Saturday, August 16, 2008

The US Dollar

My post on UK unemployment has received a couple of replies. In one the commentator suggested that the rise of the US dollar was a good thing, and suggested that the US economy was therefore on the right tracks. Another commentator replied to this post with the following:
'Isn't the value of the dollar (and the index you mention) just a relative measure, so it's entirely possible that all non-Chinese economies are collapsing together, with just a bit of jostling to see who can collapse fastest?'
In light of these posts, it might be worth just discussing the recent recovery of the $US. In particular, how is it that it is recovering? A dollar recovery does not fit the script that I have been writing over the last few months.

As it is, the second comment is on the right track. All of the currencies of the rich world economies will almost certainly decline against the currencies of the emerging economies, and the reason for this long term trend is given here. However, with regards to the RMB it is a managed floating exchange rate, such that it can not automatically respond to market conditions. This is a big spanner in the workings of the currency system, and continues to be a partial block to the rebalancing of the world economy.

This is obviously just a very broad context and does not explain the recent rise of the dollar. My own suspicion is that the rise in the dollar is nothing to do with fundamentals but just the result of habit. In times of uncertainty, which I think would be a good summary of the current economic climate, people automatically look to the dollar as a safe haven. The trouble is that the dollar is now no such thing, and is still highly vulnerable. It's a bit like the business saying of 'nobody has ever been sacked for buying IBM', but in this case of the dollar it is flying in the face of reason. The simple question to ask is 'what has changed in the state of the US economy in the last few weeks to justify this appreciation?' As soon as you ask the question the only answer is that there has been no major change. As such, sentiment rather than reason is driving the dollar higher.

The real problem here is that the revaluation of the dollar upwards is just storing up even more trouble for the US economy. The US economy needs to be rebalancing towards export led growth, and this will delay progress towards this end. It is only through the relative impoverishment of the US that is represented by a weaker dollar that the US can regain a competitive position.

As such, the dollar may rally for a while, but in the end it can only last for so long before economic reality trounces market sentiment. At some point there needs to be an economic justification for a stronger dollar, and force of habit is a poor justification.

Comments from MattinShanghai:

I have had a couple of interesting comments from a person who presumably lives in China. I am particularly pleased to have a comment coming out of China, as it is only through seeing China 'on the ground' that the reality of that country's economic development is apparent (with Shanghai as a quite startling example).

One point of note was a link to an article/essay that Matt posted. The article can be found here. It offers a very challenging perspective on Japan, and is worth reading. I keep on meaning to address the subject of Japan, but it is on an ever expanding 'to do' list, so will have to wait a while longer.

For his other comment, I will not try to paraphrase it, but it gives an outline of a historical perspective on my post on Synthetic Economics. As such I would recommend a quick read of the comment. Matt refers to one author and his writing can be found here (I am downloading it now, so can not comment on it yet). However, it sounds like the author has an interesting perspective.

Recession Prediction

I have just been looking through the Sunday papers, and it is interesting to note that the British Chamber of Commerce is now saying that the UK is heading for a recession (article in the Times):
'THE British Chambers of Commerce (BCC) will this week become the first leading business group to predict a recession in Britain.

Its quarterly economic forecast, to be published tomorrow, is expected to say that Britain is heading into a “technical” recession of two or more quarters of declining gross domestic product over the next six to nine months.

It will say that a deep recession, of the kind last experienced by Britain in the early 1990s, remains unlikely, but that the risks to the economy have grown significantly over the past quarter and unemployment is set to climb by up to 300,000.'

On the positive side, at least they are recognising that the situation is bad, but their optimism over the length and severity is completely unjustified. I have looked at their website, and assume the source is the quarterly survey, which is only available with a subscription, so am unable to see how they reasoned their prediction. However, whatever their reasoning, at least the conclusion is positive in that they are pressing the Bank of England to ease interest rates. This is desperately needed in a sinking economy and will help the UK to adjust to the economic imbalances through weakening the £GB.

A good example of the non-argument for raising interest rates is given by Simon Heffer in the Telegraph. He calls for higher interest rates to fight inflation, but as is typical of such commentary, fails to explain (and presumably understand) by what process raising interest rates will prevent inflation. He says:

'A rise in rates, which I believe is necessary to drive the last ravages of inflation out of the system, would be the final humiliation not just for Mr Brown, but for the system of economic management that he has made his own.'
'I know a rise in interest rates will cause more houses to be repossessed, more businesses to fold and more bankruptcies.

Sadly, that is what the economy needs in order to turn itself round. You can't have sustainable "growth" on the back of an economy where people and enterprises are living beyond their means. You can have it only where they are living within their means.'

He may not have noticed, but this is already happening. Regardless of the interest rate, this process is already in train, so how is accelerating it going to help? He suggests that it is better to have the pain now than later. However, an interest rate rise will have the effect of being a prop for the £GB (though will just slow the fall), and this is will only have a negative effect. I give the example of Heffer, because his line of thinking is not isolated. Underlying such thinking is a lack of acceptance of both the severity of the current situation, and the changed reality of the world economy. Britain, along with the rest of the rich world, are going through a crisis, and and this lack of recognition of the crisis is one of the great dangers in the current situation.


  1. Thanks for your kind words about my small contributions to your very excellent blog. I don't have any professional background in economics, but have been researching the subject for the last couple of years after becoming disillusioned by the sheer intellectual squalor of what passes for "economic thought" in the mainstream. My background is in mathematics/computer science/electronics. I've worked as an academic for a number of years, before getting involved in various startup companies. Four years ago I left the UK to work for a high-tech(ish) startup in Shanghai.
    My moment of "enlightenment" occurred after I returned for a short holiday to London after 10 months in Shanghai. I was walking around my old neighborhood in Kingston and was struck by the fact that half of all business premises were now occupied by estate agents, with the remainder taken by betting shops, charity shops, cheque cashing bureaus and pubs. The thought that sprang to my mind was "where's the beef?". What is the advantage that this country has over the rest of the world? Surely an economy cannot be sustained indefinitely by people selling (existing) houses, at ever-inflating prices to each other. So you can imagine that your posts such as "a funny view of wealth" and the "chinese lighter problem" struck a sympathetic chord with my thinking.

    As far as Macleod goes, I would recommend his "Elements of Banking", rather than the earlier "Theory and Practice..". It is shorter, has far fewer Greek quotes from Aristotle and others, and the gist of his thinking appears in the first 50 or so pages. The link is:

    I would suggest getting the DJVu viewer (available as a free download) and downloading .djvu files instead of the PDFs (you need to go to the 'All files: HTTP' and then right click on the appropriate .djvu file in the list)

  2. Mark,

    I wondered what you thought to this article
    and some of the comments. In particular, I was intrigued by this one:

    "All that seems to be racing to the bottom right now is asset values, and that will continue as long as the central banks stay transfixed by the 2% inflation target.

    But I agree that the currency devaluation race has only just begun in earnest, in the sense that the rest of the world realises that the US has stole a march on them with their 3.25% interest rate cuts.

    The race to the bottom of the western currency devaluation will end as a dead heat with most currencies still at their current exchange rates, because all western currencies are overvalued. On the way there will be some jockeying to get ahead.

    The real race to the bottom will be nominal interest rates, a race to 0%. Then the race will be to print money to try to stop the fall in the general price level and take real interest rates negative.

    Key to remember right now is that we are not entering an anti-inflationary recession like those of the seventies, eighties and nineties, but a deflationary recession leading to depression. The situation only has superficial inflationary aspects related to asset prices – there is no dynamic supply-demand inflation, except that which relates to the investment boom, caused by excessively low nominal interest rates and high real interest rates this last quarter century.

    Another key thing to remember is that we are entering a depression due to a central bank rigidity - the 2% inflation target - just like the Gold Standard caused the Great Depression. The difference is that at the time of the Great Depression our knowledge of how to escape was limited, whereas today it is not.

    The central banks and politicians know how to get out of it, and they will do all that is necessary to do so – zero nominal interest rates, slashing taxes, increasing public expenditure, printing money - and once they start this race to the bottom in earnest, all asset markets will become extremely volatile, even compared to the last twelve months. At times, whether you make or lose money will become almost a lottery. Land prices may bounce back dramatically nearly overnight, for example.

    However, none of this will be hyperinflationary because we can be sure that the central banks will suck some of the volume of money back out of the system as soon as they have driven the velocity of money up so that the effective money supply is restored to something like pre-credit crunch levels.

    The money supply will have to be driven up to that level because that is the level required for the conduct of trade at the intrinsic capacities now available. Either that or horrendous geopolitical upheaval.

    Finally, unless the central banks abandon their 2% inflation target we will remain on an ever more volatile deflationary cusp, even if this time they succeed in getting us out of this totally unnecessary mess they have caused. The tragedy is that millions of ordinary hardworking people are going to be financially crucified in the process. "

    Do you think this person is talking sense?

    If I understand him correctly (and I probably don't!) he seems to be saying that the world economy must be 'reset' by throwing the pieces up in the air and shaking the whole lot around until a balance of sorts is restored, and we can effectively start again. It sounds like a recipe for chaos, but it is clear to me that people are prepared to accept that unseen "global forces" are robbing them of their savings and investments and putting prices up, much more than they would be prepared to accept government policies designed to achieve the same thing in a more predictable, orderly way. Most people are going to appear to lose out, but they don't know that it will be as a result of a deliberate, but "unseen" policy.


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