Tuesday, September 16, 2003

Why the US Dollar has further to drop

In two of my previous jobs, I was involved in foreign exchange. Forecasting the vagaries of currency movements is always difficult. As a treasurer, the rule is: "If you are right, you are lucky. If you are wrong, you must have been stupid."

But I am going to go out on a limb here. I think the US dollar will depreciate further. Now, let me add the normal caveats - that is assuming no major events come along that make the US dollar a safe haven. But if current US fiscal polices don't change, then it is hard to imagine the US dollar not depreciating further.

There have been a number of warning signs. The first is the huge balance of trade deficit. But perhaps the most major is the current and predicted high level of deficits for the Federal government. Paul Krugman, writing in the New York Times magazine this past Sunday (http://www.nytimes.com/2003/09/14/magazine/14TAXES.html?pagewanted=1) describes the elaborate "Tax Cut Con" that right wing ideologues have been promoting for the past twenty odd years or so.

The article is well worth reading and so will the book version be when it is published (''The Great Unraveling: Losing Our Way in the New Century"). I will certainly be buying it.

Krugman does not argue in his article for depreciation of the dollar, but I am going to for several reasons, even recognizing that the US dollar has already depreciated 25% or so against the Euro.

My reasons are as follows:

1. Any rational investor thinking about investing in the US with a high level of deficits and low interest rates will only do so if other international investments are too risky, or if he speculates that US interest rates will go up, or if he thinks American assets can be bought cheaply.

2. So, barring war, disease and destruction outside the US, if you think the US economy is weak, you are better off waiting for the depreciation in the dollar and buying cheaper later. Given demographcis, the inescapable consequence of current fiscal policy is that the deficit problem will get worse not better.

3. If interest rates go up, several things are likely to happen. First, large scale bankruptcies would likely occur due to a drop in the value of the housing market. Second, the value of stocks will not go up as much. Third, corporate bankruptcies will also likely increase. Politically, it would be very difficult to have a housing prices collapse in the US. It is the biggest tax deduction in the US and would upset a huge percentage of the population. In fact, the shallowness of the current recession is due in many regions to borrowing by homeonwers against the increased value of their homes. The US is a strange society. Tax deductions to the middle class make home ownership compulsory and the home becomes unemployment insurance.

Some will argue that mortgages in the US are often 30 year term, but in recent years, many homeowners have found it less expensive to stay short. And given that the fiscal problem is long term, interest rates are likely to stay high if the federal government is borrowing and putting pressure on interest rates.

4. The insanity of the US medical system is such that it costs about 3-5% more of the economy that in Canada and arguably on average produces worse health care. This cost is very large. If the US were able to grow at 3% per year faster, it would be a profound change of astounding proportions. Such a change would be the way solve a large number of today's problems.

But the current consequences of health care costs in the US are that many large and politically important US corporation, such as the Big 3 automobile companies are stuck with health care and pension costs for more retired employees than they have current employees. And their competitive position is perhaps less strong than ever before. Other writers have suggested that there is extensive lobbying going on for reduction in the liability of such companies. If one of them goes bankrupt, then it is can reduce these liabilities.

However, the political and cost fall out of such a bankruptcy would be enormous. So the easy way out, is to depreciate the dollar. By doing so, American producers become magically healthy. Imports become more expensive. Foreign companies have to invest in the US to stay competitive. So some foreign investment will occur and marginally push up the US dollar, but it won't likely be enough to drive the dollar back up given the fiscal and trade deficit position of the United States.

Krugman argues in his article that the "supply side" argument for massive tax cuts is a giant con. He points out that:

1. Americans are not taxed heavily.
2. Tax cuts have and will primarily benefit a very small and wealthy group in the population.
3. Tax cuts have been sold on the basis of economic growth, but for many ideologues, the real issue is cutting back the size of government.
4. The allocation of the tax cuts has been consistently misrepresented with misleading statistics.
5. "Supply side" economics, the notion that tax cuts will stimulate the economy more than they will cost is not considered accurate by economists. He distinguishes clearly between Keynesian deficits to stimulate a down economy and long term structural deficits which just increase the debt burden.

But what makes the economic situation so dire is that the majority of spending that conservatives would like to cut are politically uncuttable. Homeland security and defence are not on the table for the right wing and have received increased budgets. The cost of Medicare and Social Security is going up, predictably. What is left is the 5% of the budget that is devoted to education, transportation and other useful programs. So where will the cuts come from?

The evidence of the Reagan years is that the result is more spending and higher deficits.

Some Predictions Based Upon Canadian Politics
Canada in the 1970s had a very similar situation. The Liberals had used deficits to maintain the Canadian standard of living in the aftermath of the oil crises, which essentially transferred wealth to the Middle East and devalued assets designed for a low energy cost environment.

When the Liberals were thrown out of office in the middle 1980s and moderate right wing government took power under Brian Multroney (whom I temporarily worked under in the Office of the Leader of the Opposition), two key policy changes took place. They were widely contested and may only have been implementable because Canada has a Parliamentary system of government, which gives more power to governing party than the tripartate structure of Congress, Senate and the President in the US.

These two policies involved: (1) massive change to a major piece of the tax code, and (2) the creation of the North American Free Trade Area (NAFTA). These had three major consequences:

1. The change in tax regime rationalized a previously invisible wholesale tax that had the unfortunate effect of making it more attractive to manufacture off shore and import into Canada, than to produce and export from Canada.

2. The goods and services tax or GST expanded the tax base to include services and was a positive compliance system so that if you paid GST and exported, you got back the GST on what you exported. As a result, you had an incentive to collect GST. The more you collected the more you would get back if you exported.

3. NAFTA transformed the Canadian economy and made it more efficient. But just as importantly, it put in place a series of safeguards that allowed firms targeted by political protectionism in the US to have a court of appeal. Non tariff barriers had by this period become more important than tariffs.

So what does this say about the US?

Well the decentralization of power in the US, combined with options such as "Buy a legislator" means that change happens slowly. The US probably will need a major crisis before change occurs. A drop in the US dollar may not be enough, but a crisis will occur if legislators fail to address the problem.

My predictions are that:

1. The US will be forced to pull back from many of its bases overseas. The consequences of the Iraq war will be the demonstration of "Imperial Overreach".
2. The next administration will be more multlateralist in approach.
3. Healthcare reform will come to the US, painfully, irrationally, but it will come. The dollars are just too big and the excesses just too large for this problem to go away. SIgns of this are the recent approval in California of compulsory health insurance for all businesses with more than 20 employees. Once this type of program is in place, single payor systems or simplification of billing starts to become easier to implement.
4. Taxes are going to go up. States will put taxes up first, but I predict a long term trend towards more taxes in the US, perhaps not in the short term, but certainly the in medium term.
5. The dollar will go down. It's the coward's way of stimulating the economy. Better would be to have the US economy investing in creating high value R&D and exporting high value goods and services.

A final reason for worrying about the value of the American dollar is the impact of government cut backs on education. In the long run, a society creates jobs by being able to (1) attract investment, (2) creating centers of excellence, and (3) developing talented and entrepreneurial people (or so I argued in our book, Seizing the Future in 1983).

A major side effect of diverting government spending into non-productive areas such as Homeland Defense and the military is that while some innovations do occur, the majority of the spending is not productive and the cutbacks in education reduce the availability and quality of the workforce. And in a knowledge-based economy the quality of people counts. In other words, foreign policy affects defense spending. Defence spending affects the budget. The budget affects education. Education affects productivity growth and innovation. Lack of productivity and growth and innovation reduces the pie. A smaller pie causes a drop in the standard of living.

It is no coincidence that the Tigers of south-east Asia -- South Korea, Japan, Singapore and Hong Kong all place great emphasis upon education. And many have argued that the GI Bill after the Second World War was one of the most significant social programs ever.

So we are left with a picture of the US, painted ably by Paul Krugman, of a society where political voice has enabled the wealthy to become weathier, where taxes have remained constant for the middle class but where they have dropped for those needing it the least, where education and infrastructure are deterioriating. The US is maintaining its standard of living by borrowing excessively to give tax cuts to the wealthy. And long term investment will be diverted to funding government.

It's not a pretty picture, so I hope my analysis is 100% wrong. But I don't see how.

Alistair Davidson

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