A few years ago I wrote in Euromoney that a country whose currency was in demand as global capital could run a relatively high current account deficit without suffering a currency collapse. That country was the US and the currency was the dollar.
It is tempting to view the world’s imbalances as the result of a new economic order, whereby the rich economies become shopping malls filled with old age pensioners and the emerging economies produce everything for the malls and invest their economic gains there. Thus, the US becomes the world’s consumer and Japan and China are the world’s producers. And everything is priced and paid for with dollars that can be printed at will by the Federal Reserve. So the world economy moves forward seamlessly in a new long-term sustainable economic paradigm.
But does it? If you look at the world from the point of view of money flows, things do not look so stable. And if the monetary explanation is right, then the world of the dollar will not last.
Dollars exported by the US current account deficit flow fast to China and Japan. Normally, such dollar inflows would cause those countries’ currencies to rocket. But neither the Chinese nor the Japanese want that. So these dollars are sold by exporters to the banks at a “fixed” exchange rate for local currency and flood into domestic liquidity. The dollars are then reinvested by the Chinese and Japanese monetary authorities into US debt.
In the past two years, the Federal Reserve has removed the exceptional easing of monetary conditions that followed 9/11. Real Fed interest rates, by most measures, have returned to their long-term mean. But if you compute the cost of money used to price credit, Fed tightening has had little effect. The US yield curve has flattened or even inverted as the Fed tightened, because bond yields have not moved up much.
Inflation-risk optimism
The main reason for this is that markets are extraordinarily optimistic about long-term inflation. Think of a 10-year US treasury bond: what is the risk of investing in it? There is no material risk of default. The US government can always print money to pay its debts. The risk is that inflation will erode the value of your investment. Over the past decade, bond markets have become increasingly sanguine that inflation will stay low and have reduced the inflation-risk premium in bond yields accordingly. So the Fed’s tightening cycle has had little or no impact.
This will change when one or more of the following events occur. First, a return to persistently higher inflation. There’s plenty of inflation around at the producer level in terms of costs and prices. But it hasn’t translated into higher consumer prices yet. However, a simultaneous strong recovery in Japan, the US and Europe might just trigger this because that would use up spare capacity, labour and other commodity resources more rapidly.
Second, there could be a simultaneous tightening of monetary policy by the European Central Bank, the Fed and the Bank of Japan. This would suck liquidity out of asset markets and finally cause the ripple of tightening policy rates to become a tsunami for the cost of long-term capital.
Third, profits globally are near record high levels. But if wages rise, profit margins will fall. This could happen if tightening labour markets caused wages to rise faster than productivity and corporate pricing remained weak. Rising capital spending and lower profits would scissor corporate cash mountains.
Fourth, there is a whiff of protectionism in the air (whether over the free flow of goods or capital). This has the power to cause global liquidity to contract. The prime loser would be the US, which relies most on external financing.
Finally, there could be external political shocks. Energy empowers geopolitics economically. A ruthless Russia is already showing its readiness to use energy as a foreign policy tool. So is Iran over nuclear power. An Iranian oil embargo following a US military strike would create an earthquake in financial markets.
Any one or several of these trends could cause the cost of capital to revert to its mean, or double the current real rates. Then the US economy would lose its paragon status and the external deficit would become much more difficult to finance. The dollar would weaken as a result. The dollar’s role in the new global paradigm will not save it.
| The global liquidity story |
| How the dollars go around and around |
 |
| Source: Instrategy |