Could This Be The Tipping Point?

Amidst the headline news of failing financial institutions and stagflationary conditions in the United States, there has been one U.S. story that so far has been good news: central banks in Asia and oil-exporting countries continue to support the financing needs of the United States. According to Brad Sester, this foreign financing was $283.5 billion during the first half of 2008 and continues unabated. As is well known, this support one day will end--the United States cannot forever live beyond its means--but now would not be a good time. Most Americans do not recognize their dependence on this foreign financing nor the added stress the U.S. economy would be under in its absence. The sustained nature of this quiet bailout, as Brad Sester calls it, has been good news for the weakened U.S. economy.

Some observers, however, are now warning this financial lifeline may be in jeopardy given recent events. Ambrose Evans-Pritchard reporting on a Merrill Lynch paper writes the "US faces global funding crisis." From his article:

Merrill Lynch has warned that the United States could face a foreign "financing crisis" within months as the full consequences of the Fannie Mae and Freddie Mac mortgage debacle spread through the world

The country depends on Asian, Russian and Middle Eastern investors to fund much of its $700bn (£350bn) current account deficit, leaving it far more vulnerable to a collapse of confidence than Japan in the early 1990s after the Nikkei bubble burst.

The main point of the Merrill Lynch report is that the recent spate of bad economic news may be the tipping point for the end of this global financing arrangement, popularly known as Bretton Woods II (BWII). Nouriel Roubini makes similar points here. So what do you think? Is this really the end of BWII?

A Future of Stagflation or Deflation?

Maybe neither, but economic doomsayers seem to be divided on this issue. Here is what Google trends is reporting (click on picture to enlarge):


Google trends, then, indicates more people are concerned about a future of stagflation. It would be interesting to see what a prediction market contract would say on this question.

The Meltdown Continues: the Fannie and Freddie Edition

So Fannie Mae and Freddie Mac have fallen and will get a government bailout. Clive Crook has nicely summarized this latest financial domino to fall in the ongoing financial crisis:

US taxpayers are about to find out what their long-standing and (strictly speaking) non-existent guarantee of Fannie Mae and Freddie Mac will cost them. One way to think of it is this: take the US national debt of roughly $9,000bn and add $5,000bn. Not bad for an obligation still officially denied.

James Hamilton, Arnold Kling, and Mark Thoma also provide good discussions on this development. It is worth noting that Nouriel Roubini predicted Fannie and Freddie's collapse back in August 2006. If you are curious as to how the rest of this financial crisis will unfold, take a look at Nouriel's 12 steps to financial disaster. Let me add Nouriel to my list of certified economic prophets.

Dump the Dollar Peg Week

This has been the week of dump the dollar peg in the Gulf States. First, it was reported on Sunday that some officials from Abu Dhabi think the United Arab Emirates should replace its dollar peg with one tied to a basket of currencies. At the same time, Nouriel Roubini posted an article comparing the coming collapse of the Bretton Woords II system with that of Bretton Woods I where, among other things, he too called for the end of the dollar peg in the Gulf States. Then on Monday the Financial Times (FT) published its "Dollar-pegged out" editorial. Here the FT similarly argued the Gulf States needs to abandon the dollar peg and move to a basket of currencies that included the price of oil. The FT's editorial, in turn, made Brad Sester happy who followed up on Tuesday with a posting to his blog that furthered the arguments made in the FT. On Wednesday, Jeffrey Frankel, the originator of the currency-basket-including-oil idea chimed in on this debate with this piece. Then on Thursday the Wall Street Journal RTE blog posted the "Dollar Peg Gets Taken Down a Peg." And today, ordinary people like me are sifting through this debate, considering how such a change would take place and what it would mean in the near term.

But first, let's review the thinking behind the calls for the Gulf States to abandon their dollar pegs. Martin Feldstein explains it this way:

The double-digit inflation problem in Saudi Arabia and its Gulf neighbours is different from that of other emerging market economies. Although the rising price of imported food affects them all, the inflation problem in the Gulf region is exacerbated by their fixed exchange rate policy.

The peg to the dollar contributes to Saudi inflation in two ways. First, the dollar link forces the Saudi central bank to match US interest rates. As the Fed lowered its interest rate from 5.25 per cent last summer to 2 per cent now, the Saudis had to cut their interest rate. If they had not done so, investors around the world would have flooded Saudi Arabia with funds seeking the higher yield on a currency that is pegged to the dollar. While cutting rates was a good policy for the US as its economy weakened, it was a terrible policy for Saudi Arabia, which is experiencing an overheated domestic economy with rapidly rising inflation.

The dollar peg also raises Saudi inflation by increasing the cost of imports as the dollar declines relative to the euro, the yen and other currencies. The US is the source for only about 12 per cent of Saudi imports. The 15 per cent decline of the dollar relative to those currencies during the past year meant that the prices paid by the Saudis for the goods that they bought from Europe, Japan and elsewhere rose more than 15 per cent. The large US trade deficit is likely to continue to force the dollar to decline against other main currencies. The result will be a continuing source of imported inflation in Saudi Arabia and other countries that tie their currencies to the dollar.

Inflation in Saudi Arabia and the other Gulf states is depressing real incomes of millions of low-income workers. The combination of the dollar peg and the declining dollar is also reducing the value of the remittances that large numbers of foreign workers send home to their families in low-income countries such as India and Pakistan. Since these foreign workers make up more than half of the total workforce in Saudi Arabia and an even larger share in the less populous states of the region, their discontent is a significant risk to local stability.

Because of their dollar pegs, then, the Gulf States are importing the highly stimulative U.S. monetary policy at the very time their overheating economies need a tighter monetary policy. The remedy, as argued by the above individuals and media outlets, is to change the composition of their peg to a basket of other currencies and oil. Doing so, would mean that their "currencies would appreciate when oil is strong, and depreciate when it is weak" and "make for smoother adjustments than double-digit inflation" (FT).

It is clear that the dollar peg is distortionary for the Gulf States. It is also clear there is an end game in sight: either the Gulf States change their peg or continued inflation will effectively do it for them. The currency-oil basket makes sense to me as a long-term solution, but what about in the short-term when the transition between pegs would take place? What happens if in abandoning their dollar peg the Gulf States make other important dollar peggers like China nervous about capital losses on their own dollar holdings? This could start a run on the dollar and lead to more distress in our battered financial markets. So when I read these calls for dumping the dollar peg, I agree in principle but get concerned as to what would actually happen in practice.

Is there a way to guarantee the transition will be orderly? My current thinking is that part of the solution lies with the Fed: it should do more to reign in global inflation. This would remove the inflationary pressures in the Gulf States and give them more time to work on a orderly transition. It would also reduce the likelihood of a run on the dollar.

NCAA Tournament-Style Brackets: Who Killed the Economy?

Take a look at this Portfolio.com NCAA tournament-style bracket where you pick who killed the economy. I might have added some brackets for certain mortgage lenders, the debt-addicted American consumer, and those prominent academic economists who gave credence to the Fed's low interest rate policy back in 2003. Still, it is a fun distraction to check out.

Double Trouble

History is Repeating Itself

In thinking about today's global inflation problem and the role U.S. monetary policy is playing in it, it struck me that we have seen this story before. The collapse of Bretton Woods system--the global monetary system from the end of WWII through the early 1970s-- was due to the United States abusing it role as the anchor currency. During this time, many countries outside the communist block pegged their currencies to the dollar, which was ostensibly backed by gold. Consequently, these countries were willing, initially, to take dollar and dollar-denominated assets for international payments. The United States, however, had pressing domestic spending objectives--the Vietnam War and the Great Society--that required foreign financing. This meant foreign countries took increasingly more dollar and dollar-denominated assets as payment. After some time, these countries began to question whether the U.S. really could back up all of these dollars it was exporting with gold. The answer, of course, was that it could not and eventually the system collapsed. Along with the collapse came a surge in global inflation--the delayed consequence of the U.S. exporting its loose monetary policy to the rest of the world for so many years.

Today, we see the same thing happening. Nouriel Roubini has a post yesterday that makes this very point:

Will the Bretton Wood 2 Regime of fixed and/or heavily managed exchange rates in many emerging market economies collapse in the same way as the Bretton Woods 1 regime (the “dollar standard” regime that ruled after 1945 in the global economy) collapsed in the early 1970s? What are the similarities and differences between those two regimes? It is interesting to note that the same factors – U.S twin deficit, U.S. loose monetary policies and fixed pegs to the U.S. in the dollar standard regime of Bretton Woods (1945-1971) - that led to the commodity inflation and goods inflation in the early 1970s and thus to the demise of the Bretton Woods 1 regime (in the 1971-73 period) are also partially the same factors that are leading now to the rise in commodity and goods inflation in emerging markets that are pegging to the U.S. dollar and/or heavily managing their exchange rates.

Suffice to say history seems to be repeating itself. Maybe this time around the world will become once bitten twice shy about the dollar.