When Only a Much Weaker Dollar Will Do, Part Two of Two
How large a decline in the dollar is required to allow for a meaningful adjustment in relative wages? While it is impossible to make precise estimates, taking a look at real effective exchange rates, which allow for such cross-border wage comparisons, something on the order of 30-40% is probably required. This is in addition to the approximately 20% devaluation of the dollar that has already taken place since 2002, when the current downtrend began.
Once unemployment declines far enough, say to 5% or so, wage pressures are likely to build. Eventually, wages will rise to the point that they enable households to service previously accumulated debt burdens. Once that happens, sustainable growth will again be possible, although households will find that their global purchasing power and relative standard of living has declined dramatically. This is another lesson of the stagflationary 1970s, in which the US standard of living was more or less stagnant yet that of the ROW, including Japan and Germany, increased markedly.
Those who recall the 1970s must wonder why on earth the Fed would want to enact policies which would in all probability lead to a similar set of stagflationary conditions. Well, the Fed might claim that it doesn’t have much of a choice. Once originated, debt needs to be serviced. It can however be serviced in a strong or in a weak currency. A country with a solid infrastructure and industrial base and with plentiful natural resources might manage to service debt in a strong currency just fine. Indeed, had the US run up its accumulated debt in order to finance sensible investment projects over the years, it would most probably be able to manage to service this debt without resorting to dollar devaluation. But sadly, much of the debt the US has piled on in recent decades has been used to finance consumption rather than investment. And to the extent that the US has invested in rather than consumed capital, much of it went into malinvestments: the dot.com and subsequently far more massive housing and securitized credit bubble, which grew with the support of all manner of federal subsidies–courtesy of Fannie and Freddie, among other federal agencies–and, of course, artificially low Fed interest rates.
The debt-financed consumption and housing boom is now over. Yet the debt remains. It cannot be properly serviced with the existing productive resources of the economy. As such, the debt needs to be either devalued or defaulted on. The Fed and US policymakers generally have made it exceedingly clear that they prefer to devalue–inflate–the debt burden away rather than to go through a comprehensive default and debt restructuring process.
Of course that other road could be taken. But why are policymakers so dead set against it? Well believe it or not, Chairman Bernanke himself has previously weighed in on this matter. In his opinion, it comes down to politics and the ability, or inability, to make tough choices:
[R]estoring banks and corporations to solvency and implementing significant structural change are necessary for … long-run economic health. But in the short run, comprehensive economic reform will likely impose large costs on many, for example, in the form of unemployment or bankruptcy. As a natural result, politicians, economists, businesspeople, and the general public … have sharply disagreed about competing proposals for reform. In the resulting political deadlock, strong policy actions are discouraged, and cooperation among policymakers is difficult to achieve. [emphasis added]
Now wait a minute. When did Bernanke say that he preferred “comprehensive economic reform” rather than zero interest rates and open-ended liquidity creation (e.g. quantitative easing)? Well guess what, he was not talking about the US in the above paragraph, but rather about Japan. What Mr. Bernanke thinks is required for Japan to achieve “long-run economic health” somehow doesn’t apply to the United States!
But of course it does. The above quote indicates that he probably knows that it does. But as he also says above, to take such action “will likely impose large costs on many”. Indeed it would, including of course those financial institutions supposedly regulated by the Fed, many of which have been bailed out, yet are still sitting on large holdings of bad loans and toxic securitized debt. It is much easier to understand recent Fed policy actions in light of the above admission that the Fed is focused primarily, perhaps exclusively, on the short-run health of the financial system rather than long-run health of the US economy generally.
It is quite possible that the euro-area governments, Japan and other countries will resist a US Fed policy of foreign asset purchases by countering with purchases of their own, the net result being that the dollar does not devalue but rather that the global money supply soars. There is no doubt that, in this situation, investors will attempt to escape the risk of a general, global fiat currency devaluation by fleeing into real assets, most probably liquid commodities, including of course precious metals. An all-out currency war could thus spark an incipient hyperinflation which, if policymakers did not take immediate action to restore fiat currency credibility–possibly by implementing Volcker-style rigid money supply targets, or even by pegging to gold–could spiral out of control. While we consider a global hyperinflation scare unlikely, the fact that a global currency war has begun should give investors pause for thought.
[Editor’s Note: The above essay is excerpted from The Amphora Report, which is dedicated to providing the defensive investor with practical ideas for protecting wealth and maintaining liquidity in a world in which currencies are no longer reliable stores of value.]