US debt puts strain on dollar – The Financial Times
by Tom on November 29, 2008
in Market Musings, banks
In the short term an expected equity market rally, quite plausibly the beginning of a cyclical, although not secular, bull market should bring an end to the dollar’s recent “repatriation rally”. The inverse correlation of the dollar and the S&P 500 is well established and not expected to break any time soon, given the global macroeconomic backdrop. The short term trend should be further reinforced by the broken financial system which impairs the US economy’s ability to releverage and mutes the strength of its cyclical recovery. The inability to releverage precludes the US from leading the global economy out of this recession. That also reinforces the dollar’s short term unattractiveness.
In the medium term, the US economy faces significant, albeit not insurmountable, structural problems. In particular the interaction of a heavily indebted economy with a broken financial system suggests a decade of poor domestic economic growth as savings are rebuilt and trust in the system restored. The US is a debtor nation and owes the rest of the world more than $2,000bn (up from $750bn as recently as 2000). Indeed both the household and the government sectors have been dis-saving in recent years – a trend that now needs to reverse. All of which suggests an extended period of sub-par domestic economic growth.
FT.com / Markets / Insight – Insight: US debt puts strain on dollar.
Tom here…..
Translation – the short term – once the stock market turns around, the value of the dollar will drop. The “broken” financial system is going to make it very hard for the US to begin being a leader in lending again and get things moving and rebuild the economy.
Translation – medium term – we’re in a tough spot, our system is structurally in trouble. When you combine an overly in debt economy with a broken financial system, we’re in for a long road ahead.
Back to the article…..
There are two distinctive policy choices for an overly indebted economy when confronted by a breakdown in the financial system. Which is chosen can have a significant impact on the long term outlook for the currency.
Policy choice 1 – do nothing and allow the economy to work itself out with a severe recession or even depression, with a cleaning out of the system as weak companies fall into bankruptcy, leaving strong companies and a base from which to build recovery.
Policy choice 2 – use all policy tools available to attempt to stem the downturn.
Choice 1, not surprisingly, is considered politically unpalatable as millions of people lose their jobs and many companies go bust. Choice 2, while seemingly more palatable, carries far greater risk. If it doesn’t work it sows the seeds for a decade or more of disappointing growth as savings are rebuilt slowly and the pain of the adjustment prolonged. If it does work it sows the seeds for significant inflation……
Currently, US policymakers are halfway through policy choice 2. Interest rates have been cut aggressively and are now almost zero. Politicians are about to embark on their second fiscal stimulus. The banks have been recapitalised. The government has started buying and guaranteeing distressed debt. Finally, the Federal Reserve has begun in earnest to use its balance sheet (in a sterilised manner) to step into the absent shoes of the private sector in the financial system. The Fed’s balance sheet has expanded from $900bn just three months ago to $2,200bn today.
A failure of the initial set of policies to reflate the economy is likely to lead to the next, more risky, set of policy choices – those involving unsterilised intervention. Given the breakdown of trust in the financial system, the lack of savings by the US and the continued deleveraging of balance sheets, however, those initial policies, aimed mostly at supporting the economy through creating credit (rather than increasing savings) seem destined to fail.
Tom here again…..
Policy Choice #1 doesn’t work.
Policy Choice #2 is what we’re working on.
When you look at what our government has done so far, we’re attempting to do policy #2, but it’s not working so far. Why? I think that he says it quite well:
“Supporting the economy through creating credit (rather than increasing savings) seem destined to fail.”
I’ll be writing more on that later, but did you hear that? We need to stop trying to create more credit and instead set up programs where we reward savings and end up with a much healthier society.
What do you think?
I believe strongly that the government has to intervene with the current situation and do what they have been doing – flush money into the system until it starts working again. Unfortunately, we will have to pay for this money at sometime, but for right now this is the only solution.
The system is currently broken and their is no question about that. Currently, their is a wrench that has been thrown into the system and you first have to allow for the system to just work before we can get the “Change” which Obama has promised for America.
So when will the system just start to work normally? If we continue throwing money into the system as well as continue having low interest rates we will see an insurgence in the housing market. At the end of the day that is what we need to build this economy again – a robust housing market. I believe we will see a stabilization around the second half of next year.
The only way we can do that is if we continue to throw money into the system whether that be into credit cards, car loans and home loans. It is an unfortunate situation but what needs to be done to get us out of this mess.
Prabhjit Singh
P.,
I agree, the situation is desperate enough that it’s going to take a LOT of money to get us out of this situation. However, I’m not convinced that the money that has been spent so far has been spent in the appropriate ways.
It’s sort of like the “mud on the wall” philosophy. Let’s throw as much mud against the wall as possible and hope some of it sticks. The rest just gets swept out the door.
So far, the $600,000,000,000 that the Treasury has spent has bought us .375% in mortgage rates. That has equated to a nice little refinance boom. But is that enough to solve the problems in the housing market?
I don’t think it is.
Tom