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The Barbarian at The Gate
'Barbarous Relic' Sounds Death-Knell for Keynesians
by Alex Wallenwein, Editor & Publisher
The Euro vs Dollar Currency War Monitor
December 22, 2003
The following Reuters news item is outstanding in itself. Probably one of the best examples of financial news reporting I have seen so far. The reporter, Daniel Bases, is not afraid to say the unspeakable: that what normally counts as the accepted perspective of economic analysis - Keynesian analysis - is at a complete loss to explain the current phenomenon of free-falling dollar values during a time of rapidly improving US economic performance.
At the same time, the facts reported show not only the validity of - but the dire necessity for - ‘euro vs dollar’ analysis to get to the truth of the matter. Any economic analysis that fails to take into account the protracted assault on the dollar that the creation and existence of the euro has made possible, will be unable to explain current economic phenomena.
The Reuters news article is reproduced below, with commentary inserted in bold so it’s easy to tell which is what.
Alex Wallenwein
FOREX-Dollar gets no respect, hits record low vs euro
Reuters, 12.02.03, 3:37 PM ET
By Daniel Bases
NEW YORK, Dec 2 (Reuters) - The dollar hit a record low versus the euro on Tuesday in a broad sell-off as investors ignored a U.S. economic upswing and instead went along with the dominant dollar downtrend. (Emphasis supplied)
Interesting. Investors have never ignored an US economic upswing yet. What’s different this time?
Tuesday's strong November auto sales data and Monday's factory report showing the fastest pace of growth in 20 years would normally benefit the dollar. But investors have been forced to either join the dollar sell-off or get out its way.
That’s a strong statement: If you fight the dollar sell-off, you’ll get hurt.
"People try to put a reason behind this sell-off, citing steel tariffs or trade protectionism, but the truth is the United States has a huge trade deficit but does not have high enough interest rates to attract enough capital here to finance it," said Mike King, trader at Commerzbank in New York.
I thought we were told that a lower forex value of the dollar would help lower the current account and trade deficits? Why is this no longer so? Does it mean the dollar has yet to go lower? How much lower?
"Dollar weakness is just the way of things, and people need to sell dollars which, in a thin holiday market, makes the moves one way and very violent," he said.
Interest rates in the United States stand at a 45-year low of 1.00 percent and are not expected to rise anytime soon. With rates in the euro zone at 2 percent; in Britain at 3.75 percent; in Canada at 2.75 percent; and in Australia at 5 percent, the dollar is less attractive for foreign investors to purchase.
This is extremely significant. Worldwide, the US has the lowest interest rates which, all other things being equal, would make the dollar a less attractive currency than virtually any other. But other things are not equal. The US economy is running ahead of all others, even China’s, but the dollar is still being sold off. Why?
The euro surged to a fresh record high for the third day straight, touching $1.2091<EUR=> according to Reuters data, and measured a 1 percent gain on the day. Traders see the next resistance level for the surging euro in the $1.2125 area.
... and we will blow right through it.
In the last month, the U.S. financial markets have seen an outflow of foreign capital that is highly correlated to the decline in the dollar.
Here it comes:
According to the Bank of New York's portfolio flow monitor, a tool used to predict the direction of currencies, a net $2.3 billion in cash from both equities and fixed income exited the United States, while the euro zone has seen non-European investors plug 1.6 billion euros into the region's stock and bond markets. (Emphasis supplied)
And this despite the euro’s internal crisis threatening to derail the much-vaunted "Growth and Stability Pact", formerly the centerpiece of EU monetary and fiscal policy. The "Pact" was set up to discourage individual member governments from deficit-spending their way out of economic recessions. The recently revealed cracks in this bulwark against financial profligacy should have served to weaken the euro. Why didn’t it?
Further, this is first-hand proof of the validity of euro vs dollar fundamental analysis: These 2.3 billion in cash didn’t just exit the geographic United States: they exited the dollar-system altogether. That means dollars were sold and other currencies (mainly euros, as is apparent) were bought. Where do these divested dollars end up? In US hands. Some will go to pay for US imports, others will stay and circulate inside the US economy, further expanding the already bloated US money supply. A central axiom of classical economic thought is that:
Monetary inflation always causes price-inflation – eventually.
We are now entering that "eventually" phase of the fiat-dollar system’s thirty-year sojourn. Until recently, international dollar demand for trade and reserve purposes has enabled the US to run its printing presses till they glowed red-hot in the dark. Now, dropping world-wide dollar demand is sending those greenbacks flying home. The inevitable result: inflation.
Welcome, dear Traveler. Welcome home to true (classical economics-style) fundamental analysis. It doesn’t get any more ‘fundamental’ than this.
"We would have expected the U.S. equity markets to rally with such strong economic data and corporate earnings. On the fixed income side there is disappointment. Foreigners are not investing in U.S. fixed income because of interest rate differentials," said Michael Woolfolk, currency strategist at Bank of New York. (Emphasis supplied)
Oh boy! More pressure for Brother Al to raise rates - but he CAN’T! If he does, this "recovery" will run out of the only thing that really fuels it: printed paper of the currency variety.
Greenspan’s game plan is to "hope" that his printing presses will produce such a strong economy that he can afford to gently start raising rates. But where will the dollar be by that time?
If the dollar keeps dropping at its current clip, despite a booming economy, it will have lost another 20 to 30% by the time it’s safe to raise rates. We can let economists figure out what that means, quantitatively, in terms of domestic prices. But, one thing is for sure: they will go higher. Much higher.
Prices will go higher by the simple fact that a lower dollar means higher prices for imports, such as oil, electronics, and cars. Then add the "returning dollar" effect, and you have a recipe for hyper-inflation - US-style.
On Tuesday, Sterling hit a five-year high against the dollar for the fifth straight session, reaching $1.7309<GBP=> according to Reuters data, a gain of roughly 0.75 percent on the day. If sterling hits the $1.7350 area, it will be its strongest point since busting out of the ERM 10 years ago.
The dollar fell to a near two-week low against the yen of 108.60<JPY=>, off 0.68 percent, while hitting a six month low of 1.2850 Swiss francs <CHF=>, off nearly 1 percent, according to Reuters data.
Gold hit a 7-1/2 year high in the wake of dollar weakness.
U.S. ACCELERATION
But the dollar drop comes amid more good news for the economy.
Brother Al can only forestall, not prevent. To keep the economy bounding upwards while dollar-values drop, he must pump even more liquidity into the system. He doesn’t have much room left on the interest rate side of the equation. He will soon have to buy treasuries: at first short-term, then longer term ones. This will directly inject money into the system (the printed dollars he uses to pay for outstanding treasuries) and drive up bond prices, lowering their yields and thereby long term interest rates. He said he wouldn’t do it, but that was said after he had previously threatened to do exactly that, so don’t tell me he won’t go back on his word.
Buying treasuries, especially long-term ones, is about the only arrow he has left in his quiver. He may be hoping to entice foreigners into the game by hypnotizing them with rising treasuries prices – but $400-plus gold is now blinding their greedy little eyes to the splendors of dollar-investing. Will they jump aboard this treasuries-train? It doesn’t look that way. They already know where this train is headed.
If they don’t, who will finance the trade and current-account deficits? Answer: Nobody! The dollar will have to go lower still - way past the pain-threshold of Americans, and therefore of US policy makers.
On Tuesday, November U.S. car sales data were generally strong, giving more reason to believe the U.S. economy, which grew at a blistering 8.2 percent overall in the third quarter is speeding ahead, whereas its peers in Europe and Asia are still languishing.
"I call this the death of fundamental (economic) analysis. Every piece of economic data points to a stronger dollar, but it is not having an impact," said a market source at a money center bank in New York who requested anonymity. (Emphasis supplied)
Yes, that’s right. It is in fact the death of "economic" (speak: Keynesian economic) analysis. All of these factors interacting in this way cannot possibly be explained without taking Keynes’ nemesis - that "barbarous relic" called gold - into account.
On Friday, the November payrolls report will give a better read on whether job growth, a lagging economic indicator, is finally confirming the growth seen elsewhere in the economy.
Maybe it will, maybe it won’t. None of that will change the picture fundamentally. (Sorry to rub it in like that.)
U.S. payrolls are expected to rise by 135,000, but the November unemployment rate is seen unchanged at 6.0 percent.
(Hmm. How does that work??)
Elsewhere, the Bank of Canada kept interest rates steady at 2.75 percent on Tuesday, as expected. The U.S. dollar traded at at C$1.2970 <CAD=>.
The Reserve Bank of Australia is expected to hike rates 25 basis points to 5.25 percent when it meets late on Tuesday (New York time). The Australian dollar rose to a six-year high of US$0.7322 <AUD=> in anticipation of the rate increase. The Aussie dollar is now up some 30 percent since its 2002 close.
That traditional central bank policy tool for increasing currency-attractiveness is now a pure luxury - one the US Fed no longer has access to. It’s "Fed-in-the-Box" time. Brother Al’s only way "out" is to dig himself - and the US economy - in even deeper by opening the floodgates of monetary expansion even further.
That is, if he stays within the confines of Keynesian economic thought.
Within that confinement, the air is getting pretty stale by now. Sooner or later, he (or whoever will replace him) may just have to open the door to the golden Barbarian who is standing there, knocking ..... waiting ....
Might as well let him in now.
(Additional reporting by Gertrude Chavez and John Parry in New York and Justyna Pawlak in London)
Copyright 2003, Reuters News Service
© 2003 Alex Wallenwein
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