What's Worrying The Chairman?
John Mauldin's Outside the Box

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Introduction

This week's letter is by Richard Duncan who is based in Hong Kong and is one of the brightest financial analysts I know. Richard is the author of one of my favorite books called The Dollar Crisis: Causes, Consequences, Cures. A new paperback edition that is revised and updated is now available at Amazon for under $14.

Richard said this piece is really an updated version of one of the new chapters in The Dollar Crisis. It looks at the federal deficit, the dollar, Greenspan and offers another explanation for why the longer end of the yield curve has stayed low while the Fed is raising rates on the short end.

Can the current account deficit undermine the Fed's ability to control US interest rates? Let's find out in this week's Outside the Box.

- John Mauldin

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Has The Fed Lost Control Over Interest Rates?

On November 19, 2004, Fed Chairman Alan Greenspan made an uncharacteristically blunt speech at the European Banking Congress in Frankfort that sent the dollar tumbling. He said the rest of the world would not be willing to finance a large US current account deficit forever and called into question the rest of the world's appetite for dollars. This may well prove to be the speech for which he is remembered by posterity, capping his tenure as the world's most influential central banker during an epoch of irrational exuberance that he did not prevent and that he was unable to control. He said:
Current account imbalances, per se, need not be a problem, but cumulative deficits, which result in a marked decline of a country's net investment position--as is occurring in the United States--raise more complex issues. The U.S. current account deficit has risen to more than 5 percent of GDP. Because the deficit is essentially the change in net claims against U.S. residents, the U.S. net international investment position excluding valuation adjustments must also be declining in dollar terms at an annual pace equivalent to roughly 5 percent of U.S. GDP.

The question now confronting us is how large a current account deficit in the United States can be financed before resistance to acquiring new claims against U.S. residents leads to adjustment. Even considering heavy purchases by central banks of U.S. Treasury and agency issues, we see only limited indications that the large U.S. current account deficit is meeting financing resistance. Yet, net claims against residents of the United States cannot continue to increase forever in international portfolios at their recent pace. Net debt service cost, through currently still modest, would eventually become burdensome. At some point, diversification considerations will slow and possibly limit the desire of investors to add dollar claims to their portfolios.

Net cross-border claims against U.S. residents now amount to about one- fourth of annual U.S. GDP.

This situation suggests that international investors will eventually adjust their accumulation of dollar assets or, alternatively, seek higher dollar returns to offset concentration risk, elevating the cost of financing of the U.S. current account deficit and rendering it increasingly less tenable. If a net importing country finds financing for its net deficit too expensive, that country will, of necessity, import less.

It seems persuasive that, given the size of the U.S. current account deficit, a diminished appetite for adding to dollar balances must occur at some point. But when, through what channels, and from what level of the dollar? Regrettably, no answer to those questions is convincing.
His remarks stunned the financial markets. Such straight talk from Chairman Greenspan on any subject is highly unusual, but on the topic of the dollar, it was almost flabbergasting, particularly since, as a matter of policy, the Fed does not comment on the dollar, ever. Within the United States government only the Treasury Secretary is permitted to discuss the value of the currency.

So why did Mr. Greenspan chose this time to draw attention to the long-run impossibility of financing the U.S. current account at current exchange rates? He pointed to the deterioration of the net international investment position of the United States, but that is hardly news. As can be seen below, it has been going on since Ronald Reagan was President.

Chart 1

Be that as it may, the deterioration in the country's net international investment position does not seem to be so alarming as to necessitate such an uncharacteristically blunt speech by Chairman Greenspan on a subject as sensitive as the value of the dollar. He, himself, said there was no problem financing it at present. Foreign central banks (although not foreign private sector investors) appear to have an unlimited appetite to buy dollars to prevent their currencies from appreciating so as to protect their countries' trade surpluses. Will they stop acquiring dollars and watch their economies be thrown into recession as their currencies rapidly appreciate just because the Net International Investment Position of the United States has reached a deficit equivalent to 25% of US GDP? Why would 25% be the threshold that would trigger a change in their behavior? Why not 75% of US GDP? Or 150%? When there is only one buyer in the market, vendor-financing will carry on for quite a long time even after the first signs of deterioration in that buyer's financial health have become apparent. And so it is in this case. If the United States' trading partners, particularly those in Asia pursuing an export-led model of economic growth, stop financing the US current account deficit, the US will import less and their export-dependent economies will be thrown into crisis.

There is a wide-spread misconception that the United States relies on the savings or other countries to finance its current account deficit. This is incorrect. During recent years, at least, the US current account deficit is financed primarily by money newly created by the central banks of other countries. Newly issued paper money is not the same thing as a county's savings. The companies that earned money by exporting to the US keep their savings. It is only that they keep them in their domestic currencies after having sold the dollars they earned from exporting to their central bank. In fact, the banking systems of the export-oriented economies all across Asia are burdened by too much savings. Excess deposits are increasing more quickly than viable lending opportunities and, consequently, interest rates have fallen to historic lows.

Therefore, it is not a matter of the US using up all the rest of the world's savings to fund its deficit. It is a matter of that deficit being financed by the central banks of the United States' trading partners. And, for their part, Asian central banks, in particular, have consistently demonstrated their ability and willingness to create money in order to finance the US current account deficit. Given that nothing has occurred to call into question their determination to continue doing so, there is no reason to expect that behavior to change any time in the near future. What else, then, could be worrying Chairman Greenspan?

He does not seem to be concerned about the loss of jobs in the United States even though the trend of moving manufacturing jobs to low wage countries is now being followed by a trend to outsource service sector jobs abroad as well. In fact, in his Frankfort speech, the remarks quoted above were preceded by a erudite preamble more typical of Mr. Greenspan identifying the diminution of "home bias" during recent years as the reason behind the radical expansion of the U.S. current account deficit; comments which helped obscured, without completely denying, the obvious fact that the deficit has been caused by the desire of Americans and non-Americans alike to buy their goods from the lowest cost producers, who for the most part do not manufacture their products in the United States.

Mr. Greenspan even concluded his remarks by calling for yet more product and labor market flexibility in the United States and elsewhere. He cited labor mobility as the reason that interstate trade imbalances are resolved without provoking crises within the United States. It is not quite clear what purpose he intended that example to serve, however, since it is unlikely he meant to advocate unrestricted labor migration between the United States, with a population of 300 million, and the developing world, with its population of over four billion.

He is concerned about a protectionist backlash against free trade, as he has made clear on many occasions. However, with the presidential elections just completed and little opportunity for voters to express their frustration over job losses until the next election in 2008, that would not have been reason for expressing concern over the current account deficit now. What else could be on his mind?

It may be that he is growing concerned that he and his colleagues at the Fed are losing control over interest rates, and, therefore, over the broader economy. The Fed began raising the Federal Funds rate in June 2004. Since then it has increased rates by 25 basis points on eight occasions, by a total of 200 basis points, to 3.0%. Despite that, the market-determined rate on 10 year government bonds has actually fallen over that period by 50 basis points to just above 4.0%. That cannot be what the Fed had hoped for when it began raising rates.

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The explanation for this unexpected outcome can be found in the imbalance between the amount of dollars being accumulated by the central banks of the United States' trading partners and the issuance of new US government and agency debt.

Chart 2

The former can be thought of as the supply of paper dollars, while the later represents the demand for paper dollars. When there is more supply for paper dollars than demand for paper dollars, as has been the case since the second quarter of 2004, interest rates fall.

Chart 3

Many countries around the world accumulate large stockpiles of dollars as a result of their trade surpluses with the United States. The central banks of most of those countries print their own currency and buy those dollars in order to prevent their currencies from appreciating when the private sector companies that earned the dollars exchange them for the domestic currency on the foreign exchange markets. The central banks then invest the dollars they have acquired into US dollar-denominated debt instruments, preferably US treasury bonds or agency debt, in order to earn a return. If the amount of dollars accumulated by foreign central banks exceeds the amount of new debt being issued by the US government and the US agencies during any particular period, then the central banks will buy existing government and agency debt instead of newly issued debt. By acquiring existing debt, they push up the price and push down the yield. That seems to explain why long bond yields have been falling since mid-2004 even though the Fed has been increasing interest rates at the short end of the yield curve.

If this reasoning is correct, the implications are quite disturbing given current trends in the current account deficit and the budget deficit. If the US current account deficit continues to expand from its level of $666 billion in 2004, as seems likely so long as the dollar remains at existing exchange rates, then the amount of paper dollars that foreign central banks wish to invest in US government debt will continue to expand. Meanwhile, the US budget deficit is widely expected to be lower in FY2005 (approximately $370 billion) than in FY2004 when it was $413 billion. That means that the government will issue less new debt this year than it did last year. Presumably, the same will be true of Fannie Mae and Freddie Mac, in light of the accounting scandals in which they have become embroiled. Under such circumstances, there will not be enough new government and agency debt issued to satisfy the demand of foreign central banks. Consequently, they are likely to buy existing debt instead, which will have the effect of pushing up the price of those bonds and driving their yields down even further...regardless of what the Fed does to the Federal Funds rate.

Mortgage rates are determined by the yield on 10 year treasury bonds in the United States. Therefore, if foreign central bank buying drives down the yield on treasury bonds, it will also push down mortgage rates, which in turn will cause the rate of increase in US property prices, already the fastest in 25 years during 2004 (and the fastest ever in real, inflation- adjusted terms), to accelerate still further. Higher property prices will allow yet more equity extraction which, in turn, will stimulate US consumption further. Additional consumption will pull in more imports and exacerbate the US current account deficit. And, a larger current account deficit will put yet more dollars in the hands of foreign central banks, who, then, will look for still more dollar-denominated assets in which to invest them. At the same time, rising house prices and booming consumption will lift US tax revenues, causing the US budget deficit to shrink much more than currently expected.

In other words, if the US current account continues widening faster than the US budget deficit, it could drive down yields on government bonds and therefore the interest rates on mortgages so low that it creates an asst bubble in the United States that the Fed could not control.

What policy options are still open to global policy makers to prevent the current imbalances from leading to a cycle of spiraling economic overheating along the lines described above? Mr. Greenspan told his Frankfort audience that the US government should reduce its budget deficit in order to reduce the country's current account deficit. Specifically, he said:
U.S. policy initiatives can reinforce other factors in the global economy and marketplace that foster external adjustment. Policy success, of course, requires that domestic savings must rise relative to domestic investment.

Reducing the federal budget deficit (or preferably moving it to surplus) appears to be the most effective action that could be taken to augment domestic savings.
But, what would happen if the US government did balance its budget? It is possible that the US current account deficit would expand less quickly, although that was not the case in the late 1990s when the government's budget actually went into surplus while the US current account deficit continued to worsen. It is even possible that the US current account deficit would contract a little. For sake of argument, then, imagine that the budget deficit is balanced and the US current account deficit is reduced from $666 billion a year to $500 billion a year. At present, foreign investors own approximately 50% of the $4 trillion in US government debt that is held by the public. Under the circumstances just described, within four years, foreign investors could end up owing all outstanding US government debt. After that, they would have no choice but to invest their annual surpluses into other dollar-denominated assets, such as agency debt, corporate debt, equities, property, bank loans, etc. Such a scenario would cause extraordinary asset price inflation, directly as foreign investors bought more and more US assets, and indirectly as their acquisition of bonds drove down interest rates, providing still more unwanted stimulus to the US economy. Perhaps Mr. Greenspan should be careful what he wishes for.

Regardless, then, of whether the US government reduces its budget deficit or not, it would appear that the rapidly expanding US current account deficit has begun to undermine the ability of the Fed to determine the level, or even the direction, of interest rates in the United States. Moreover, if the present trend in the current account deficit is left unchecked, the investment of ever larger amounts of dollar surpluses by foreign central banks into US dollar-denominated assets threatens to produce asset price bubbles and economic overheating in the Untied States over which the Fed would have no power to control. Seen from this perspective, there is little wonder that the Fed has begun to talk down the dollar. These fears may also explain why the United States has recently launched an aggressive campaign to force China to revalue the Yuan.

Finally, it is also worth noting that the extraordinary accumulation of dollar reserves has begun to impact third party countries, as well. When investors diversify out of dollars and into euros, for instance, they then invest those euros in euro-denominated debt instruments and thereby push up bond prices and push down bond yields in Europe. This explains why German government bond yields are currently at a 109 year low. Soon, this could make economic management in Europe more difficult, too.

Such low yields on government bonds in Europe, the US and elsewhere around the world also threaten the solvency of life insurance companies and corporate pension schemes which will be unable to meet the guaranteed returns promised to policy holders and retired workers if interest rates continue falling.

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The surging US current account deficit is creating numerous destabilizing imbalances in the global economy. The Fed seems to have only begun to understand the full implications of this now that the current account deficit has grown so large as to undermine their ability to control US interest rates. Their best hope of regaining control over the situation is for the United States to force a sharp devaluation of the dollar relative to all the Asian currencies in order to reduce the US current account deficit; the European economies are simply too weak for the Euro to bear any more of the burden of adjustment. The United States has now adopted – and begun to enforce – a Weak Dollar Policy. Asia must come to terms with this fact and recognize that this policy shift poses a grave threat to its export-led model of economic growth.

Conclusion

I hope you enjoyed this week's look at the global imbalances, the dollar, the Fed and interest rates. You can read more of Richard Duncan's thoughts by ordering a copy of The Dollar Crisis: Causes, Consequences, Cures from Amazon.

Your still bearish on the dollar (except for the euro) analyst,


John F. Mauldin
johnmauldin@investorsinsight.com

Disclaimer

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Posted 06-20-2005 2:47 AM by John Mauldin