So here we are nearly 6 years removed from the last global financial crisis – surely not the last – and while a lot has been done by global economic policymakers, it seems that not much has really been accomplished. Globally, debt has risen since the crisis despite the cries from some quarters of “austerity”; deleveraging is a myth. Even in the US, where we have had at least a minor amount of debt reduction relative to GDP, the mortgage debt that caused the last crisis has merely been replaced by government debt (to fund questionable “stimulus” projects and income supports), corporate debt (to fund stock buybacks), education debt (to fund bloated university budgets), sub prime auto loans and debt used to fund energy exploration (shale). Monetary policy has been the main economic tool utilized – despite the fact that monetary policy was largely to blame for the last crisis – and we’re once again, predictably, talking about the possibility of bubbles in various asset classes.
And yet, despite the fact that we haven’t really addressed our problems, something very positive is going on right now – the US dollar is rising against the rest of the world’s currencies and against gold and other commodities. I’ve spent most of my career tracking the flight of the dollar and the global capital flows it precipitates and much of my negativity about the US economy over the last decade has been merely a recognition of the weak dollar environment. A return to a strong dollar would be very positive for the US economy in the long run but only if US policymakers see it for the positive it really is and resist the urge to join the global currency war. I am far from certain it will be seen that way.
The great irony of the currency wars is that the countries who see themselves as “winning”, by driving down their currencies’ value relative to their neighbors, are actually waging war against themselves and their own citizens. They are, quite deliberately, driving capital out of their countries and discouraging investments that will lead to improvements in productivity and long term economic growth. The choice to devalue is, more than anything, a political choice. A country with economic problems can opt to devalue their currency over time, revealing the impoverishment of their citizens slowly, or they can reveal it all at once and allow the bad debts to be extinguished through default. Either way the impoverishment has already happened; the choice is how to reveal it to the populace. The first choice is the easier one politically because the pain is spread over a longer period and the politicians can find villains to blame for the weak growth that results (see the current debate over inequality). The second choice involves considerable short term pain and a quicker, more robust recovery but reveals the bad political choices that generally caused the underlying problem.
The contrast between the two paths is starkly illustrated by the difference between the response to the 1920-21 US depression and the one that stretched from 1929 to WWII and required the use of capital letters. The first one, as outlined by Jim Grant in his new book The Forgotten Depression, lasted roughly 18 months and involved little government interference in the healing process known as depression or recession. The second one involved massive intervention – started under Hoover and accelerated under FDR – and lasted for a decade. The Grant book has created a firestorm of controversy within the economics profession especially after Robert Samuelson had the temerity to write a column in the Washington Post musing that maybe, just maybe we ought to think about whether our adherence to the Great Depression approach explains our current weak recovery.
What is amazing to me about the debate is that both sides seem to have missed the obvious. The overarching theme of Grant’s book is that it was the laissez faire approach to the 20-21 depression that allowed a quick recovery. The Harding administration (and later Coolidge) cut government spending (we were coming out of WWI), cut taxes, balanced the federal budget and let private businesses deal with the fallout. The interventionists, those who dominate the current economic profession, say that isn’t true, that although the federal government didn’t engage in “stimulus”, the Fed did indeed intervene and that their actions explain both the depression and the quick recovery. The Fed did indeed raise interest rates at the beginning of the depression and later cut them, leading to the recovery – according to the interventionists.
Those arguing against the Warren Harding/Benjamin Strong (he was the head of the NY Fed) approach must not have read Grant’s book, a well written, well researched effort that spends considerable time explaining the actions of the early Fed. They obviously don’t understand the difference between how monetary policy was conducted then and now, something Grant spills a lot of ink attempting to explain. Grant, for his part, seems to believe that the lack of action by the federal government and the ability of businesses to cut wages were the main causes of the recovery. I do think Grant has the better argument but its application to today, with downward wage rigidities and individual income supports that didn’t exist back then, is not that great. As I said, both sides seem to have missed the obvious.
The recovery was created by the Fed not when they cut rates but rather when they raised them. At the time, the world was still on a gold standard (or going back to one after the war) and interest rates were a tool used primarily to adjust to changes in gold flows. Under a gold standard, gold was capital, and its exit from a country signaled economic problems. It’s return was a signal that recovery was in the offing. When the Fed hiked rates, it attracted gold to the US and I would argue that it was that influx of capital, that had to be invested somewhere, that healed the economy. Yes, businesses’ ability to cut wages rather than fire people (although they did a lot of that too) and government’s action to cut spending and taxes had an impact but it was lower prices and more capital that created the robust recovery. Yes, the Fed did raise and then lower rates but the impact of those changes were not what modern economists think they were (read this post by George Selgin for a detailed explanation).
The parallel with today is found in the currency markets. Just as then, a falling currency (gold/capital flowing out) is a sign of weakness, not strength. Likewise, a rising currency (gold/capital flowing in) is a sign of economic healing. In essence, the weak dollar period that lasted from 2002 until recently was a period of capital fleeing the US. During times of a falling currency, especially once it becomes ingrained and expected, remaining capital tends to flow to investments which protect purchasing power (real estate and commodities; real assets). Since capital is scarce due to the devaluation policy, productivity enhancing investments are starved and economic growth disappoints. If you doubt this, take a look at productivity growth during weak and strong dollar periods over the last few decades. From 1982 to 1986 and 1997 to 2002 (both strong dollar periods) productivity grew at 2.5 to 3% annually. The weak dollar periods (1973 to 1981, 1987 to 1996 and 2003 to recently) have productivity growth rates roughly half the strong dollar periods.
I know this is getting long (and probably boring to all but econ geeks) so let’s cut to the chase and the title of the post. The good news is that the dollar is rising and the inflow of capital will eventually have a large positive impact on investment, productivity and economic growth. It will take time but the rise in the dollar is a sign that the healing has started. The bad news? Well, the bad news is that the transition from weak dollar to strong dollar is not an easy one and will involve, as I said earlier, considerable economic pain. The weak dollar investments will have to be liquidated and the transition to strong dollar investments will take time. The depression of 1920-21 was severe with unemployment (as best as can be determined) rising to the mid-teens. Commodity prices fell hard, hurting farmers and anyone else involved in commodity resource extraction. Industrial production fell hard and wages for those who kept their jobs were cut. It was not an easy time and those Americans didn’t have the social safety net we do today.
What I’m saying is that if we allow the dollar to keep rising, we are likely to gain a recession in the short term for our efforts. The world has, since 2002, come to expect a weak dollar and investments – massive investments – have been made based on that expectation. Part of that malinvestment is being revealed right now in the shale industry as oil prices drop due to the stronger dollar. As the BIS pointed out last week, the rest of the world has also invested with a weak dollar bias, with cross border dollar lending tripling to $9 trillion over the last decade. As the dollar rises, those debts become harder to pay and the global scramble for dollars to pay those debts will only push the dollar higher, a self perpetuating cycle that will persist until the debts are paid or defaulted upon.
The key to the long term health of the US economy depends critically on the Fed’s response to the stronger dollar. If they opt for actions that weaken the dollar, we will get nothing more – and quite possibly a lot less – than the ragged, weak recovery we’ve seen since the 2008 crisis. If they opt for policies that support the dollar, the recession will be deep but the recovery will be robust and more widespread. Fiscal policy will have to bear the brunt of this next recession and should involve permanent tax reform, intelligent public investments and a robust effort to eliminate counter-productive, capital wasting policies. A move to consolidate and simplify our regulatory regime would also have a salutary effect.
A US recession is not a certainty. It is possible that the Fed finds a way to navigate the transition with little disruption. Strong dollar investments could wax at the same rate the weak dollar investments wane. Even if that happens though, the effect on the stock market may not be benign. More capital spending and fewer stock buybacks may mean less earnings growth, lower profit margins and lower stock prices in the short term. The effect of a stronger dollar on the rest of the world cannot be dismissed either especially when so many of our multinational companies depend on foreign markets for marginal growth. A debt crisis that hinders growth in the rest of the world will certainly have an impact on US corporate profits. The Fed has a very difficult period immediately ahead.
In the days of a gold standard, it was critical for investors to monitor gold flows. For modern investors, the equivalent is watching currency markets. Currency movements shift capital flows, creating booms where the capital lands and busts where it flees. We’ve been on the fleeing end of that for 14 years and we’ve suffered dearly for it. We are now on the receiving end and the rewards will come if we let the healing process run its course. The Fed has to commit to a strong dollar, resist the urge to compete with the world’s currency warriors and our politicians must enact policies that make the US an attractive option for global capital. The real war is over capital not currency values and right now the US has a big lead. Let’s try not blow it.
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For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@alhambrapartners.com or 
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