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Dollar Devaluation Is a Dangerous Game

Posted by Larry Doyle on October 8, 2009 9:24 AM |

Can we ‘devalue’ our way back to our days of economic ‘wine and roses?’

Many debt-laden countries throughout economic history have chosen to implicitly or explicitly pursue a devaluation of their currency as a means of improving their economies. Are the ‘wizards in Washington’ taking this approach? Aside from a few perfunctory comments in defense of the greenback, Washington has been largely silent on the topic of the declining value of the dollar. Many believe Washington very much favors a weaker currency as a means of supporting our economy. I believe this of Washington, as well. Let’s navigate.

Going back to the G20 in London last Spring, the Obama administration has attempted to curry political favor with emerging economies, especially the BRIC nations, by ceding dollar sovereigncy as the preeminent international reserve currency in return for support of global economic stimulus programs. Why does Washington believe a weak currency serves our economic interests? A weak currency generates and supports the following:

1. Promotes inflation as imports decline. Washington would like some inflation, given the massive deflationary pressures presented by falling wages and declines in the value of commercial and residential real estate.

2. Promotes exports for corporations with a multi-national presence.

3. Supports labor by making it more attractive for companies to keep jobs here as opposed to opening factories or sending work overseas.

So, in light of our current economic crisis, why wouldn’t we want a substantially cheaper dollar to maximize these benefits?

Recall that economists always need to keep certain variables static in order to study the impact of a change in another variable or multiple variables. This approach, known as ‘ceteris paribus,’ is not quite as easy as some may think. Why? Variables are NEVER static, or ‘ceteris is NEVER paribus.’

While the above three developments very likely will occur in the face of a decline in the value of the dollar, there is another very critical factor that must be weighed. I tried to highlight this yesterday in writing, “U.S. Markets Play Follow the Leader.” I wrote:

My gut instinct tells me that overall pools of capital will be flowing away from the United States and, as such, people and private corporations will have to pay more to attract capital here in our country. I think those entities which focus the bulk of their economic activity here in the United States will be forced to pay higher rates to attract funding.

I witness a very similar sentiment in commentary written by a very highly regarded economist, David Malpass, in this morning’s Wall Street Journal. In The Weak-Dollar Threat to Prosperity, Malpass highlights that the policies promoted by Washington to devalue our currency primarily support Wall Street by creating a cheap funding vehicle, but will ultimately do very little for Main Street. Why? Capital flight from our country combined with ongoing asset sales by domestic owners to foreign entities. Malpass supports a number of my assertions. I want to specifically highlight Malpass’s point on capital flight. He writes:

On the surface, the weak dollar may not look so bad, especially for Wall Street. Gold, oil, the euro and equities are all rising as much as the dollar declines. They stay even in value terms and create lots of trading volume. And high unemployment keeps the Fed on hold, so anyone with extra dollars or the connections to borrow dollars wins by buying nondollar assets.

[malpass]

Investors have been playing this weak-dollar trade for years, diverting more and more dollars into commodities, foreign currencies and foreign stock markets. This is the Third-World way of asset allocation.

Corporations play this game for bigger stakes, borrowing billions in dollars to expand their foreign businesses. As the pound slid in the 1950s and ’60s and the British Empire crumbled, the corporations that prospered were the ones that borrowed pounds aggressively in order to expand abroad. Though British equities rose in pound terms, they generally underperformed gold and foreign equities. At the end of empire, the giant sucking sound was from British capital and jobs moving offshore as the pound sank.

Some weak-dollar advocates believe that American workers will eventually get cheap enough in foreign-currency terms to win manufacturing jobs back. In practice, however, capital outflows overwhelm the trade flows, causing more job losses than cheap real wages create. This was the lesson of the British malaise, the Carter malaise, the Mexican malaise of the 1990s, Yeltsin’s Russian malaise through 1999 and the rest. No countries have devalued their way into prosperity, while many—Hong Kong, China, Australia today—have used stable money to invite capital and jobs.

While those in a position to move capital and invest overseas may benefit from a weak dollar, in my opinion the nation as a whole will suffer. Why? Capital is the necessary ingredient to drive our economy. Capital is the yeast that makes the dough rise. Capital is the octane that drives the engine.

Ceteris is never paribus.

LD

  • http://InvestorRebellion.com Matt

    Excellent points Larry. The other downsides are that gas and food become more and more expensive (like we saw last year), and the combination of high (and rising) unemployment, along with high (and rising) food and gas prices, along with very tight consumer credit (note the consumer credit report yesterday) does NOT bode well for the economy at all.

    • Mark G.

      Increases in producer prices cause those producers to pass those increases on to consumers thus weakening demand further. This causes these producers to cut costs elsewhere, plant closings, lay offs, wage freezes which further dampens demand causing more plant closings, lay offs, etc. The drug of Fed liquidity, hot money inflows as an attempt to re-flate gives a great but brief high. Like all drugs, you come down harder from the high than the drug induced high provided you in the first place.

      • Larry Doyle

        Not a big proponent of drug use to begin with but having seen people go through withdrawal, it is never a pretty sight.

        That said, at some point the patient has to face reality.

        • D Lawrence

          “That said, at some point the patient has to face reality”.

          Not necessarily! The patient could overdose and die. To carry that analogy over to a national economy, the social fabric can rupture and the government can collapse. We may not be there yet, but the example of the Weimar Republic is a pretty scary example.

  • Aaron Kramer

    I have been hearing noise about a inter-meeting Fed hike that may be in the works. I can’t confirm the validity but I was not surprised to see Bernanke bring it up after the close. The Fed will lose all power if they kill the dollar, do they really want this outcome? Does 25 bps matter? 50 bps? This type of move won’t affect business loan availability. They have already destroyed most of the competition for the large banks, which hold massive capital at the FED earning interest. The Curve might actually flatten for a few months if the market views the FED as moving towards a neutral stance. An inter-meeting rate hike would change the game for at least a quarter or two and the Fed and Administration are just buying time. Everyone knows adding more liquidity won’t help, does Bernanke want to be at the helm when hyper inflation breaks out? Deflation destroys those who are levered, hyper-inflation destroys economies and countries. He seems rather aware of his legacy considering his comments on 60 minutes and the Depression. The Fed has been active around expirations so keep an eye out over the next 5 trading days. They don’t have much time to change the tone and Asian currencies are already intervening to support their currencies. Remember this is speculation by some trading Eurodollars and Bonds so watch the short end and good luck.

    • Aaron Kramer

      Asian governments not (Asian Currencies)

      • Larry Doyle

        Aaron,

        Thanks for this color. I think the chances of an inter-meeting hike in rates at this juncture are quite low, BUT I think the Fed very easily could engage in aggressive amounts of reverse repos with Freddie, Fannie, or any other ward of the state in an attempt to temporarily drain some liquidity from the system.

        • Aaron Kramer

          LD
          I agree the chances are very low but the rumor started in NY at a certain bank’s repo desk, where a certain central bank does business. I don’t put a high probability on the event but rather see it is a example of how the FED is aware and closely monitoring the situation. The fact that they are aggressively watching the $ value show a level of consternation not previously seen. I WOULD NOT TRADE OR INVEST ON THIS INFORMATION.

          • Larry Doyle

            Aaron,

            Certainly the dollar is ‘the story’ and getting a LOT of attention around the world. Thanks for sharing this color.






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