or how to begin. And what little I see on the subject tends to look like a thinly-veiled sales pitch for highly questionable investment schemes.
Fiat Lux
The key is diversification of holdings. I have some ideas further up.
You could plausibly put up to 40% of your assets in non-US dollar funds using mutual funds which do not hedge foreign currency exposure (key). European bonds are perhaps the safest asset in a dollar collapse scenario. It may be possible to hold foreign currency money market funds as well or FDIC guaranteed deposits in foreign currencies at US banks (stay within the FDIC limit).
There are exchange traded funds which track overseas stock markets: not sure how they handle currency exposure.
Gold stocks have a place as well-- I would say 5% of a portfolio through 2-3 mutual funds which invests in gold producing companies. I am not a big gold bug per se but gold does well when the dollar is weakening.
For your US assets, you could hold a big weighting of I Bonds and US inflation linked securities (the latter in tax deferred accounts primarily as the increase in face value is taxable even though you haven't been 'paid' any of that money until maturity).
Lastly some big US companies like Exxon-Amoco have huge overseas exposure, when the dollar falls they make more money from their non-US dollar production.
The big thing is in any US dollar crash scenario, interest rates will go up which will hit long maturity bonds, and any variable interest rate debt you may have--- those debts are the thing you have to worry about most (ARMs, credit cards etc.). Higher interest rates will hit the housing and commercial property markets.
These are just some ideas. I suggest surfing the Vanguard Website and Bill Gross's writings at Pimco (largest bond fund in the world). Also warren Buffet's recent writings on the dollar in Fortune and his latest annual reports at Berkshire Hathaway (see their website).
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Fiat Lux
Didn't mean to be preachy in the above.
Pimco, Vanguard are definitely places you should be looking for foreign currency exposure in your investments. They are both quality operations with long histories of serving investors well (I tend to favour passive/ indexed funds, but there are some low cost, good performing active fund families like Pimco in bonds). I understand American Century has a good overseas bond fund as well. Dodge and Cox is another fund family that has a good long term record of providing low cost fund management to investors.
Most of all you should be looking to fix the interest rates of your debts in the US: the US borrows in its own currency (ie unlike Argentina) so the big risk in a dollar collapse is interest rates going up. All of Paul Krugman's popular books are worth reading in particular the one about the 1998 Asian currency crisis (?' Return of Depression Era Economics?' I think is the title).
I don't have any financial affiliation to the above mutual fund families. I wish we in the UK had access to quality operators like Vanguard, as personal investors.
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