The Currency Crisis

Finance at First Light
Good morning! Let’s take a look at the currency crisis.

Simon Johnson at Project Syndicate says the brewing currency wars are not just China’s fault, though it “certainly bears some responsibility.” He mostly blames “Europe’s refusal to reform global economic governance, compounded by years of political mismanagement and self-deception in the United States. … the US has run record current-account deficits over the past decade, as the political elite — Republican and Democrats alike — became increasingly comfortable with overconsumption. These deficits facilitate the surpluses that emerging markets such as China want to run — the world’s current accounts add up to zero, so if one large set of countries wants to run a surplus, someone big needs to run a deficit.”

Paul La Monica at CNN is worried about the dropping value of the dollar, and says the Fed may be going too far. He wrote, “If the dollar gets so weak that the likes of China and Japan pull out of the US debt market and other nations find that there’s no incentive to invest here, then [a nightmarish future where the dollar has essentially no value and China gets tired of backing worthless US debt] could become reality.” He quotes Anthony Welch, co-manager of The Currency Strategies Fund, saying, “The dollar had been rallying earlier on a flight to perceived safety. Now the behavior of the dollar is a function of our economic policies, which people can argue are not really that sound.”

Hossein Askari and Noureddine Krichene don’t mince words when placing blame squarely on the shoulders of Federal Reserve Chairman Ben Bernanke. They wrote in Asia Times that the “Fed is promoting monetary competition throughout the world [and] each central bank is counteracting with monetary expansion” to the point that “central banks are now entangled in currency manipulation and competitive currency devaluation. Central banks are striving to depreciate their currencies to get a competitive edge for their exports and fuel their economic recovery, while monetary anarchy spreads around the globe.”

They remember that in 2007-2008, “Bernanke’s loose monetary policy fueled unprecedented commodity price inflation. But Bernanke put the blame on China and on oil producers. So far in 2010, the price of crude oil has jumped by 27%, of corn by 63%, of wheat by 84% , of sugar by 55% , and of soybeans by 24%. Without the Fed’s unprecedented loose monetary and near-zero interest rates, it would have been highly unlikely for commodity prices to increase at these alarming rates.”

They remind us that monetary policy produces real-world consequences, something that is too often lost in the academic debates at the top:

The frightening food price inflation has raised the specter of another food crisis and food riots. High commodity inflation is an indicator of scarcity of real capital and very low savings for sustaining economic growth and employment creation. High food and energy prices are instantly transmitted to retail prices. Consumers suffer dramatic losses in their real incomes and are forced into scrimping on food, and in the case of consumers in the US to relying on food stamps. Since liquidity for commodity price inflation is abundant and cheap, food price inflation could run up, stall world economic growth and spread social unrest.

While we worry about food price inflation, the Fed with its obsession on core inflation dismisses any talk of inflation. Fed governors should do their family grocery shopping and then talk. They should talk to ordinary Americans and see what they say about food prices after each visit to the supermarket.

They warn that the Fed is on a path that history has shown to ruin national banking systems:

The present policy course of the Fed could ruin the banking sector no matter how perfect the regulations. A regime of near-zero interest rates and abundant liquidity will expose banks to high risks. As in Japan, banks [will] get bitten only once, and become reluctant to follow the course set by the central bank — to lend and assume high risk.

Policymakers in the US have to face up to the limits of monetary policy. A return to sustained economic growth cannot be achieved by simply adopting near-zero interest rates and cheap liquidity. Such a policy, even if it succeeds, is most inefficient and creates distortions and asset bubbles. It will ruin the banking sector, as it has done in the recent and distant past, and will create a high degree of exchange rate instability and disorder in international finance and international trade.

They consider the situation to be so serious that world governments must “arrest the devastating monetary expansion initiated by central banks. The stance called for by G-20 summits to unleash money unorthodoxy has turned out to be self-defeating. Governments have to agree on some form of monetary targeting and renounce interest rate setting. A monetary conference is urgently needed.”

Not that it would do any good. Bill Wetherell, Chief Global Economist at Cumberland Advisors, wrote in his market commentary on last weekend’s annual meetings of finance ministers and central bank governors in Washington the following upbeat report: “No one expected these meetings to produce an agreement on global foreign-exchange coordination or even first steps in developing a substantive action plan to address the situation. But the meetings fell short of even these limited expectations.”

What went wrong? Efforts were “hijacked by the mounting hostility between the US and China over China’s resistance to a more rapid appreciation of their currency, on the one hand, and the very loose monetary policy and near-zero interest rates in the US and elsewhere in the advanced world, on the other.” He finds that there is no “shared analysis as to what are the most important risks to the global recovery and the required policy responses.” Ahead of the November G20 summit in Seoul, he expects that “the already high volatility in the currency markets will increase, interventions in these markets will also increase, and the ‘global musical chairs’ process will continue.”

Martin Wolf says bluntly that the US will win. He wrote in the Financial Times that “the US wants to inflate the rest of the world, while the latter is trying to deflate the US. The US must win, since it has infinite ammunition: there is no limit to the dollars the Federal Reserve can create. What needs to be discussed is the terms of the world’s surrender: the needed changes in nominal exchange rates and domestic policies around the world.”

He shared the following charts (and two others) showing why the Fed is worried that the US is following in Japan’s footsteps, which have taken it into a 21-year recession — and counting:

Japan and US deflation charts

He concluded that “the adjustments ahead are going to be very difficult; and they have also hardly begun.” His closing words:

Instead of co-operation on adjustment of exchange rates and the external account, the US is seeking to impose its will, via the printing press. The US is going to win this war, one way or the other: it will either inflate the rest of the world or force their nominal exchange rates up against the dollar. Unfortunately, the impact will also be higgledy piggledy, with the less protected economies (such as Brazil or South Africa) forced to adjust and others, protected by exchange controls (such as China), able to manage the adjustment better.

It would be far better for everybody to seek a co-operative outcome. Maybe the leaders of the group of 20 will even be able to use their mutual assessment process to achieve just that. Their November summit in Seoul is the opportunity. Of the need there can be no doubt. Of the will, the doubts are many. In the worst of the crisis, leaders hung together. Now, the Fed is about to hang them all separately.

Whew! Better get your cash somewhere they can’t blow up with a pen stroke. Kelly Letter subscribers, I’ll have more ideas for you Sunday including a look at where we are in the market run-up. I know many of you are eager to set stops into strength.

Have a great weekend, everybody!
Jason Kelly

These periodic “Finance at First Light” briefings present a glimpse into my research. If you would like to read actionable investment advice based on this and other information, please consider subscribing to The Kelly Letter.

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