Foreign Exchange Insights: July 17th
July 17, 2009
What ended the Great Depression? The commonest answer, the Second World War, tells only part of the story. Here’s a clue: currency policy played a critical role in the solution. Had U.S. economic activity kept declining at the horrific pace of 1930-32 until America’s entry into war at end-1941, there would not have been any embers of economic life left to resurrect. As the current global recession and Japan’s lost decade demonstrate, protracted financially triggered downturns transition through distinctly different stages, none of which should be mistaken for a normal business cycle. The heart and soul of the Great Depression occupied the calendar years 1930-2, when real GDP plunged 9.6% per annum. During the six years to 1938, annual growth averaged +5.4% despite negative growth of 1.2% in 1933 and 3.6% in 1938. After a lively recovery bunched into 1934-7, the experience of 1938 was a sobering reminder that the economy had not in fact healed to the point of standing on the private sector. An attempt to withdraw fiscal and monetary stimulus produced the setback of 1938. So the whole 1930’s are remembered as a period of depression. It indeed was from a labor market standpoint, and it took a very long time for activity, demand, and wealth to return to pre-depression levels.
The Great Depression stabilized a long time before it truly ended. In the Lords of Finance, an accounting of global financial and economic history from just before the First World War to the Second World War, Liaquat Ahamed argues that closing all banks for several days at the start of the Roosevelt Administration gave a vital boost to depositor confidence but that the myriad New Deal fiscal programs and accommodative monetary policy measures had little lasting effect and were counterproductive in some instances. Ahamed maintains that the real stroke of genius was taking the United States off the gold standard and devaluing the dollar. Roosevelt ordered this move April 1933 against the advice of virtually all his advisors and most of the economists at the time. John Maynard Keynes was incidentally a notable exception from informed experts. While many people fretted about future inflation from deficit spending as they are doing now, Roosevelt reasoned that the immediate threat and key economic albatross was deflation, that commodity prices tend to rise when the dollar falls, and that a devaluation would be the best way to stop deflation, which had driven the propensity to save to excessive heights and was producing draconian real interest rate costs. Financial markets and the U.S. economy both responded positively to dollar depreciation, just as Britain had earlier been spared the severity of downturns elsewhere after that country abandoned the gold standard in September 1931.
It figures that a period of greater currency micro-management lies ahead. The attraction of a soft currency to promote growth persists, even though fixed exchange rates were discarded almost 40 years ago and global deflation in the past year has been not nearly as intense as in the 1930’s. The bankruptcy of Lehman Brothers last September ushered in the ground-zero portion of the Great Recession. The two-quarter sequence between 3Q08 and 1Q09 was akin to 1930-32. The net movements of the euro and dollar since September 12th are insignificant. EUR/USD firmed 09%, while the trade-weighted dollar and euro are respectively about 2.0% and 3.0% stronger. Other currencies, however, have either moved more sharply or drawn closer scrutiny from their governments and others.
In a prescient move before the brunt of the global recession, Beijing officials halted a three-year-long gradual appreciation of the yuan in mid-2008. In the four years since an initial revaluation on July 21, 2005, the yuan has gained 4.9% per annum against the dollar and performed much more weakly against other major currencies. A currency policy that protects exporters continues to augment massive fiscal support, and China’s economy is leading the Asian economic revival of 2009. With $2.132 trillion of reserves, Chinese officials have also been outspoken in lecturing U.S. officials not to debase the dollar. While participating actively in Treasury auctions, there are indications that Beijing may be discretely diversifying into other currencies at other times.
Swiss monetary officials are more sensitive to the franc’s value within Europe than against the dollar and launched a policy in March to prevent any further appreciation with currency intervention and a loose monetary policy. The line in the sand is believed to lie at Chf 1.50 per euro, although officials have avoided mechanistic formulas to retain unpredictability. The strategy has been very successful. The franc had been as strong as 1.458 prior to the new policy but has stayed consistently above since it, including 1.522 at present. Even so, the dollar is down 4.6% against the franc since September 12 in contrast to its modest gain versus the euro.
If currency strength equates to economic weakness, the biggest loser among G-7 countries has been Japan. The yen has advanced about 15% against the dollar since September 12 and a nearly equivalent amount on a trade-weighted basis. Japan’s currency also has soared 30% over the past two years against the dollar, a move that could not have occurred at a worse time. Japanese GDP plunged 8.8% in the year to 1Q09, more than equivalent drops of 4.9% in the eurozone and 2.5% in the United States. Since a controversial policy of extraordinarily heavy intervention by Japan, the Ministry of Finance has stayed on the sidelines since mid-March 2004, but that abstinence may end soon. The incoming vice minister for international monetary affairs, Tamaki, hints that Japanese currency policy may turn more proactive. In the likely event of a new party in power after Japanese elections on August 30, the political opposition also is predisposed to revisit intervention and other tactics to weaken the exchange rate.
Among many structural and cyclical problems plaguing Britain, an appreciating currency is not one. The dollar is about 10% stronger against sterling than it was on September 12th. Bank of England officials have been criticized by officials in Euroland for not paying enough attention to the falling pound. Currency manipulation can take two forms, blatant steps to promote a directional movement or doing nothing to stop a trend that appears excessive.
Commodity-sensitive currencies were the most well-bid group during this past week but remain weaker than last September. So far this week, the dollar is down around 3-4% against the Canadian, Australian and New Zealand dollars, but the buck’s gains against them since September 12th range from 2.5% to 5.0%. From time to time, monetary officials in those three commodity producers have spoken about the negative implications of currency appreciation for growth prospects. Statistics Canada reported the first on-year drop of consumer prices since 1994 today, and New Zealand earlier this week announced a drop of its inflation to a 7-quarter low of 1.9% from 3.0% in 1Q09 and 5.1% in the third quarter of 2008. This is not a time to worry about imported inflation associated with currency depreciation.
Confusion over whether the green shoots of spring will continue to bloom or get eaten prematurely by the deer has lately robbed currency trading of any strong follow-through. One day, investors are inclined to extend risk, and the next can see fear recapture market psychology. The dollar has been one of several barometers of risk, gaining favor in risk-averse markets and sliding back wh
en risk-taking returns. Complaints from Chinese officials reflect a long-term view in ascendency that when support from risk aversion disappears more enduringly, the dollar will become susceptible to a major downward adjustment because of enormous budget deficits that are not counter-balanced with an equally tight monetary policy.
And what about gold, the measure of currency strength or weakness when the Great Depression struck? While the U.S. currency’s most important bilateral relationship with the euro has been remarkably steady over the past three months and shows trivial net change since Lehman’s failure, a weaker dollar picture emerges when one considers the 22.5% net rise of gold, implying a roughly 18% debasement of the greenback. Perhaps gold is foreshadowing what lies ahead for the dollar’s currency relationships, but perhaps not insofar as much else is not the same as in the early 1930’s. Interestingly, commodity prices did not rise, which after all was the intent of Roosevelt’s gamble. Such instead have dropped by about 21% since mid-September.
Copyright Larry Greenberg 2009. All rights reserved. No secondary distribution without express permission.
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