Sunday, September 14, 2008

When the dust settles...

…the sky opens… the light comes down… Lehman is history… and Fannie and Freddie are happily snuggled in the Federal government’s coffer… what happens to the dollar?

One of the most mystifying developments in recent weeks has been the dollar’s audacity in the face of tremendous and persistent upheavals in America’s financial markets. Upheavals that, somehow, don’t seem to rhyme well with the customary verse that “dollar = safe haven.” Yet, the dollar has been relentless, rising by double-digits against most major currencies—partly the result of a widespread stampede out of risky assets, be it commodities or emerging market stocks.

There are two ways one could proceed here. One is to spend endless sleepless nights, twisting and turning, trying to fathom investors’ psychology at times of generalized panic. Another is to keep cool and try to figure out instead what investors might do with their stack of repatriated dollars once the dust settles and the US Treasury opens the tap to support Fannie, Freddie and their debt/mortgage holders.

Not that the latter is an easier problem to tackle. If history is any guide, larger fiscal deficits have had a mixed impact on exchange rates: For example, the dollar strengthened during the early 1980s, when America’s fiscal deficit increased. Ditto for Japan, in the early 1990s. But other industrialized countries had the opposite experience, seeing their currencies depreciate as deficits widened: France in the early 1980s, Canada in the mid-80s or Finland and Sweden in the early 1990s. But then, is there anything we can say about the future of the dollar?

The good old story: Standard economic textbooks give us the story as first told by economists Robert Mundell and Marcus Fleming. Accordingly, when Hank at the US Treasury raises the budget deficit (say by giving out tax rebates or a fat bailout for Freddie), Americans will likely spend more—be it Heinz ketchup or a new home. Aggregate demand will go up, putting pressure on prices, and forcing Ben at the Federal Reserve to raise interest rates to keep inflation at bay.

Suddenly, American bonds look more attractive, so foreign money floods in to take advantage of the higher yield. Mind you, not only foreigners; Americans too, from pensioners in Topeka, KS, to teachers in St Paul’s, MN might decide that those exotic Japanese bonds they own are not longer as appealing as their American equivalents. And as the money flows in, the dollar goes up. So a larger fiscal deficit should be good for the dollar, right?

Ce n’est pas la vie: Life is not as simple as that… First of all, the story assumes that Ben will play it tough, rather than letting monetary policy loose to accommodate a rise in prices. But if he doesn’t, the higher inflation should be bad for the dollar, eventually. Importantly, the framework set by Messrs Mundell & Fleming makes a number of brave assumptions (for simplicity’s sake).

First, expectations are supposed to be static—meaning that the value of the dollar today will not be affected by how you, the Topekans or the Chinese expect future government policies to evolve. That’s kind of hard to buy—if you thought Hank or Ben might “blow” it at some point down the road, by letting public debt swell or inflation spike, you might want to sell your dollars today and send your money back to Japan… Read “larger deficit bad for the dollar.”

Secondly, the Mundell-Fleming model does not take into account any changes in investors’ perceptions of how risky are American assets compared to assets elsewhere in the world. What could prompt such changes? Uncertainty over future government policies, among other things. For example, if our foreign lenders suddenly feared that a larger deficit (and thus debt) might prompt the government to inflate its way out (i.e. allow higher inflation so that the value of its debt falls in real terms), they might decide to get out today. Read: “larger deficit bad for the dollar.”

How will it play in Beijing? But think of another scenario: What if investors bought US assets like Fannie and Freddie debt and MBSs precisely because they expected the US government to bail these companies out, if they failed? What a terrible disappointment it would be, if Hank let them down! I mean, who cares about the larger deficit (at least for the moment)? “Either you keep your (implicit) promise, Hank, or we get out!” Read: “larger deficit, good for the dollar!”

Arguably, Hank’s bailout of Fannie and Freddie was partly aimed at maintaining the appeal of US assets. For good reason, you might think. With foreigners holding 2.6 trillion of America’s debt, and a hefty chunk of Fannies and Freddies, it’s kind of hard to tell the Chinese “we don’t need you!” (Although… I can’t help thinking of the old motto that “if I owe you 100 dollars, it's my problem. If I owe you 2.6 trillion, it's yours!”) So Hank delivers, bond markets rally, mortgage rates drop… and the dollar?

Ultimately, persistently large budget deficits raise America’s foreign debt. So either the dollar has to fall to boost American exports and help us grow out of our debt (read: “deficit bad for the dollar”); or interest rates will have to rise to keep luring foreigners into buying US debt (read: “bad for mortgage borrowers,” defeating the purpose of the bailout in the first place!).

True, some foreign creditors (like the Chinese government) seem to be “infatuated” with US debt assets for their own growth-policy reasons, even if expected returns are negative. But even those guys are sending subtle signals they are considering alternative options.

Importantly, if I am a private, profit-maximizing investor, there is little to stop me from cashing in my gains from last week’s bond rally and get out of dollar assets—until I see interest rates rising again to levels that compensate me for the risk of higher government debt issuance in the future. Read: “larger deficit bad for the dollar!”

So there you go. A bailout providing short-term respite but building up pressures for both long-term interest rates and the dollar. Hard to see how Hank could stop these... well, unless of course he took out a real, M20B1 Super Bazooka!

Glossary: Mundell-Fleming model, deficit vs. debt, bailout, super bazooka.

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