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Dubai, Don't Buy



The word from the G7 nations in Dubai, as you already are well aware, is that the US$ should fall in order to rebalance the massive current account deficit and the growth disparity between the US and the rest of the world. Interestingly, headlines across my Bloomberg are replete with finance ministers suggesting that Alan Greenspan himself played an important role in convincing the G7 that US$ weakness is imperative to address (1) the US current account balance, (2) the export-focused EU and Asian economies, and (3) the import-driven US economy. The idea being that, via a smooth transition in exchange rates, the above global imbalances would be realigned without having real and negative impacts (pressures they called them) on either investment flows between countries or inflation.

And with that, the US takes up the last macroeconomic reflationary weapon it has to stimulate the US economy back to life: currency devaluation.

Of course, that we already have seen the majority of the benefits of fiscal policy stimulus (2 tax cuts in 2 years) and monetary stimulus (historic declines in the Fed funds and discount rates, as well as excess reserves pumping), goes unsaid. And unanalyzed: we have been blurting to anyone that would listen that the benefits of tax rebate checks and mortgage refi cash-outs were seeing decreasing returns and that they were not capable of stimulating our way out of the overcapacity that was generated in the 1990s easy credit boom.

But maybe a currency devaluation will reflate us?

There is no easy answer to the above question, as the mechanics (pace) of the decline will matter as much as the level of the decline. And, too, the effects of the decline will matter differently to different sectors and markets.

For their part, US treasuries are selling off and yields are rising. As the dollar depreciates, foreign holders see the value of their US$-based assets decline unless they have hedged 100% of their exposure. Few do that, so there is at least nominal US$ exposure. Thus the selling. As well, given the fiscal deficit we are contemplating here in the US, the increasing need to float treasuries might find fewer foreign buyers, as their fear of a US$ decline keeps them from the bidding table. Again, potentially more selling.

Rising yields, of course, mean the rate-sensitive part of the US economy - cars, homes, durable goods - will come under pressure. A falling dollar also means that consumers will pay more for imported goods, this at a time when wage growth and employment trends are bad and getting worse. In sum, the consumer balance sheet gets pressured on the cost side immediately.

The hoped-for offset to these economic headwinds is that US exports will now be more competitive in the global marketplace. In other words, the administration and the Fed are betting that currency devaluation will help the manufacturing sector and employment more than it will hurt consumer consumption and the interest-rate sensitive parts of the US economy. When parsing this likelihood, keep this fact close at hand: the services part of the economy accounts for 80% of US employment. Manufacturing? 13.5%. So you can see that this is one hell of a bet, but it goes to show you the pickle that they have gotten themselves into when they have to make these kinds of bets.

It can be persuasively argued that the last two reflationary bets, massive tax rebates and monetary policy easings, have not worked as planned. The honest debate rests upon how much they have helped long term economic growth. There is no debate, however, that those two bets have created enormous fiscal deficits and equally large consumer and corporate indebtedness respectively, to say nothing of the malinvestment that those two reflationary tools have caused. So, net/net, the Fed's last two bets didn't produce much short term benefit (jobs) but did produce lots of long term costs (debt).

One must consider too the negative impacts that our devaluation has on our trading partners - the Eurozone and the Asian economies. You might be curious why they would be willing to let their currencies appreciate, putting deflationary pressures on their economies and reducing the cost competitiveness of their own exports? In effect, placing more headwinds on their own nascent recoveries.

The answer is that they realize that they cannot have any real recovery without the US recovering first and foremost. The reason is illustrated in the following almost unbelievable statistic: since 1995, fully 97% of world GDP growth has come from the US. The other 3% was divided up among the rest of the world's economies. As goes the US, so goes Europe and Asia but worse. In effect, they have become captive bankers to the US: we are too big to let fail, so they have to put up with more pain in the hopes that we "Get over the hump" of this current economic weakness and start to grow sustainably again.

Predictably, strategists, central bankers, and politicians will trump the benefits of a weaker currency on S&P earnings, global imbalances, and jobs respectively. Today's tape is already full of them. You can expect lots more of those kind of bleatings over the ensuing weeks. In times past (particularly the 1980s) such currency adjustments and macroeconomic impacts might have been more predictable and beneficial. But in this economy, in this "post-recession" growth phase, nothing has played out like it should have: not employment, not capacity utilization figures, not leading indicators, not consumption expenditures, nothing. All have given highly unusual readings this far into the "growth" cycle. Expecting a de-facto currency devaluation of the world's reserve currency to act "like it should" feels just a tad risky in this post-bubble environment.

A US$ depreciation; it's Greenspan's last weapon in the reflationary arsenal. Financial markets are betting that it works where the other two did not. Once again policy makers are betting on the triumph of hope over reality.

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