Tuesday, March 24, 2009

Will the exogenous demand for dollars reverse in 2009?

Less International Transactions in 2009
The easiest dynamic to demonstrate is a decrease in transactional liquidity needs. The world is experiencing a contraction in both real and nominal GDP. And while GDP has contracted on the order of a few percent, exports have contracted by much more. Over the span of a year, China's exports in February fell by 25.7% , Germany’s exports in January fell by 20.7%, and Japanese exports in January fell by 45.7%. While it is possible that we have reached the trough for export numbers, it is very likely that exports for the year of 2009 will fall by more than 10%. This decrease in trade means that the world will need fewer dollars for transaction purposes. As countries come to realize this fact, we can expect a marginal dis-hoarding of dollars allocated for transaction purposes.
Foreign Investment Opportunities Improve
There is no question that the desire for security of asset value has been a factor driving up the value of the dollar over the past 8 months. Why, then, might this trend reverse? There are two reasons:
1. Foreign holders of dollars might judge that the dollars are better spent on domestic consumption than on savings, or might judge domestic investment more attractive than dollar alternatives.
2. It may be judged that the US dollar is actually less secure than an alternative monetary asset.

The potential for the first reason can already be seen in China’s plan to spend $583 billion dollars on infrastructure and domestic growth for 2009 and 2010. I assert that much of the private savings in the world will shift toward investments such as this. Although the first reaction to a marginal decrease in yield on investments is for savings to seek a safe harbor, the next step is to spend those savings on consumption goods. This spending on consumption, in turn, improves the expectation of yield on investments and leads capital back into so-called risky assets. Thus, the first reaction of the world economy to a poor growth outlook was to seek a safe harbor (US treasuries). I predict that the next step will be for countries to reduce the stock of savings by spending a portion on real consumable goods and services. This leads to the final step of increasing expectations on investment yields. I expect that independent of other factors, the savings rate in China, Japan, and Germany will decline by the end of 2009, and that expected yields on private investment will increase over 2010 and 2011.
The second reason the trend might reverse is a Black Swan type of event (the Black Swan theory (in Nassim Nicholas Talib’s version) refers to a large-impact, hard-to-predict, and rare event beyond the realm of normal expectations). One possibility of such an unpredictable event might be that a powerful individual within the Chinese government became convinced that the US could not honor its debts with real production, either now or in the future. An argument I would like to refute is that the Chinese can’t stop accumulating treasuries or the value of their savings would go down. What kind of logic is this?
"See, if you try to spend it, it isn’t worth anything; therefore you should continue to accumulate it. So send what you produce with your hard labor to us instead of consuming it yourself and you can guarantee more of this asset that isn’t worth anything if you try to spend it."
This line of argument is simply rationalizing throwing good money after bad. If the only way to maintain the value of the dollar is by buying more of them (with yuan), than every dollar bought now will essentially be guaranteed a lower value when exchanged for yuan in the future.

A Zero-Growth World Economy
Finally, I believe that the strategy for export-led growth will change. A shift in this strategy could be led in the short-term by the increase in saving in the U.S. As the U.S. has been the primary engine of the export growth strategy, a secular reduction in U.S. consumption could make the strategy less attractive. However, there is a more fundamental and non-transitory reason why I believe this shift will occur: if the medium-term growth rate for the production of real goods and services in the world is zero or negative, then export driven growth is irrational.
To see this requires a bit of a thought experiment. First, take two extremes: imagine one world where the next period availability of goods is vastly greater and superior, and a second world where the next period availability of goods and services is vastly smaller and inferior. In the first world, export-led growth would make sense because the accumulation of savings in period one would lead to investments and projects that yielded a vastly greater amount of consumable goods in the second period. In the second world, export-led growth would backfire because the savings in period one would lead to investments and projects that yielded vastly fewer amounts of consumable goods in the second period. In a zero-growth case, large savings would yield the same amount of consumable goods in the second period. However, if the savings were in a medium that decreased in value, then it would be irrational. Using the same argument as presented above, if an accumulation of dollars increases its value, than a dishoarding of dollars decreases its value. Thus, the strategy of export led growth through pegging (saving in dollars) in a no-growth or negative growth world yields a lower level of consumable goods in the future.
As a side-note, the myth of never-ending growth is something so entrenched in economic theory and thinking, that some economic models aren’t even well defined when using a negative long-term growth rate. An analogy to this myth is the belief that the world was flat and the importance of this belief to clergy in the time of Galileo. While Christianity survived the realization that the world was round, religious leaders of the time could not imagine it to be so, and the very thought threatened their understanding of the world, including the place of religious dogma. So it is with the myth of never-ending growth: economics and human existence will continue after the myth has been dispelled, but any current suggestion that the economy will not grow forever often is discounted or treated as heresy. Among other things, a careful inspection of the recent history of marginal costs for producing new oil fields suggests that we should develop theories for zero-growth, as well as contingency theories for medium-term negative growth scenarios. Even the finest golden rule steady-state loses utility if its reality is confined to textbooks.
A Question of Probabilities
The US has a Current Account deficit of close to 6% of GDP, and has a net foreign asset position of negative five trillion dollars. The economy is contracting and this will lead to a lower demand for dollars for the purpose of transactions. Both of these factors unambiguously work to depreciate the dollar. While a reversal of the other two mechanisms is more speculative, consider this question: is it more likely to reverse or to continue the way it is? Put another way: are countries more likely to abandon export-led growth or to redouble their efforts? Are foreign investors and countries more likely to increase US treasury demand above their current level, or to increase their exposure to domestic industries and investments in other countries? I believe that the greater likelihood is that these mechanisms will reverse. Because these mechanisms have the potential to be discontinuous (such as when China abandons its currency peg), I believe that the time frame for a drastic adjustment in the dollar value could be quite short. In fact, I speculate that before the end of 2009, the majority of financial agents will see “the writing on the wall” and that a stampede out of dollars will ensue. Independent of timing, eventually the value of a currency needs to be tied directly to the relative supply of the currency and the relative attractiveness of goods produced by that country. Just as the US has enjoyed the benefits of exogenous factors of demand for its currency (in the form of increased purchasing power, and producing less than it consumes), so must the US suffer through the tax of exogenous factors that lead to the dis-hoarding of its currency.

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