Currency Thoughts

Weekly Foreign Exchange Insights: February 22nd

February 22, 2009

Intensifying risk aversion was apparent last week in loud chatter over the possibilities of emerging market debt defaults and nationalisation of many big banks.  If vocalized fear wasn’t enough, sharp additional declines in share prices provided quantifiable proof that elevated risk aversion was indeed real and not just a lot of talk.  In currency trading, the dollar continued to thrive especially against commodity-sensitive currencies on risk aversion, advancing by 1.9% against the kiwi, 1.5% against the Ozzie dollar, and 1.1% against the Canadian dollar.  But in a twist suggesting a mutation in the currency market response to the ebb and flow of risk preferences, the yen dropped 1.1% against the dollar and touched 94.47 at one point versus a previous week high of 89.72 per dollar.  By contrast, the dollar edged only 0.1% higher on balance against the euro and lost 0.5% against sterling, currencies that previously had done poorly when risk aversion spiked.

The conference on the financial crisis that I attended on Friday at Columbia left the attendees like myself with many questions.  The adage was proven that three economists asked a question will give you four explanations, only in this case there were 32 esteemed experts on the program.  Some big concerns of mine were not resolved.

• Will the United States, like Japan before it, emerge with a substantially reduced trend rate of growth?  I believe it will, and I worry too about the economy’s future tolerance for incremental increases in interest rates.  Part of Japan’s liquidity trap has been the inability subsequently to tighten either fiscal or monetary policy without fear of a new recession.
• Will lessons learned from the 1930’s prevent this crisis from approaching the severity of that one even if the financial market difficulties, as many of the experts think, are worse now than then?  Or is it possible that elements of the Great Depression were overlooked and that either not enough knowledge was gleaned to prevent its replication or that political roadblocks will impede the ability of avoiding dire consequences this time.
• Where’s the bottom in the current recession from the standpoint of timing and cumulative magnitude?  This question can be applied either to asset prices or to real economic activity?
• What is the primary cause of the crisis, and what should be done to fix that problem and make sure it doesn’t happen again in a few years?  This was the main search of the conference.  Many plausible causes were offered, and recommended policy changes also ranged widely, depending on the perceived main area to be repaired.

The discussions left me pessimistic.  Here we are nearing the U.S. recession’s 16th month, and the dinner speaker, George Soros, captured the mood of almost all speakers in declaring no evident sign of a bottom to yet be in sight.  Professor Jeffrey Sachs observed that $40 trillion of lost global wealth isn’t coming quickly back even if the banks were to be fixed.  Professor Bruce Greenwald blamed the collapse of manufacturing in one economy after another over many years and found such to be reminiscent of a similar destruction of agriculture that occurred in the 1920’s.  I figured somebody was going to blame Federal Reserve policy, and that explanation came from Professor Bob Mundell, who said the 30% rise of the dollar against the euro from $1.6038 on July 15th to $1.2331 fifteen weeks later represented a huge tightening of monetary policy in a period of soaring demand for money that wasn’t allowed to get met by equally rapid growth in the money stock.  For the record, the dollar fell 13% against the yen over those weeks but did gain 21% on a trade-weighted basis.  Mundell recommends that officials target the dollar between $1.20 and $1.40 against the euro and stop the hemorrhage of wealth by slashing taxes on corporate profits and making the Bush tax reductions permanent.

Professor Bob Aliber outlined a domino theory of bursting bubbles, each created by Ponzi finance: first the Latin American debt crisis, next Japan’s property and stock market bust, then the Asian crisis of 1997-8 and now the U.S.-triggered global banking crisis.  Another way to look at this view is that the three earlier events were serious but preliminary earthquakes leading up to the “big one.”  Aliber blamed savings/investment imbalances in different regions.  Martin Wolf also pointed a finger at current account imbalances, noting that China had and remains determined not to repeat the mistake of earlier crises when countries heavily reliant on foreign capital inflows suffered deep currency depreciations and recessions when money flows reversed direction. I confess to a certain satisfaction to hear that yes, Virginia, current account imbalances do matter.

Other speakers blamed regulatory lapses but disagreed over whether the fault lay in the design of regulations or in how they had been implemented.  Several felt that a two-tier regulatory approach in the future would be necessary including former Fed Chairman Paul Volcker, with any systematically important institutions subjected to very close scrutiny.  Fears were also expressed about how to strike the right balance between preventing destructive cycles of boom and bust without squelching necessary opportunities for innovation and the funding of entrepreneurship.  A working paper was presented by Professors Roman Frydman and Michael Goldberg that identified a capital-allocating role for asset price swings but a need to respond to swings that become too excessive.  Their paper, which struck this long-time observer of currency movements as practical, recommends the establishment of guidance ranges beyond which policy resistance would be applied progressively to further cumulative movement.  Professor Shiller said that what we need to restore is not so much confidence, a term we analysts like to throw around, but animal spirits, and he recommended a number of steps that could improve the dissemination of risk information like subsidies for people to employ a personal financial advisor.  Others attacked transparency as a red herring, maintaining that such is plentiful and that the real problem lies in misunderstanding information that had intentionally been made too complicated for mere mortals to fathom.

The conference did not leave me with significantly altered currency views.  The second dinner speaker Dr. Josef Ackermann of Deutsche Bank, was asked a question I get often, namely whether members will defect from Europe’s common currency union.  He warned of possibly catastrophic consequences if that happened, which isn’t the same as saying it couldn’t happen.  The message on all economies is that they will remain in deep recession in the near term and that surprise policy changes will continue to happen  In such uncertainty, the response of currencies accordingly also remains very opaque.  Risk aversion isn’t about to melt away, but neither can one be sure that risk aversion will continue to translate into dollar appreciation.  My long-term view on the dollar remains adverse.  The United States has a current account deficit that needs to shrink.  That goal would not be served by appreciation.  It also seems that there is no going back to the world before August 2007, and a major hallmark of that world was the sustainability of very large external imbalances.  If Fed policy has to be very loose for longer than generally expected, the dollar also will be prone to negative forces.  Only Volcker from among all the speakers expressed strong concern that present policy stances may be planting the seeds of future inflation.  Finally, gold is again on the rise, a development that suggests mounting doubts about long-term dollar stability.

Copyright 2009 Larry Greenberg.
  All rights reserved.  No secondary distribution without express permission.

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This entry was posted on Sunday, February 22nd, 2009 at 10:48 pm and is filed under Foreign Exchange Insights and Next Week. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.