Saturday, February 26, 2011

The Down Staircase

The Stairway to Poverty

Several times I’ve said in this blog that I don’t expect the imminent collapse of the dollar. This isn’t because I’m blind to the dollar’s fatal flaws, but because of the time required for the unfolding of this nation’s budgetary and economic problems, and because the dollar is only one of a number of troubled currencies of declining developed nations.

But I don’t want to give the impression that the dollar is safe. We know that the dollar is on an unsustainable trajectory, and its decline seems inevitable. It’s just that the path isn’t necessarily straight down, and the timing of the dollar’s decline is highly uncertain.

The Dollar Cascade

There is no doubt that the direction is down. Even Chairman Bernanke has said that the US needs to reduce debt, and that the process of deleveraging will involve high rates of bankruptcy and unemployment. In such a spare environment, low rates of economic growth will force governments and individual citizens to adjust their expectations and economic activities downward. Because governments and citizens do not willingly adjust their expectations to reduced circumstances, we cannot expect the process to be a smooth one.

Until the financial crisis hit, the risk of financial collapse because of rising levels of private and public debt was met with official denial. When collapse became imminent, the official response was a bailout of key financial players, a policy of rock-bottom interest rates, and quantitative easing – all temporary measures that left the underlying issues untouched. Private debt was partially transformed into public debt, but the debt remained. The system was stabilized temporarily, but this was only the first step in a multi-year process of deleveraging and economic adjustment.

For these reasons, I see the continuing decline of the dollar as a sequence of stair steps. After falling down a step, the US finds ways to arrest its decline partially and sustain itself at a lower level for a few years. Eventually, the pressure on the US (declining economic competitiveness, value of the dollar, political influence) builds up to a point that resistance gives way and we fall down another step. Over a period of decades, some of the steps may be small and others large and catastrophic. However long we may loiter on any single step, the direction is down.

Printing Money Is Not the Answer, It Is a Symptom

There is a school of thought, based on Modern Monetary Theory, that the US cannot become insolvent. The thesis is that the Fed is not monetizing the debt, and a truly sovereign currency can not be debased into hyperinflation. This position posits that the government does not print money, but rather pushes buttons to create amounts in bank accounts or remove amounts from bank accounts. The blog Pragmatic Capitalism has published a number of articles supporting this position, which might be summarized as: “a sovereign government with monopoly supply of currency in a floating exchange rate system has no solvency issue.”

In my opinion the main problem with discussions of this point of view is that they discuss the wrong problem.  The real issues are this country's ballooning federal debt and its persistent negative balance of payments.  Those are the main forces driving this country to penury, not monetary policy. 

Easy monetary policy, however, exacerbates the problem because it distorts market prices, resulting is the allocation of resources into speculation rather than productive activities.  Nevertheless, I was still interested to read a critique of modern monetary theory in a recent series of articles in another blog that I enjoy, Jesse’s Crossroads Café (Jesse Part 1, Jesse Part 2, Jesse Part 3).  To quote Jesse, the critique might be summarized as “I can print money, therefore I can never go broke.”

A government with a monopoly supply of currency may remain solvent in the limited sense that it can pay its debts in its own currency, but that is such a myopic issue as to be meaningless. What is that currency worth in real terms? Not much, if that government’s debts expand without limit. If debt grows uncontrollably, no sovereign government can escape the consequences.

Theoretical solvency is a false issue if your currency declines against all others, and if everyone understands that the trend is going to continue indefinitely.

If debt grows uncontrollably, relative to the size of an economy, citizens and creditors will notice. What exchange rates will foreign trading partners demand, what interest rates will foreign creditors demand, and what rate of price inflation will domestic consumers experience? As Jesse put it:  “The limit of the Fed's and Treasury's ability to create money is the value and acceptance of the dollar and the bond in market transactions.”

And at some point, after exchange rates, interest rates, and price inflation have escalated to the point that the people are mostly in penury, who will accept that currency in exchange for any service or real good?  At that point such a government really does become insolvent.

The Runaway Fiscal Trajectory

The US and other advanced nations seem unlikely to take significant steps to bring their houses into fiscal order until catastrophe is staring them in the face, and by that time it will be too late. It may already be too late. Even holding social entitlements (such as Social Security and Medicare) at current levels (as a percent of GDP) may be insufficient, according to a study by the Bank of International Settlements.

Both monetary and fiscal policy now appear to be impotent, and there is an increasing risk that government policies may be unable to avoid financial collapse. As Charles Hughes Smith recently wrote in “Beyond the False Dawn: Global Crisis 2020-2022” in his blog Of Two Minds, the policy of easy money is a trap, because we cannot reverse it without catastrophe: “… the status quo is now addicted to unlimited flows of free money. If the flow continues, then inflation will destabilize it; if it's cut off, then rising interest payments will destabilize it.”

Although I mentioned inflation as a problem, this does not mean that every step forward will be inflationary.  Government budget cuts, recession, and falling real income are among the strong deflationary forces that lie in our future at some point.  Different steps on the down stairway will bring different conditions, whether  inflationary and deflationary, whether in the price sense or the monetary sense.  The overall direction is toward economic decline and monetary devaluation, however.

Despite political rhetoric, US fiscal policy is still on a runaway trajectory. Recently The Economist reported in its Daily Chart feature, "I O USA" that neither the Republicans or the Democrats are serious about the deficit:

“Both sides talk about cutting the deficit but are unwilling to risk losing voters by trimming the big budget items: pensions, Medicare, Medicaid and defence. Republicans, who were initially pushed to talk tough on cutting spending by the Tea Partiers, have backed away from what plans they had to take on entitlements since gaining control of the House.”

Stumbling Down the Stairs

At some point people will not accept dollars without a suitable discount, or else they will not accept them at all. I agree with those who argue that the dollar is already unstable and that the present conditions supporting the dollar are unlikely to continue forever. As Jesse stated: “the question is when markets will start putting pressure on governments, not if.”

Apparently, people are catching on to this idea. Mohammed El Erian recently commented ominously about the failure of the dollar to rise in reaction to the crisis in Egypt, Libya, Bahrain, and other countries in the Middle East (my emphasis):

"It is a warning shot to America that we cannot simply assume flight to quality, flight to safety. That people are starting to worry about the fiscal situation in the U.S., worrying about the level of debt and what they're hearing about states and municipalities. I would take this as a warning shot that we cannot assume that we will maintain the standing of the reserve currency as we have in the past."

It does not matter whether the US dollar is or is not the world's reserve currency, as long as the world has confidence in the dollar.  Losing the dollar's status as the reserve currency does matter, however, because it signals that the world has recognized lost confidence in the US.  It signals that our underlying problems of debt and lack of competitiveness have become unmanageable.

As recognition of the fiscal and economic problems of the US become widely accepted, there will be little to restrain the fall of our currency. The debt has been accumulated, the industrial system has been eroded, and government policies are not being meaningfully directed to remedy the fundamental problems underlying the crisis. This mantra quoted from Jesse’s Crossroads Café is an insightful comment on the need for new solutions:

“Both austerity and stimulus will falter in the mire of imbalanced, broken systems and corruption. The Banks must be restrained, and the financial system reformed, with balance restored to the economy, before there can be any sustained recovery.”