Thursday, November 18, 2004

Why is the Dollar declining?

Daily Duck regular Michael Herdegen clued me into this article by Donald Luskin at

SHOULD YOU BE WORRIED ABOUT the U.S. dollar? Should you be worried that it's trading at all-time lows vs. the euro, and at more than nine-year lows vs. a trade-weighted basket of foreign currencies?

Yes — you should be worried. The falling dollar is the one dark cloud on the market horizon right now, the one thing that has the power to threaten the post-election "Bush rally."

But the reason you should be worried about the dollar is very different from the scare stories you're hearing in the media. Let me explain. But to do so, I will
have to take the dangerous step of daring to disagree with a very popular and powerful market guru — Warren Buffett.

Buffett has announced to shareholders of his company Berkshire Hathaway (BRK.B) that he has taken a short position in the U.S. dollar. I'm not sure exactly how he implemented that trade, but at the moment, it's almost certainly in profit. That's great — my hat is off to him. The problem is, Buffett is making money on this trade by sheer luck, because his reasons for putting it on in the first place make no sense at all.

To oversimplify Buffett's reasoning a bit, he has shorted the dollar because he is worried about the impact of the U.S. trade deficit, which is now running at record levels in excess of $166 billion at a quarterly rate, as of the second quarter. As he wrote in an article for Fortune magazine, "our trade deficit has greatly worsened, to the point that our country's 'net worth,' so to speak, is now being transferred abroad at an alarming rate."

Luskin points out the real culprit:

Longtime readers of this column will know the answer to that. It all comes down to another financial guru who is just as dangerous to contradict as Warren Buffett — Fed chairman Alan Greenspan. Greenspan, like Buffett, is making a mistake about the dollar, and Greenspan's mistake is what's making the dollar fall. Greenspan's mistake is that he has kept interest rates too low for too long, and now inflation is beginning to creep back into the U.S. economy.

At last week's Fed meeting, Greenspan and his colleagues stated, "Inflation and longer-term inflation expectations remain well contained." They may be right about "expectations," but the reality of inflation is anything but "contained." Already this year, the "core" consumer price index, which excludes food and energy, has nearly doubled.

And don't let yourself think that the high price you are now paying for gasoline doesn't reflect inflation — it does. Measured in U.S. dollars, oil prices are near all-time highs. But measured in euros, oil prices are no higher today than they were three years ago. That's because the Fed has let the dollar weaken (so it buys less oil), while the European Central Bank has kept the euro strong (so it buys just as much oil as it used to).

And that's why the dollar is falling. It buys less than it used to — while the euro buys just as much. Therefore, by simple arithmetic, the dollar buys fewer euros than it used to. The falling dollar is a bad thing — but not because it means we are living in Squanderville. It's a bad thing because it means we are living in Inflationville.

So who do you believe? If neither Buffet or Luskin sund convincing, there are other theories. Larry Kudlow, on his weblog, argues that it is the fault of the Europeans (scroll down to the post titled "Money" from 11.10.04):

The Fed is right to follow market interest rates, especially its unregulated T-bill cousin. Would that the central market would decontrol its own overnight target rate; then market forces would run monetary policy rather than econometric models that abide by discredited trade-offs between inflation and unemployment. Also in the realm of market forces, the dollar lately has lost some additional value in terms of gold and foreign currencies. So there could be a small amount of excess money which needs to be absorbed by the government bank. When they raise their target to 2.25 percent next month it is quite possible that they will have removed the monetary excess. One important issue not mentioned in the Fed’s policy statement was the dollar. Everybody on Wall Street is talking about the falling dollar. They are obsessing about it. And most blame the lower greenback exchange rate on America’s widening trade gap. This is totally wrong. The main reason the dollar has slipped when measured against the euro is that European monetary policy and their creation of new euros is way too stingy; it is in fact still deflationary.
As for the trade deficit, the U.S. grows faster than its biggest customers. So we import more than we export. However, exports are rising at a 13 percent pace; a great sign of economic health. Imports are rising even more by 17 percent. We are selling goods and services to China at a 37 percent rate. But the volumes are too small to dent the trade gap. This will change over the next decade. Meanwhile, America’s profitable investment margins attract foreign private capital inflows from all around the world. Lately foreign inflows have come in around $600 billion, about the same as our $570 billion current account deficit for goods and services. In other words, there is no financing problem at all and no reason to tie the dollar to the trade accounts.However, it would be foolish if the U.S. Fed started targeting the euro for its monetary policy. If the Europeans are stupid enough to crash their economy, that’s their business. But whatever hedge fund traders may say, the U.S. must not make the same monetary mistake that would wreck our prosperous recovery. Domestic price stability should be the Fed’s strategic goal. As long as they follow interest rates and commodity movements, as Greenspan seems to be doing, then the U.S. will continue along a path of non-inflationary economic growth.

So you have 3 arguable "experts" on the economy giving 3 different explanations for the falling dollar. How does the average citizen, who is not an expert, decide who is right?

One of the challenges that I undertook with this blog is the question of how the average citizen, who is not an expert on such topics, should make decisions based on the multiple and contradictory positions taken by the "experts" in that field. We are all faced with that challenge, whether in economics, foreign & social policy, or science & technology.

One way to evaluate the experts is to look at their track records. From the trio cited above, Warren Buffett has by far the longest and most impressive track record. Buffett has been managing Berkshire Hathaway, a small insurance company turned investment portfolio, since 1965. He has turned many ordinary investors in his company into multi-millionaires, and his investments have far oustripped the major market indices through good times and bad.

Another way, and perhaps the best, is to reduce the topic to a question of basic principles. Economics, for all the mathematical complexity that is invested in some of its more advanced theories, is at its heart a simple set of relationships. When you hear justifications for policy based on a statement that deficits don't matter, a statement that contradicts a basic foundational principle of economic truth that any homeowner trying to balance her monthly household budget knows, then you know that you are being asked to look through the wool.

Deficits do matter, and that is why the dollar is heading south. For more deficit discussion, Matthew Yglesias has a good roundup from the blogosphere.


Blogger Hey Skipper said...


"Economics, for all the mathematical complexity that is invested in some of its more advanced theories, is at its heart a simple set of relationships."

Interesting you should say that. Sometime in the late '90s, The Economist ran an article on this subject, only taking a look at it from a slightly different angle.

One of the simple relationships is that until we start trading with an extraterrestial civilizartion, the summing inflows and outflows across all countries should, in theory, yield precisely zero.

It doesn't

In fact, at the time, the magnitude of the unexplained imbalance was nearly equal to, but opposite in sign from, the contemporary US trade imbalance.

While that was likely coincidence, the article noted that the trade figures were notoriously weak in measuring services, an economic sector at which the US is particularly strong.

Therefore, it is just possible the actual trade imbalance is less than the headline figure, possibly substantially so.

The more I read economic figures, the less confidence I have in any of them. In a similar sense to trade figures, the US savings rate is said to be abysmal. But said rate completely excludes assets in real estatem for instance.

So when I finish paying off my mortgage (none of which represents consumption, BTW, although somehow it is treated as such), I will somehow have managed to accrue $400,000 in assets. How did that happen?

November 21, 2004 1:01 PM  
Blogger Duck said...

The home is counted toward your net wealth, but it is not considered savings in the sense that it does not constitute a source of funds that banks can use to make loans. The savings that you relied on to make your mortgage had to come from someone's savings, although not totally, given that with fractional reserve banking that amount of savings is multiplied several times.

Americans, through governmental, personal or corporate borrowing are currently soaking up 3/4ths of the world's savings. We are not generating 3/4ths of the world's income, so it is an imbalance that cannot be sustained indefinitely.

November 21, 2004 4:23 PM  
Blogger Michael Herdegen said...

I agree with Larry Kudlow; almost all of the EU's economic growth is due to exporting to the US.

If they're having problems sustaining that growth against a weak dollar, the logical move is to reduce the strength of the Euro, not to complain that Americans aren't doing enough to subsidize European growth.

The US soak up 3/4 of the world's savings because many investors value stability above profits.
They're investing to avoid loss, not necessarily to build wealth.

International investors know that the American Stock Exchanges are the world's gold standard for accuracy and honesty, and that US accounting practices are among the world's most transparent.
They know that the US gov't isn't suddenly going to decide to confiscate foreign assets without criminal activity, nor is American society going to dissolve into widespread chaos and looting.

November 22, 2004 2:47 PM  
Blogger Hey Skipper said...


First, my mortgage payments are supported out of earnings, not savings. And by and large go to supporting ongoing lending.

My conclusion remains: statistics as collected completely fail to account for my growing net worth. Similarly, I have been taxed to death for unearned income over the years that doesn't count as savings when I reinvest instead of spending.

What do you think of the net global imbalance between in and out flows?

November 22, 2004 5:09 PM  
Blogger Duck said...

The advantages that you state about the American financial markets are true, but even they cannot support the imbalances that we are seeing forever. And they are not. Net private investment in America has turned the corner recently, it is turning negative. It is the central banks, primarily Japan and China, that have maintained the positive investment inflow to the dollar, and they do this to peg their currencies, not to see returns on their investment. Even they know that they can't keep it up forever, and they aren't. The dollar is falling.

Kudlow's answer is that Europe should just loosen their credit as much as we have. As we are soaking up over 3/4ths of the world's savings now, where would the additional savings come from to fuel Europe's borrowing binge? If everyone in the world borrows, who is left to lend? It is a ridiculous proposition - if everyone gets out of balance to the same degree, then we'll all be in balance?

November 25, 2004 11:51 AM  
Blogger Duck said...

Your financial budget assumes that you will continue to earn income over the life of the loan to pay it off, which isn't a bad thing to assume. But the underlying assumption that is not stated is that somewhere someone is putting away savings to make your mortgage possible. The aggregate situation balances out, and as long as the aggregate situation stays in balance for the future the assumption that you will sustain your income long enough to pay off your loan is good.

The problem is, the aggregate situation is out of whack. Borrowing has skyrocketed and savings has plummeted. When savings can no longer support this level of borrowing, rates will climb. Borrowing will drop. As consumption has been dependent on borrowing, consumption will drop. Those incomes that people have assumed would be there to pay off their mortgages will go away, as layoffs will follow in the wake of the drop in consumption. The basis of your net wealth will be undercut as housing prices decline. Don't count too highly on the value of your house as it is today, unless you plan on selling it today.

November 25, 2004 12:02 PM  
Blogger Michael Herdegen said...

The answer for Europe is to lower their interest rates, not necessarily to borrow more.

Also, they need to reform their retirement programmes...
Although I fully appreciate that they won't do so until after inflating their currencies.

November 27, 2004 3:07 AM  
Blogger Hey Skipper said...


My problem isn't with economic principles, nor do I have a panglossian notion that we can run deficits forever without repercussions.

I'm fine with your analysis, but I have serious questions about the underlying data.

Back in economics 101, I learned there are roughly two things you can do with money: spend it or save it, where spending was defined as making a demand on current production. Take my house for instance. It is 30 years old, which means that the cost of land (which may not even count), materials and labor has long since been covered. Therefore, not one cent of my mortgage payment--whether interest or principle--counts as spending, in terms of consuming goods and services.

This has a knock-on effect when discussing borrowing and savings. Roughly 3% of my income goes to house principle, pretty typical for the four year mark in a 30-yr mortgage. That doesn't count as savings, but if I put it into a passbook account, it would. Fifteen years down the road, that disconnect gets even worse, and at the last payment on the mortgage it becomes ludicrous.

Because your housing collapse scenario is dependent upon a savings-consumption disconnect, these statistical oddities bear some examination. My savings rate is either 0% (the amount I put into conventional bank accounts), 20% (the amount I don't spend in a month), 23% (the amount I don't spend plus house principle), 45% (that, plus the interest on my mortgage that doesn't go to current consumption), or up to 70%, depending upon how how much long & short-term capital gains I had the opportunity to reinvest in a given year.

Given the very high rate of home-ownership in the US, and the abject inability of headline savings numbers to account for even a dime of a huge store of personal wealth, I am extremely suspicious of any argument that relies upon said rate.

On the other side of the coin is skyrocketing borrowing. Is it? Compared to 10 years ago, my credit card debt has at least doubled. Clearly a sign of skyrocketing borrowing, right? Well, maybe not. My cash flow as a portion of income is unchanged, and the credit card performs precisely the same function my checkbook did 10 years ago--it balances at the end of each month--only more conveniently.

So I am faced with trade balance statistics that are notoriously weak in accounting for services, savings rate numbers that appear to defy common sense, and borrowing numbers that are scarcely any better.

I suggest before we start drawing any conclusions that we do a little statistical analysis.

November 28, 2004 6:13 AM  
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