Sunday, November 22, 2009

The Weak Dollar vs. Strong Dollar Dilemma

Does the US really want a weak or strong dollar? No matter what the setting or topic, lately just about every discussion between economists, market participants, and government officials turns to the US dollar. Tim Geithner says the US has a strong dollar policy. Unfortunately, that’s about as credible as the International Federation of Bodybuilders saying that is has a no steroids policy. One look at the impressive but clearly unnatural Ronnie Coleman and it becomes obvious that the very large pink elephant in the room is that those body builders are not clean. In a similar fashion, the Fed’s money printing and the willingness of the federal government (both democrats and republicans—let’s not forget that the Bush tax cuts and Medicare Part D were deficit funded) to run massive fiscal deficits patently contradicts the claims of Geithner. So, if the government and Fed are willing to say one thing and do another, what is the point of all the posturing? Have the leaders become resigned to some kind of stealth default on our foreign debts through inflation? Are they just jawboning with that hope that our foreign creditors don’t precipitate a disorderly unwinding of the dollar?

I honestly don’t know. There is no question that a weak dollar makes US exports more attractive. But I’m not sure how to reconcile that the deleterious impact of the falling value of the dollar on the foreign creditors we are desperately going to need to keep financing our massive spending. It was within this context that I came across a guest post on Simon Johnson’s Baseline Scenario that argued that a weak dollar may actually be just what the doctor ordered when it comes to rebalancing the world economy. I advise everyone to examine both sides of this argument because this is going to continue to be a topic that dominates the financial discourse and may eventually affect the results of numerous investment strategies:

A lower dollar is good news for US exporters and foreign importers and bad news for foreign exporters and US importers. However, if policymakers respond appropriately, there is no reason to fear overall harm either to the US economy or to foreign economies. Indeed, a lower dollar could jumpstart the long-overdue rebalancing of the global economy away from excessive US trade deficits and foreign reliance on export-led growth, putting the world on track for a more sustainable expansion.

The fear in economies that are appreciating against the United States is that a falling dollar will choke off exports and hobble economic recoveries. The correct response is to ease monetary policy and temporarily delay fiscal contraction. As I explain here, even in economies with short-term interest rates near zero, there is plenty of scope for central banks to stimulate aggregate demand, and doing so will help to limit the extent to which the dollar falls.

For the United States, the benefits of a falling dollar are obvious: stronger exports and a faster recovery. The fear is that a falling dollar would be inflationary. However, as I have shown in two recent papers, even very large currency depreciations in developed economies have no effect on inflation unless they are caused by policies that attempt to hold an economy’s unemployment rate below its equilibrium level. With US unemployment currently at 10 percent, there is no chance that inflation will rise in the near term. Whether inflation rises in the longer run will depend on whether US monetary and fiscal policy stimulus is withdrawn appropriately as the economy recovers (and tighter macroeconomic policies would tend to support the dollar). Many believe that US policymakers erred in not withdrawing stimulus soon enough in 2003-05, but policymakers now seem to be keenly aware of this mistake and have expressed their determination not to repeat it. Only time will tell, but my own view is that the Federal Reserve, at least, will not allow runaway inflation.

For economies that peg their currencies to the dollar (notably China) the costs and benefits of a falling dollar are the same as those facing the United States and so is the policy dilemma: how fast to tighten macroeconomic policy as the economy recovers? These economies differ on several dimensions, including financial market development and capital controls, strength of economic ties to the United States, and prospects for economic slack and inflation. These differences will determine the appropriate policy stance. To some extent these economies have forfeited the freedom to adjust monetary policy, but they retain the option of adjusting the levels of their dollar pegs. In some cases, a further decline in the dollar may represent an opportune moment to move to a floating exchange rate.

Two quick comments on his analysis. First, I worry about any outcome that is dependent on the Fed being able to withdraw all the potentially explosive liquidity before inflation kicks in. Even if you give the Fed the benefit of the doubt and assume that the members will be vigilant on this front, monetary policy changes are blunt instruments that impact the economy many months after implementation. As such, they are incredibly hard to time and calibrate accurately in order to get the desired effect. Second, we must keep in mind that oil is priced in dollars and dollar weakness that causes oil to increase significantly in dollar terms could put a further strain on consumer spending (as it has in the past—remember $4 a gallon gas?) and stifle any nascent recovery. Since we import far more than we export (note the current account deficit) it is hard for me to see how a weak dollar is a net benefit to the US.

Too bad Q3 GDP growth isn’t actually leading to less suffering: As we assess where the US is in terms of a legitimate recovery, it now appears that there are two very different economies and corresponding realities that both policy makers and investors need to understand. There is the government backstopped, Wall Street and multinational corporation economy that seems to be experiencing a return to prosperity. And then there is the real world economy made up of small business and individual households that is struggling to keep its head above water. Wall Street is about to have a record year. S&P 500 companies have become so lean that bottom line profitability has not shrunk commensurately with sales. When this efficiency is combined with the renewed strength abroad, many companies with significant operations outside the US have hardly missed a beat. Unfortunately, that is not true for small businesses and households. Mortgage delinquencies are at all time highs and foreclosures continue unabated. The overall unemployment rate (U3) is at 10.2%, U6 is at an astonishing 17.5% and the rates in states such as Michigan (15.1%) are downright startling. Further, as discussed in this opinion piece in the NY Times, there is evidence that the recession is having an outsized effect on people who were already not particularly prosperous:

If the elites are correct, if the Great Recession really is over, then these core supporters of the president are being left far, far behind — as are blue-collar workers of every ethnic and political persuasion. Nobody wants to talk seriously about class in America, but the elites are smiling and perusing their stock portfolios while the checklist of Americans locked in depression-like circumstances just grows and grows: construction and manufacturing workers, young men without college degrees (especially young black and Hispanic men), teenagers, and those who were already poor when the recession began.

Now we’re learning that unmarried women are among those being crushed by the epidemic of joblessness. As the Center for American Progress has noted, “The high unemployment rate of unmarried women, and particularly the 1.3 million unemployed female heads of household who are primary breadwinners for their families, is devastating to their financial circumstances and standard of living.”

This was not a normal recession, and we are not on the cusp of anything like a normal recovery. The unemployment rate for black Americans is 15.7 percent. The underemployment rate for blacks in September (the latest month for which figures are available) was a gut-wrenching 23.8 percent and for Hispanics an even worse 25.1 percent. The poverty rate for black children is almost 35 percent.

Wall Street can boast about recovery all it wants, much of America remains trapped in economic hell.

Not that Bob Herbert does this in the article but, honestly, I am sick and tired of people using the Great Depression as a benchmark for this recession. Yes, the current unemployment situation is nowhere near as bad as it apparently was in the 1930s. Great! People are not as desperate as they were in one of the worst periods in this country’s history! That’s not much to celebrate in my eyes and unfortunately the diminished relative severity certainly does not preclude a dangerous situation from emerging. My fear is that people who have nothing more to lose are willing to do things they never would have dreamed of in better times. It doesn’t matter what color or age a person is, we all need to eat. While spikes in crime and widespread social unrest may be on the periphery of proximate concerns, policy makers need to remember that a Wall Street and stock market recovery just leads people who don’t have the means to invest even further behind. So, before we all start celebrating the economy’s apparent return from the abyss, let’s keep our eyes on what is at stake: there is no Wall Street, stock market, or K Street if we disenfranchise every person on Main Street to save the elites from suffering any harm.

How can the US avoid “turning Japanese?” No two countries face the exact same headwinds or tailwinds and thus policy decisions will inevitably have varying impacts depending on the country and the exogenous circumstances of the times. Therefore, comparisons of the current US situation with that of Japan in the 80s may be about as enlightening as the aforementioned benchmarking off of the Great Depression. However, the attempts of the Japanese to extricate themselves from the aftermath of the stock and real estate market crashes of the late 1980s do provide an interesting template to scrutinize as the leaders of the US embark on a similar task. For better or for worse the US has decided to follow the dubious path blazed by the Japanese when it comes to a potentially insolvent banking system cluttered with bad loans and dodgy assets. Extend and pretend was chosen over the Swedish model in which banks were quickly forced to recognize their losses and were then recapitalized. Could it work out differently for the US? Sure. A lot of components of the economy are subject to positive feedback loops in which more confidence leads to increased spending (this link is to an article from Bob Schiller from this weekend’s NY Times on this topic), bank lending and eventually to real growth. If that dynamic played out, the banks (given the incredibly steep yield curve) might be able to earn their way through the cycle and be able to sell their toxic assets at much more favorable prices once the economy had recovered. Having said that, I think there is a compelling argument to be made that we should all be aware of the underlying factors that clearly led the Japanese to fail to reinvigorate their economy and asset markets. In that vein, the following article (hat tip to the Pragmatic Capitalist) discusses some of the elements that did not work in Japan:

The Japanese government’s easing of credit rates, instead of spurring real demand, created artificial demand. Federal loans and stimulus spending were not economically productive, and they vastly increased the nation’s debt and prolonged the economic malaise. Worse, businesses spent critical time on the sidelines, waiting for government bailouts and other centralized actions, instead of speedily consolidating their losses, clearing their balance sheets of bad investments, and reorganizing.

The United States in 2008–09, unfortunately, has started down the same path. Federal intervention and the expectation of additional government action are removing firms’ incentive to clean up their balance sheets by selling “toxic” assets. Why accept pennies on the dollar if a deep-pocketed new bidder (i.e., the state) looms large on the scene? The Japanese experience shows that when the government is an active participant in the market, many firms would rather accept state support than initiate the inevitable financial reckoning. Such a status quo does not provide a sustainable foundation for the economy. Instead, it restricts economic growth and creates a cycle of stagnation…

Capital reserve requirements. In 1988 the Basel I Accord between the Group of 10—which then included the U.S., Switzerland, Japan, Germany, France, and the U.K., among others—set new capital requirements for banks around the world. But the requirements were focused on loan amounts and did not factor in a debt’s underlying risk. In other words, a loan to a sound borrower required the same percentage of capital to be set aside as an equal amount lent to a high-risk borrower. There was already a developing atmosphere of heavy lending and insensitivity to risk, but the Basel requirements rewarded firms for making loans to shaky borrowers because they could earn higher interest rates that way without having to set aside any more capital than they would for loans to safe borrowers.

The chief problem was not that the requirements were too low. It was that the rules created a false sense of security for investors and lenders. Banks were meeting their legal requirements, although it was never clear what kind of debt they were holding capital to cover. Without a standard or competing standards for transparently measuring the value and risks of portfolios, Basel I proved ineffective at preventing systemic rot. (Emphasis added)

Government lending to poorly managed firms. The Bank of Japan tried to ease economic pain by loaning large amounts to businesses. But the attempts to recapitalize the market ignored underlying management problems in the dying firms. It was a costly mistake. Intense lobbying from special-interest groups representing various sectors of the Japanese economy perpetuated the ill-fated loans and funneled government money to zombie businesses. [Emphasis mine—how familiar does this sound]

Conflicts of interests. With all those loans, the Japanese government found itself deeply entwined in the market, skewing its policy incentives. Daniel I. Okimoto, former director of the Shorenstein Asia-Pacific Research Center at Stanford University, points out that Japan’s banking industry and economic bureaucracies were too interdependent. Studies from Okimoto’s center and the Bank of Japan concluded that data revealing the scope of the economic malaise were suppressed and that regulations were developed with governmental interests in mind. At the height of financial industry bailouts, there was little transparency or public accountability. [Cough---audit the Fed—cough]

Short-term, static political vision. You can blame the length of Japan’s asset deflation, recession, and liquidity struggles on an unwillingness to choose hard but necessary policies, such as allowing banks to fail and the market to reset itself. Politicians bent on retaining their power and showing the public they were doing something took actions without regard to their long-term effects.

There was little effort to clean up the banking system or get rid of harmful regulations. The government refused to acknowledge the breadth of Japan’s economic troubles, and the Ministry of Finance went so far as to order banks to hide their toxic loans to create the appearance of success..

Beware of those pesky activists: The reluctance to accept any change when it comes to corporate governance in America is absolutely astounding. Despite the fact that the corporate boards of literally hundreds of financial institutions sat idly as the companies took on extreme amounts of risk, there is still a lot of resistance to any proposals that would make directors more accountable. Interestingly, buried in Senator Dodd’s financial reform bill is a section regarding shareholder rights that allows shareholders who meet certain qualifications to nominate directors. Here is an excerpt from an article by David Reilly on the subject:

The SEC would require that shareholders looking to nominate directors hold a certain percentage of stock depending on the size of the company. Shareholders also would have to show they have owned stock for a period of time, say one year. Nor could shareholders take control of a board.

One caveat: while requiring the SEC to take up the issue of giving shareholders greater say over directors, the Dodd bill doesn’t set minimum requirements for what the agency ultimately adopts.

In spite of the common-sense nature of these proposals, supporters of the present dysfunctional system still argue that the changes will ruin American business.

A memorandum on the legislation prepared by lawyers at Wachtell Lipton Rosen & Katz, and posted in part on a Harvard Law School corporate-governance blog, argued that giving shareholders greater say over boards will only increase short- term pressures on companies from “shareholder activists and hedge funds.”

Is it me or is the fallback of the opposition to any legislation to blame hedge funds? There is no question that there are some activists who are interested in short term gains. However, there are many more firms that are genuinely invested in trying to improve corporate governance, company performance, and returns to all shareholders. As it stands, it is incredibly costly to run a proxy battle and very few funds have the resources, time or patience to wage a war against a company’s board. That is a shame because it has become blatantly obvious in retrospect that directors have not been living up their fiduciary duties and have become nothing more than rubber stampers of CEO initiatives. Reilly makes the very ironic point that no matter how devious the motivations of activist investors are, how could they possibly harm the companies more than the directors have by not diligently evaluating the actions of the management teams?

Here’s something else to consider. Let’s say opponents of greater shareholder democracy are right. And let’s assume that hedge funds and union-backed pension funds run amok, dictating that boards hew to short-term profit goals or ideological agendas.

Would they actually do more damage than has already been inflicted by imperial CEOs backed by obsequious and crony-filled boards? At last count, the U.S. has lent, spent or guaranteed almost $12 trillion to keep banks, Wall Street and the economy afloat, according to the latest Bloomberg estimates.

Even the hedge-fund hordes supposedly waiting to swarm corporate boards won’t stick taxpayers with that kind of bill.

Would contingent capital buffers help to stave off a crisis? Policy makers worldwide are trying to figure out how they can prevent another financial crisis (like the one we have apparently emerged from) from happening again. Some of the options on the table are leverage caps, higher capital ratios, and even shrinking the size of large financial conglomerates to mitigate counterparty and concentration risk. Another interesting idea is to force banks to issue contingent capital that converts to equity at a certain point during uncertain times. One of the problems that a number of firms faced during the depths of the liquidity crisis had to do with not being able to raise equity. If contingent capital had been in place the stressed company would have been able to convert debt to equity and would have enjoyed a larger cushion. However, according to James Kwak of The Baseline Scenario, contingent capital sounds great on paper but has a number of potential pitfalls:

Contingent convertible bonds, a.k.a. contingent capital, are the latest fad to hit the optimistic technocracy in Washington and London. A contingent convertible bond is a bond that a bank sells during ordinary times, but that converts into equity when things turn bad, with “bad” defined by some trigger conditions, such as capital falling below a predetermined level. In theory, this means that banks can have the best of both worlds. They can go out and borrow more money today, increasing leverage and profits (which is what they want). But when the crisis hits, the debt will convert into equity; that will dilute existing shareholders, but more importantly it means the debt does not have to be paid back, providing an instant boost to the bank’s capital cushion. In other words, banks can have the additional safety margin as if they had raised more equity today, but without having to raise the equity.

[Gillian] Tett [of the Financial Times] is skeptical for all sorts of reasons — defining the trigger point (remember, Bear and Lehman were well-capitalized on paper when they collapsed), finding people willing to buy these things, the impact on the market of triggering a conversion, etc.

I’m skeptical for a more basic reason. Contingent capital, like any other type of capital requirement, assumes that we can predict in advance how bad the crisis will be and therefore how much capital will be necessary to avert a bank-killing panic. That means we have to be able to predict (a) just how fat the fat tail is, based on virtually no data points, and (b) how panicked people can get and for how long. That seems to me technocratic hubris of the first order.

So why is contingent capital so popular? (It’s even mandated by section 107(b)(1)(D) of the Dodd bill.) Well, the people don’t matter don’t listen to me or to Gillian Tett. Here is Tett’s explanation:

“Even amid all those hurdles, the CoCo idea currently has many fans, not just among investment bankers touting for business, but some western regulators too. The reason stems from a big, dirty secret stalking the financial world: namely that while global policymakers have spent a year wailing about the ‘Too Big to Fail’ problem, they have hitherto done almost nothing tangible to remove that headache in a credible manner.”

The idea that any clever regulatory scheme we come up with today, which by definition will be untested, can be counted on to come through in the next crisis seems hopelessly naive to me. I think it would be more honest to admit that there are really only two choices:

1. Break up any institution that is too big to fail.

2. Leave them in place (because “big companies need big banks,” or whatever other nonsense justification you want to use) and admit that we’ve done nothing to solve the TBTF problem.

That’s the real choice.

Properly regulating these entities has proven to be just about impossible in the past. Why do we think it will be different next time? Bankers are paid a hell of a lot more than regulators and will inevitably find a way to get around just about any regulation. Is contingent capital better than nothing? Sure, if the goal is to enact reforms that get us as close to the bubble status quo as possible without completely letting the banks off the hook. But, if we want real change and to limit the powers of the banksters, we need legislation that includes options such as contingent capital but is centered on breaking the banks into more manageable and potentially less explosive pieces.

(Picture courtesy of