Sunday, 19 October 2008

The dilemma of the dollar and the coming international summit meetings

Socialist Economic Bulletin has analysed the mechanism of the present international financial crisis in several posts. Its core is the long term overvaluation of the dollar. This overvaluation is demonstrated in the $700 billion a year US balance of payments deficit, which shows the uncompetitive position of the US economy at current exchange rates.
But such overvaluation of the dollar also means overvaluation of assets held in dollars in comparison to their real international market values. Eventually economic forces will bring dollar assets down towards their real values, but as they fall in price this destroys the balance sheet of institutions holding them - in turn creating a severe liquidity crisis. This, reduced to essentials, is the mechanism of the present global financial crisis.
Given that the decline in the price of overvalued dollar assets is inevitable, the relatively non-painful way for this adjustment to have taken place would have been a prolonged and gradual decline of the exchange rate of the dollar over many years. But this was strongly resisted by the US - it would have meant increased political discontent in the US as inflation would have risen and living standards would have been lower, and it would have put put economic pressure on the US to cut military expenditure and overseas operations such as the Iraq war. As the net debt position of the US increased large foreign holders of US assets also become concerned about a decline in the value of these holdings due to dollar devaluation.
For these reasons the decrease in the price of dollar assets took place not gradually, and over a prolonged period, but in the intense financial crisis that has gripped the world for the last months.
In the long term the uncompetitive character of the US economy means that there is no alternative to a reduction of the price of dollar assets down towards their real, much lower, values either via dollar devaluation or falls in their nominal values or both. And this will mean the US accepting a reduced role in the world both economically and militarily.
It is greatly to be hoped that the US accepts this decline gracefully, rather than running the risk of plunging the world into a new depression through futile attempts to avoid the inevitable.
There is no point, for example, in other countries lending large sums of money to the US, to prop up the dollar, when in the long run the only outcome of the attempt to avoid the inevitable will be that such countries suffer large losses as either the dollar devalues or the price of dollar assets they hold declines.
In the short term, however, an increase in the exchange rate of the dollar temporarily helps slow the decline in US asset prices, and therefore also slows down the fundamental mechanism of the financial crisis. To show the processes operating the graph below, therefore, shows the exchange rate of the dollar over the last six years. The most recent peak in long term movement of the dollar's exchange rate was on 27 February 2002.

As may be seen, for six and half years the dollar fell with only short term fluctuations. The decline between its peak on 27 February 2002 and its low point in this period, on 22 September 2008, was 23.7 per cent. To indicate the significance of the latter date, the nationalisation of US mortgage insurers Fanny Mae and Freddie Mac occurred on 7 September, the collapse of Lehman Brothers on 14 September, and the nationalisation of US insurer AIG on 16 September. By this point, therefore, the decline of US balance sheets was leading to widespread collapse of financial institutions and explicit panic on financial markets.
From 23 September onwards the dollar reversed course and began to rose rapidly - as may be seen in the graph. By the end of trading on 17 October the dollar had risen by 7.6 per cent from its low. This temporarily stabilised dollar assets in terms of real international prices.
The mechanisms by which the dollar moved sharply upwards will not be known with certainty in detail until figures for US financial flows are published but the most striking feature of this period was massive purchases of short term US Treasury Bonds - which drove up their price so sharply that the interest rate paid on them fell to record levels (if the price of a bond rises the rate of interest it yields falls). Taking closing prices on 17 October, the interest rate on 1 month US Treasury bonds fell to 0.06 per cent, that is virtually zero, and the rate on a 3 month bond fell to 0.79 per cent - that is under 1 per cent. The rate on 10 year US Treasury Bonds remained low at 3.92 per cent.
In short the rise of the dollar coincided with massive buying of short term US government bonds. It would be highly unsurprising if it were discovered that very large purchases of US Treasury Bonds by foreign banks and central banks took place in this period in order to attempt to slow down the long term decline of the dollar and take the immediate heat out of the financial crisis.
In short, two rescue packages were taking place. An open, explicit, one in most countries to save banks. And a hidden one to reverse, in the short term, the slide of the dollar. The two together slowed the slide into the financial abyss.
But this leaves the fundamental problem of the dollar unresolved. To make the US economy competitive the dollar must devalue. Even the nearly 24 per cent devaluation of the dollar up to 22 September 2008 had not brought the US balance of payments into anything resembling balance. As the dollar was overvalued US asset prices themselves remained overvalued.
The rise in the exchange rate of the dollar in the last month will have made this underlying situation worse and, therefore, left the world exposed to future precipitate collapses as dollar assets decline towards their real values. In short, the overvaluation of the dollar leaves the world open to precisely the type of crisis that has gripped it in the last month.
The process that should take place in that situation, and which would form a realistic agenda of the coming summits of world heads of state and government called by George W Bush and others, would be to organise a steady and progressive devaluation of the dollar, thereby accepting the inevitable but allowing this to occur, as far as possible, in an orderly and controlled, as opposed to a catastrophic, way. But that would be for the US to sit down and negotiate the terms of its own decline - precisely what it has refused to do for the last 20 years. But if the US refuses to accept that decline it builds into the foundations of the present economic system the potential of crises whose power has been amply demonstrated in the last month.
The coming international summits are therefore likely to be tense affairs.


Alun Griffiths said...

Earlier this morning I left a comment (under my pseudonym aneurinbevan) after the ridiculous article by Paul Myers entitled
"A rescue for everyone
Our decisive action helps families and businesses, and keeps the UK a world leader in financial services"
Yes of course Paul, we know what you mean.

My reply argued that the article was a lot of rubbish fueled by nepotism, (he was after all former Chairman of the Guardian Media group)
and invited readers who were as incensed as I ‹as to join in a potentially more meaningful and positive discussion here at SEB.
the comment was short and not impolite in any way.

This is what happened in return

Oct 20 08, 5:11am (about 16 hours ago)

This comment has been removed by a moderator. Replies may also be deleted.

It seems it maybe still difficult to get past the New Labour thoughtkeepers.

Bemused Economist said...

Terrific article.

"There is no point, for example, in other countries lending large sums of money to the US, to prop up the dollar, when in the long run the only outcome of the attempt to avoid the inevitable will be that such countries suffer large losses."

But they are still likely to lend the money. The problem being that this is not just about economics, but politics. The US is the world leader of capitalism. There is no other power that can replace it in that role: the bottom line is, the EU and Japan don't have the military capacity.

So the other capitalist countries must swallow the bitter pill and do what the US demands. The alternative is to let the US sink - but if they do that, the danger is the rise of imperialist blocs that would compete with one another and could lead to major wars breaking out. I.e. the hegemony of world capitalism would be lost.

mike said...

To Alun - perhaps if you post again, but only include the SEB link? Don't give them the rope to hang you with!

Alun Griffiths said...

Have done (there are advantages to living in France and being an early riser.

Check out the Guardian article on inequality, isn't it terrible when a grown up newspaper can't tell the difference between income and wealth distribution?

On a more mysterious note, as my alter ego on Facebook aneurinbevan I have been having some very interesting "conversations" with a Franklin B Rooseveldt, he dissapeared off the face of facebook this week. Shojuld we start getting paranoid?

And the last one, On the 24/25th November all the European Housing, Urban and sustainable development ministers are meeting here in Marseille where I live. We are making the link between, Money, Land and Environment and there is an alternative "Forum" being organised with initiatives in other european cities. I can send you some further info, but Would Ken come to Marseille 22-24 November?

Mr Banks said...

An excellent piece- just one point.

While it's true that the recent rebound in the US Dollar may have been caused by currency intervention (and we won't know until the US Treasury reports on international capital system (TICS)), such intervention is usually done with great fanfare and is generally difficult to do surreptitiously.

More likely, the temporary rebound in the US currency is because the vast foregn holdings of hedge funds and other speculators are denominated in US Dollars. So, when they are oblged to sell these foreign assets, to cover losses elsewhere or because their investors want their money back, they have to sell those foreign assets and buy US Dollars.

Why is this important? Only because it reveals a hidden truth about the period just ended; the the US and to a lesser extent the UK, were themselves operating like giant hedge funds, sucking in overseas assets, borrowing against them and investing in the rest of the world. Now that period has come to an end, the ovewhelming dominance of "Anglo-Saxon"-held capital and institutions has also ended with it.