Memo To: SSU Students, website fans, browsers and clients
From: Jude Wanniski
Re: The Keynesian Case for devaluation
[Today's SSU Lesson is also being posted as a "Memo on the Margin."]
The hot topic in global financial centers is the steady decline in the value of the U.S. dollar, which has fallen to a record low against the euro and is not far from reaching record lows against the Japanese yen. For today’s supply-side lesson, I’ve decided to examine the arguments of a well-known Keynesian demand-side economist, Stephen S. Roach of Morgan Stanley, as they appeared on the op-ed page of today’s New York Times. His op-ed is titled, “When Weakness is a Strength.” My comments are in boldface:
By Stephen S. Roach
Suddenly all eyes are on a weakening dollar. In recent days, the American currency has fallen against the euro, the yen and most other currencies around the world. The renminbi is a notable exception; China has kept its currency firmly pegged to the dollar for a decade.
I would say the dollar has fallen against gold, which traded as low as $380 oz earlier this year and now trades above $450 oz. Because other countries manage their currencies differently than the Federal Reserve, the price of gold in their currencies has not declined over this period. So we see the relative changes in the value of paper currencies and it is clear the dollar is weakening in purchasing power relative to the other currencies… except, of course, the Chinese renminbi (and the Hong Kong dollar, which is also pegged to the dollar and/or the renminbi).
The fall of the dollar is not a surprise. It is the logical outgrowth of an unbalanced world economy, and America's gaping current account deficit - the difference between foreign trade and investment in the United States and American trade and investment abroad - is just the most visible manifestation of these imbalances. The deficit ran at a record annual rate of $665 billion, or 5.7 percent of gross domestic product, in the second quarter of 2004.
Roach simply asserts the dollar’s fall is not a surprise and also asserts that its weakness is the result of the U.S. trade deficit with the rest of the world (ROW). There is, though, no correlation between a country’s trade account and the relative strength of its currency. For the entire 19th century up to World War I, the U.S. ran a trade deficit with the ROW in almost every single year and yet the US dollar/gold price was constant at $20.67 oz – except for the Civil War period when the government “floated” the dollar. When the U.S. left gold in 1971, one reason was the theory that the Japanese yen was undervalued at 360 to the $, and that a devaluation of the dollar relative to the yen would cause the U.S. trade deficit to be brought back into balance while Japan’s trade surplus would decline. The experience has been the opposite. The yen has appreciated ever since to 102 to the $ and its trade surplus is higher than ever.
While a decline in the dollar is not a cure-all for what ails the world, it should go a long way toward bringing about a sorely needed rebalancing. With a weaker dollar, economic and even political tensions among nations would be relieved, helping to promote more sustainable growth in the global economy.
A dollar that is losing its value against gold is “inflating,” causing damage to the U.S. economy in several ways that cannot possibly be of benefit to the global economy. Because it takes months and years for the general price level to catch up with the dollar/gold price, if gold remains where it is now the inflation will be so palpable in six months that the work force will be demanding higher wages, the effective capital gains tax will rise – discouraging new capital investment, and long-term interest rates will rise – forcing the Treasury to finance new debt and refinance the existing $7.5 trillion national debt at greater cost in debt service.
Still, a debate persists as to the wisdom of allowing the dollar to decline. The Bush administration seems to have given its tacit assent, and Alan Greenspan, chairman of the Federal Reserve, is finally on board.
This seems to be the case, with Greenspan now saying the trade deficit is the root cause of the problem. I have been saying that Greenspan’s policy of raising interest rates to cure a prospective inflation has had the opposite effect, causing a decline in the demand for dollars relative to the Fed’s increasing supply of dollars. Instead of acknowledging the error on his part, Greenspan finds it easier to blame trade flows for the inflation when earlier this year he correctly dismissed the trade imbalance as a reason for concern.
But outside the United States, where policymakers have long been vocal in their displeasure over America's deficits, officials are now objecting to America's cure. Europeans have referred to the dollar's recent decline as brutal. The Japanese have threatened to intervene again in foreign exchange markets. And Chinese officials have argued that global imbalances are "made in America."
Before all prices and wages in the U.S. adjust to the higher gold price, there will be painful, “brutal” losses to foreign exporters and domestic importers and temporary gains to domestic exporters and foreign importers. There are only net losses to the world economy, though, and no net change to the trade accounts. Roach’s theory, the same that persuaded Nixon in 1971 to leave gold, is that a cheaper dollar will cause foreigners to buy more U.S. goods and Americans to buy fewer foreign goods. The very idea is perverse, that we can somehow “solve” a domestic problem by changing the terms of trade to favor the ROW. In other words, if it takes 5 bottles of U.S. wine to trade for 10 loaves of Japanese bread, we will somehow be better off if we persuade our trading partner to take 7 bottles and only send us 8 loaves. What a deal!!
In this blame game, it's always the other guy. Yet global imbalances are a shared responsibility. America is guilty of excess consumption, whereas the rest of the world suffers from insufficient consumption. Consumer demand in the United States grew at an average of 3.9 percent (in real terms) from 1995 to 2003, nearly double the 2.2 percent average elsewhere in the industrial world.
America is guilty of excess consumption? This is what is being taught demand-side economists like Roach in American universities. The reason the U.S. has been consuming more than the rest of the world since 1995 is largely due to the supply-side tax policies enacted in that period, atop the Reagan tax cuts of the 1980s. The U.S. now has the most favorable tax structure of the major economies regarding capital formation, which means the ROW has been eager to send us more of their goods than they buy from us so they can use the difference to buy our financial assets, stocks and bonds.
Meanwhile, Americans fail to save enough - whereas the rest of the world saves too much. American consumers have borrowed against the future by squandering their savings. The personal savings rate was just 0.2 percent of disposable personal income in September - down from 7.7 percent as recently as 1992. Moreover, large federal budget deficits mean the government's savings rate is negative.
Roach fails to point out that the supply-side revolution has brought with it an enormous increase in the value of financial assets and real property held by American households. This means the real value of past savings has soared, obviating the need to save more out of current income. Such capital gains are not counted in the “savings” statistics, but it should be obvious that if I need XXX to meet current obligations and have XXX in after-tax income, I can spend it all and save nothing if the value of my stock portfolio and home has risen by XX. In the last dozen years, the aggregate wealth of U.S. households has risen by tens of trillions of dollars, but has not been counted in the savings rate.
Lacking in domestic savings, the United States must import foreign savings to finance the growth of its economy. And it runs huge current account and trade deficits to attract such capital from overseas.
The U.S. must import foreign savings to finance the growth of its economy??? It is more accurate to say the ROW is eager to accept U.S. financial assets because they are throwing off higher rates of return than assets they find at home.
America's consumption binge has its mirror image in excess savings elsewhere in the world - especially in Asia and Europe. For now, America draws freely on this reservoir, absorbing about 80 percent of the world's surplus savings. Just as the United States has moved production and labor offshore in recent years, it is now outsourcing its savings.
This is more nonsense flowing from the same failure to count capital gains as part of “savings,” here or in the ROW. By Roach’s reckoning, the total saving of the ROW would be roughly $800 billion, of which we grab $655 billion. Just add in the total increase in wealth in China, India and Russia in the past year and you can see ordinary savings plus capital gains in financial assets plus real estate easily eclipsed $5 trillion just in those three countries. They can’t spend it fast enough at home, so they invest it in the biggest open market in the world, the USA’s.
This is a dangerous arrangement. The day could come when foreign investors demand better terms for financing America's spending spree (and savings shortfall). That is the day the dollar will collapse, interest rates will soar and the stock market will plunge. In such a crisis, a United States recession would be a near certainty. And the rest of an America-centric world would be quick to follow.
The bogeyman will get you!! Foreign investors will demand better terms some day and if they don’t get them, ugly things will happen to us.
The only way to avoid this unhappy future is for the world's major central banks to carefully manage a gradual but significant depreciation of the dollar over the next several years. America, and the world, would gain in several ways.
In other words, Morgan Stanley’s chief economist, Stephen Roach, is telling the readers of today’s New York Times that if the U.S. has a “significant depreciation of the dollar,” i.e., a significant inflation, foreigners will be more eager to buy U.S. stocks and bonds.
First, there would be a gradual rise in interest rates in the United States - compensating foreign investors for financing the biggest debtor in the world. That would suppress growth in those sectors of the American economy that are most sensitive to interest rates, like housing, consumer durables like cars and appliances, and business capital spending. The result: a higher domestic savings rate and a reduced need for foreign capital - a classic current-account adjustment.
This is absolutely correct!! Roach at least understands that if we follow his advice, the U.S. economy will implode. People will become relatively poorer and will not be able to buy cars or appliances (or homes) or capital goods. Scared to death and seeing the value of their wealth nosedive, they will tighten their belts and save more of their current income. This is “a classic current-account adjustment” in a demand model, what they are teaching these days at Harvard, Yale and M.I.T. The cure for prosperity is poverty!!!
Second, when the dollar falls, other currencies rise. So far, the euro has borne a disproportionate share of the change. That puts increased pressure on Asian nations - including China - to share in the adjustment by allowing their currencies to strengthen. Most currencies in Asia are now rising, but the renminbi has remained conspicuously unmoved.
This is not true relative to gold. If the dollar falls against gold and other currencies, other currencies that are stable relative to gold are not rising at all. They are not inflating and we are. Roach is correct in again noting China’s link to the dollar. If I were China and saw what the demand-siders and Alan Greenspan have in mind, I would most certainly break the dollar/renminbi link and link the renminbi to gold or even to the euro.
Third, as the currencies of Asia and Europe strengthen, their exports will become less attractive to American consumers. This will force Asia and Europe to work to stimulate domestic demand to compensate - resulting in a reduction of both excess savings and current-account surpluses. This is easier said than done, especially since it may require painful structural reforms, like a loosening of domestic labor markets, to unshackle internal demand.
Just a few paragraphs after telling us how great a dollar devaluation will be for the rest of the world, Roach tells of necessary painful structural changes “easier said than is done” in Asian and European labor markets.
Fourth, a weaker dollar might defuse global trade tensions. Dollar depreciation will support American exports, and higher interest rates should slow domestic demand and reduce imports. That means the United States trade deficit should narrow - tempering protectionist risks. And with Asian countries allowing their currencies to fluctuate, Europe gets some relief and may be less tempted to resort to protectionist remedies.
This is the Rosy Scenario that was presented to President Nixon in 1971 when he took the U.S. off the Bretton Woods gold standard. He said: “We are all Keynesians now!” Inflation took off, the stock market collapsed, and with no reason to support him, the American people applauded as he was impeached and resigned in disgrace over a third-rate Watergate burglary.
What's certain is that a lopsided world needs to be put back into balance. The dollar is the world's most widely used currency, but its fall affects more than just foreign-exchange rates. A weakening dollar is an encouraging sign that the world's relative price structure - essentially the value of one economy versus another - is becoming more sensible. If the world can manage the dollar's decline wisely, there is more reason for hope than despair.
Sorry Mr. Roach. When it comes to money, weakness is weakness. The correct antidote to the falling, inflating dollar is an open admission by Alan Greenspan that he has been riding a sick moose in the wrong direction, and that we need only forget about raising interest rates and refix the dollar to gold at a reasonable rate. How about $400 oz? Between you and me, Morgan Stanley, Greenspan would love to see gold back at $400. If he said so publicly, the market would take it there lickety-split, and just stand back and watch the dollar muscle its way back into the hearts of euro and yen traders. In strength, there is strength.