Obamas Dollar Dilemma

Obama not so loved in Asia / American monetary policy angers the world

Last month, attending the annual Asian-Pacific Economic Cooperation summit, the U.S. reiterated its support for a strong dollar, but pacific rim trading partners remained skeptical, continuing their calls on Washington to stabilize its sliding currency. Ministers spent much of their time telling U.S. Treasury Secretary Timothy Geithner that they need the situation to change. Mr. Geithner responded by stating how the Obama administration understands a strong dollar is very important to both the U.S. and the global economic system in general. Geithner went on to acknowledge the role, and responsibility, the U.S. and its monetary policy has for being a source of stability and strength in the region. Despite his comments, and those earlier issued by Federal Reserve chairman Ben Bernanke and White House economic adviser Larry Summers, the dollar has sagged to a 15-month low against a basket of major currencies. Geithner, speaking in Tokyo before joining APEC finance ministers, said "it's very important for the economic health of the U.S., and confidence among investors around the world, that we maintain a strong dollar." This relentless, multi-month slide in the value of the U.S. dollar has garnered a lot of attention of late, particularly as some nations, such as China and Saudi Arabia, have diversified out of dollars in the past year and, more significantly (but not too secretly) have discussed replacing the dollar as the worlds currency reserve.

Federal Reserve officials sometimes sound as if their only worry is the domestic U.S. economy, but their gusher of dollars is starting to have serious consequences for the rest of the world. Nowhere is this more evident than in Asia, where President Obama got an earful from leaders about what all those greenbacks are doing to their economies. Many of these nations peg their currencies, formally or informally, to the greenback. So they are getting a huge dollar liquidity kick from the carry trade, in which people borrow U.S. dollars at exceptionally low U.S. interest rates and invest them for higher returns elsewhere. The source of the Asian anxiety is that the Fed is essentially running monetary policy not only for the U.S. dollar, but for all currencies that derive their value from the dollar.

Washington's claims to back a strong dollar are falling on increasingly skeptical ears as governments from around the world have stepped up efforts to stem the dollars slide. As officials grow increasingly concerned about the impact of the weak greenback on their emerging economic recoveries, many Asian central banks have repeatedly sold their currencies for dollars in an attempt to prop up the U.S. currency and bolster their export-reliant economies. Thailand, South Korea, Russia, and the Philippines have been buying up dollars in order to hold down the value of their own currencies. Thai Finance Minister Korn Chatikavanij said his country's central bank has bought about $15 billion this year and that the persistent weakness of the Chinese yuan will likely require further intervention by Asian central banks. "We're building up effectively a greater level of U.S. dollar reserves," Mr. Korn said. "I'm convinced that in the long term the dollar is more likely than not to decline in value, so we're building up assets that are declining in value over time. That's not healthy." He added, "There is not much you could do to correct what is reality. The fact is when you've got that much debt ... the only effective way of repaying that debt is basically devaluing your currency." In a nut shell, the Obama administration is socializing our budget, and our economy, to more closely resemble Europe, while pushing the economic hardship onto Asia. This makes him extremely popular in well-to-do European circles, and makes him a villain in poorer Asian countries.

The U.S. budget deficit in the first three months of the fiscal year 2009 was $485.2 billion, exceeding the previous full-year deficit of $455 billion and triple the fiscal 2007 deficit of $161 billion. Asia is telling Mr. Obama and the Fed to run a more cautious monetary policy that will lead to fewer economic distortions, run fewer financial risks, and thus increase the chances that the fragile global recovery will become a durable expansion. At a conference in Singapore, Hong Kong chief executive Donald Tsang (a former finance minister) said he's "scared" about loose U.S. monetary policy. "It's not where the money is going...it's where the problem's going to be ... Asia!," Mr. Tsang said. "You can see asset prices going up, not only in Korea, in Taiwan, in Singapore and in Hong Kong, going up to levels that are incompatible or inconsistent with the economic fundamentals." China's top banking regulator, Liu Mingkang, chimed in that the Fed's binge is the main cause of "massive speculation." The risk is more asset bubbles and misallocation of global capital.

That's the message President Obama heard in China. In response, the Obama Administration seems to be trotting out an updated version of Nixon administration Treasury Secretary John Connally's famous quip that the dollar may be "our currency," but it's "your problem." President Obama reinforced that message when he called for "balanced trade," which suggests a weaker greenback to spur U.S. exports. Gold, a popular hedge against the dollars decline, hit an all-time high in response.

There is the risk of a political backlash if countries conclude that the U.S. is deliberately squeezing their currency as a way to devalue away America's rising debt burden and increase its exports (in effect, attempting to steal demand from the rest of the world at the same time it tries to erase the debt owed to it) The Obama administrations mistake is to believe that any nation can devalue its way to prosperity. As other currencies rise in value and force productivity gains, the U.S. economy will become relatively less efficient. American living standards will decline, as those in Asia eventually rise. This is the real lesson of the Connally-Nixon devaluations of the 1970s and the inflation that followed.

"The U.S. has only limited ability to stop the dollar’s fall", World Bank President Robert Zoellick said, expressing concern along with several Asian leaders that global stimulus measures could be inflating asset bubbles. “Given the role of the dollar, frankly, there’s not a tremendous amount one can do other than try to run a good sound policy and restore the U.S. economy to growth,” Zoellick told a panel discussion on the sidelines of the Asia-Pacific Economic Cooperation forum annual summit. Zoellick said part of the dollar’s fall in recent months, as the world economy has edged back from the abyss, has been the “normal and acceptable” reversal of a flight to the safe haven of U.S. assets during the worst of the financial crisis. To boost the dollar, the Federal Reserve could raise U.S. interest rates, but “I’m not sure that would be the smartest thing to do at this point in the state of recovery.”



The Chinese solution


The sagging dollar, trading near 15-month lows, and the declining Chinese yuan, which is informally linked to the U.S. currency, had been a constant theme of last months APEC meetings. The finance ministers of the 21-member Asia-Pacific Economic Cooperation group, which includes the U.S., China and Japan, agreed that "market oriented flexible prices, including exchange rates and interest rates, that reflect underlying economic fundamentals" are important to achieving "sustainable global growth". APEC's call for currency flexibility, generally viewed as code for a rise in the yuan, comes as China's central bank made a rare change to the official language of its exchange-rate policy, giving a nod to concerns about the declining dollar and surging capital inflows.

The People's Bank of China said in a quarterly report that it will "improve the exchange rate mechanism in a proactive, controlled and gradual mannor, with reference to changes in international capital flows and the trends of major currencies" in its policy. It isn't clear how the new wording might change the bank's policy of ignoring market forces and essentially pegging the yuan to the sliding dollar, which hurts the export-reliant economies of many other Asian nations. Over the weekend, the International Monetary Fund said the yuan was "significantly undervalued."

China is coming under new pressure from Pacific Rim countries to let its currency rise, as concerns grow about the damage that weakness in both the yuan and dollar could inflict on Asian economies. As the region's main exporter, China has tried to keep its currency stable against the dollar. But it's facing a flood of hot money as investors bet that Beijing will revalue the yuan. China may eventually conclude it must revalue to avoid importing dollar inflation, but to do so too quickly would slow its own recovery.

China runs a huge trade surplus with the United States. Cheap labor is part of the explanation, but so too is a cheap currency. Over the past year, the dollar has lost 20% of its value against the Euro. And China has made periodic adjustments to match the dollar throughout it's decline. These methods keep China's economy growing, even during times of world-wide recession. It keeps Chinese workers employed at the expense of output and employment pretty much everywhere else.

China's undervalued currency gives us cheap products here at home in trade for lost American jobs. It also allows for huge job growth in China at the cost of an ever-growing cost of living. You see, to prevent its currency from rising against the downward dollar, China must print more and more money. In China's over-heated economy, more money in circulation means each unit of it's currency is worth less, shrinking savings and causing higher prices. Property prices in central Shanghai have bulged by 40 percent over the past year. Consumer price inflation rages at 15 percent or more.

The alternative is for China to do the rational thing: allow its currency to appreciate in a way that more correctly reflects market forces. This will slow their rate of inflation. The prices of imported goods, like grain to feed chickens and pigs, will drop and Chinese families will begin to experience an improved standard of living. Job growth will not be what it used to be, but the Chinese economy will be built on a more sound, and fair, foundation. And, more importantly, their economic growth will not be from cheating the world marketplace the jobs badly needed elsewhere.

The prices of cheap Chinese products here will rise. But it will be in trade for a more level playing field resulting in new American job growth from increased production and exports. Americans will have more jobs, but a higher cost of living. (the true cost of living we always should have had) Our personal finances will be stressed and stretched causing us to consume less, waste less, and save more. I know it may not sound like much of an improvement over our current situation, but more fair is more fair, and less cheating is still less cheating.

With China such a huge creditor of the United States, and lending more all the time, the United States has little leverage to force this change. Instead of the Obama administration essentially funding its failed economic stimulus plan -w- more Chinese purchased debt. The Obama administration would have been better off paying off the $800 billion in debt China already owns through debt monetization. From there they could have used the regained leverage to force the Chinese to adequately revalue the yuan, reducing the trade deficit and allowing the American workforce a more level playing field in which to compete. Sure, this too would have caused a devaluing of the dollar, and interest rates would have to be raised to counter inflation, but at least something good may have come from it.
American Jobs!



OIL BUBBLE?


The weakness in the U.S. dollar risks inflating a bubble in the oil market, which could threaten consumer spending and potentially derail the recovery and cause a double dip recession. The greenback's decline this year has been lauded as good for America as it benefits earnings, stimulates exports and helps rebalance the U.S. economy. But runaway oil prices could be the Achilles' heel to the thesis that sees only a benign impact of a weak dollar.

Today, many factors are the same as they were in the summer of 2008. There is a reason for fear of excessively high oil prices. Rising energy costs caused consumers to curtail spending in mid-2008, even before the financial crisis erupted, and another spike could kill demand again, especially with this economic rebound still a fragile one. In some respects, this is a repeat of last year when a weak dollar, along with low interest rates and growth in energy-intensive Asia, drove oil to record highs, contributing to the world wide recession. Oil prices plunged from over $147 a barrel in July 2008 to below $33 in December as the recession strangled spending. Expectations for a recovery helped oil rebound, but analysts say high inventory levels and weak global demand indicate the market may be driven more by speculation than fundamentals.

Commodities have been viewed as more of a high-yield trade. There's just too much liquidity flushing around both in the U.S. and global financial markets, fueling the speculative trades. Plus, a falling dollar in recent months has spurred investors to buy commodities as a hedge against the loss of value in other assets.

The dollar has dropped 15 percent against a basket of major currencies since highs set in March. Crude, meanwhile, has rebounded from lows around $30 a barrel early this year to top $80 in recent weeks. This year, when the dollar has been weak, oil has been strong; a weaker dollar supports oil because dollar-priced commodities become cheaper for buyers using other currencies. Some say the dollar could drop to $1.55 per euro by year end, while a decline near the record low of $1.6038 set in July 2008 cannot be ruled out. Roughly speaking, a 1 percent move in the dollar against a broad index generates about a 2 percent rise in the price of oil. $100 per barrel oil today, would have the same effect on the still-fragile global economy as $147 per barrel oil had last year. That's enough to cause severe economic stress given the current state of global recovery!




Interest rates steer the economy and the value of a dollar

(a little history)



The euro fell steadily versus the dollar in its first five years of its existence, beginning in January 1999. It did not get back to even until mid-November, 2003. At the low point for the euro you could have bought one for 84 cents. Now, it takes about $1.50. The 2001 recession coincided with the low point for the euro (or conversely, the strongest point for the dollar during this time period).

Higher interest rates cause the dollar to strengthen, but they also inevitably slow down the economy. On the other hand, lower interest rates are positive for the economy, but often not for the dollar.

The Federal Reserve began raising interest rates to slow down the internet technology bubble in 1999. When U.S. interest rates went up, the dollar rose versus the Euro.The very strong dollar and the 2001 recession went hand in hand because the Federal Reserve raised interest rates beginning in 1999, and that led to the recession.

When the economy fell into recession in 2001, the Fed began slashing interest rates and the Euro finally began strengthening versus the dollar. After the 2001 recession ended, our economy strengthened for years and the dollar fell, more or less continuously during that economic upturn.

The Fed began raising rates again in 2004 due to inflation concerns and the Euro stabilized versus the dollar until the Fed stopped raising rates in 2006.

At that point, the Euro began climbing and the process accelerated when U.S interest rates were cut significantly, beginning in 2007 as the economy began to weaken. At first, lower interest rates led to a weaker dollar, but then something strange happened. As the financial panic deepened last year, interest rates were cut further, but the dollar actually strengthened. The change came about because the financial panic caused investors to worry more about the return of their money rather than the return on their money.

As fears of a collapse of the financial system receded, the normal relationship between the dollar and short-term interest rates came back into play and the dollar began falling again versus the euro.

The big difficulty we face now is that the economy is weak, the dollar is weak, and the Fed needs to maintain low interest rates to help the economy begin to grow again. Essentially a strong dollar is less important than a strong economy. All politics, and policies, are local. If the neighborhoods on fire, you put your house out first. History tells us the value of the dollar wont start rising on a sustained basis until 12 months after the Fed begins to raise interest rates. And that will not happen until they start to see sustained economic recovery and/or inflation. It's a tough balancing act. Interest rates and economic stimulus are set at different ends of a see-saw. And the stable value of a dollar rests in the balance.
-The Conservative