Currency Determination at the Intersection of Economics and Politics

July 14, 2016

Contrary to popular opinion, politics and economics do not operate in separate universes.  Politics is the business governing who gets to make the rules for all other business activity and how the laws will be enforced and interpreted.  Politics determines policy, and abrupt changes in policy and policy communication influence economic performance profoundly.  That’s why forward-looking currency markets are very sensitive to political change.

While some big political changes affect economic trends only slightly, history is full of ones that have been flashpoints for economic change.  The election of Francois Mitterrand, a socialist, to France’s presidency in May 1981 was followed by the implementation of broad leftest macroeconomic policies including the nationalization of some industries, and three devaluations of the French franc ensued within a year and a half. Alternatively, when Helmut Kohl led a right-of-center coalition to power in Germany, winning his first election in March 1982, the ensuing change in policy was not as meaningful as might have been expected, and the mark and its many European satellite currencies failed to halt a broad dollar upswing that began in 1980 and did not crest until February 1985.

Some of the biggest economic disturbances with political origins occur in the absence of a government-toppling election.  Political scandals can do enormous damage to investor confidence.  The Watergate crisis of 1973-74 saw U.S. share prices lose almost half their value.  In that period, too, world oil prices quadrupled, fixed dollar parities were abandoned, and the U.S. economy experienced its most severe post-WW2 recession up to that point.

Markets are now coping with three enormously important political changes and some other strains of a political nature.  These are early days in the Brexit saga.  Initially, the yen and sterling moved sharply but in opposite directions.  Against the dollar, sterling plunged from a high of 1.5019 to a low of 1.2798, and slightly more than three-quarter’s of that slide remains intact.  The yen was a beneficiary of safe-haven inflows, rising from 106.94 per dollar to a peak of 99.10, but just 17.7% of that movement has not been reversed already.  Brexit has direct short-term and long-term negative implications for the British economy that most people agree on, even if the magnitude of the likely damage is still in dispute.  Japan, by contrast, was affected indirectly and for reasons that had nothing to do with the current state or outlook of Japan’s economy.  Moreover, while sterling depreciation is a natural market adjustment to changed fundamentals, yen appreciation constitutes a movement that would deepen Japan’s economic woes eventually.  While British officials accept the need for a weaker pound, their Japanese counterparts wasted little time in indicating a readiness to take potentially drastic policy measures to restore the yen to a more competitive level in keeping with Japanese fundamental economic trends.

The U.S. election of 2016, should Donald Trump win with his unique blend of changed policy changes, might dwarf all other political market triggering events seen in the last 50 years.  Federal Reserve independence likely would be one victim.  Elements in the Republican Party led by Ron Paul want to return to the gold standard and perhaps eliminate a U.S. central bank altogether.  Paul’s professional training was as an OB/GYN, and his ideas on matters of economic policy were influenced heavily by Ayn Rand, a novelist.  In politics, unlike most professions including medicine, proof of technical competence is not a requirement.  A lot of what Trump would like to do might be challenged on constitutional grounds, but that would create even more uncertainty and confusion, which oftentimes spurs financial market volatility.

The Trump phenomenon tells more about the state of America in 2016 than about one particular aspiring political leader.  There is great anger in the land, as also attested by the unexpectedly strong run of Sanders for the Democratic Party nomination.  Trump’s anger is directed against the “other,” whether that be other countries, other races, or women.  In Trump world, every interaction between people is a competition resulting in a winner and a loser.  Life is a zero-sum game, and this explains his suspicious view about trade.  Trade only makes sense if it can be so arranged as to give the United States an unfair advantage.  Those feeling the Bern also see the world organized in a we versus they way, only for them along lines of class.  The system is rigged against the have nots.  The popularity of Trump and Sanders with wide segments of the U.S. population reveals a loss of confidence in U.S. capitalism and democracy to the point of feeling there is nothing left to lose.  Political revolution is a gamble that societies seldom are willing to take except as now when the status quo feels intolerable and expectations of a evolving change for the better are extremely low.

From where I sit, neither Trump’s xenophobia nor Sanders’ railing against Wall Street explains the root cause of the disturbance, which is the homegrown changes made possible by Silicon Valley.  Without those breakthroughs, globalization would not have occurred on the scale that it did at this time.  The subprime mortgage crisis and ensuing global recession would not have transpired.  The fastest growing elements of the U.S. economy would not be employing as few people as it does.  In this different world, U.S. productivity would probably be expanding faster, not slower, than  it is.  Sooner or later, Silicon Valley will likely fall into the cross-hairs of the public’s search for something to blame for the present state of affairs.  That’s going to happen regardless of who wins November’s election, because curtailing the power of Wall Street and turning America’s back on the rest of the world are not going to make the evolution of social problems go away.

Copyright 2016, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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