Thursday, July 5, 2012

A weak dollar points to need for supply-side policies

The dollar is very weak, which is good evidence that monetary policy in the U.S. is very accommodative. But at the same time, the demand for Treasuries is very strong, which suggests that the market is extremely risk averse. What's needed is fiscal policy inspired by supply-side principles, not more monetary ease.

This chart shows the dollar's inflation-adjusted, trade-weighted value against a very large basket of currencies (over 100) and against a basket of major currencies. This is arguably the best the way to measure the dollar's value vis a vis other currencies. No matter how you slice and dice the numbers, the dollar remains at or near its lowest levels ever. A weak dollar measured against almost all currencies in the world is a prima facie evidence that dollars are in abundant supply relative to the supply of other currencies. There is no shortage of dollars; the Fed is not restricting the supply of the dollars, either intentionally or unintentionally. This observation can be confirmed by measuring the dollar's value relative to almost any commodity.

The price of gold and the value of the CRB Spot Commodity Index are both much higher than they were a decade ago when monetary policy was intentionally tight—whether measured in nominal or in constant dollars. It takes a lot more dollars today to buy these commodities.

The same can be said for the price of crude oil, which, although it has weakened some this year, is still very close to an all-time high in real terms.

In stark contrast, the extremely low level of Treasury yields tells us that the demand for Treasuries is extremely strong, and that Treasuries are relatively scarce. Real yields on 10-yr TIPS are negative, which means that those who buy TIPS today are willing to sacrifice 0.5% of the future purchasing power of the dollar per year in order to be sure of not losing even more by investing in other things. There are plenty of dollars in the world, but there is a relative shortage of risk-free, interest-bearing securities, and Treasuries are still the standard against which all other securities are measured.

How can Treasuries be in short supply if there is over $11 trillion of Treasury debt held by the public? (The Fed only holds about 10% of the Treasuries held by the public, hardly enough to make a significant difference in the relative supply of Treasuries.) The answer is that the demand for Treasuries is extremely strong, and that implies that the world is extremely worried that the return on alternative investments is likely to be very low—which can only be true if the prospects for economic growth are miserable.

In other words, it is almost certainly not the case that the prospects for growth are miserable because the Fed has not been generous enough with the supply of dollars. The Fed has increased the supply of bank reserves to such an extent that there are now $1.5 trillion of excess reserves—reserves that are not needed to back up bank deposits, and which are being held by banks because they are still very risk averse. If the Fed were to engage in yet another round of quantitative easing (which would involve the purchase of more Treasuries and the creation of more bank reserves), this would only exacerbate the relative scarcity of Treasuries, and would not likely do much if anything to increase the relative supply of dollars, which are already in abundant supply. More monetary ease could also exacerbate the problems already caused by an extended period of super-accommodative monetary policy, as the eminent John Taylor explains in his WSJ op-ed today:

... loose monetary policy was likely a big factor pushing up commodity prices. The current sharp slowdown in most emerging markets coincides with an inevitable bust of this easy-money induced boom, and the decline of foreign demand for American goods is now feeding back to the U.S. economy.

Indeed, one reason that global growth prospects are dismal is precisely because monetary policy has been so accommodative. Think about this: all currencies are weak relative to gold and commodity prices, not just the dollar. Central bankers can only do so much to stimulate growth, and they have probably done too much already. That might explain why the market's reaction to today's coordinated easing by the central banks of England, the Eurozone, and China was tepid if not negative. Enough with the easy money stuff, what we need is a reason to be genuinely confident about the future. In the absence of any clear vision in Washington or the Eurozone for fiscal policies that could accomplish that, what we are left with is a market that is extremely risk averse.

From my supply-side perspective, what's needed is fiscal stimulus that shrinks the relative size and scope of the public sector (yes, cutting government spending from its current lofty level is quite likely to be stimulative because it allows the private sector to more efficiently deploy the economy's scarce resources), reduces the burden of regulations, broadens the tax base, and lowers and flattens tax rates. We've had enough money printing and faux-stimulative Keynesian policies. Going forward, governments need to step back and give the private sector a chance to work its magic. Unfortunately, Romney only imperfectly understands this, while Obama believes in the exact opposite. The market is pointing politicians in the right direction, if they would only pay attention to its signals.


Bill said...

Do you agree with the WSJ opinion piece today which argues that loose monetary policy caused the 2008 panic and that current policy may result in another panic?

McKibbinUSA said...

If austerity is to work, it's time to talk about double-digit wage decreases in America, especially for those in the public sector -- I was an early advocate for monetary expansion, but now that austerity is plan for the future, now would be a good time to get started on public wage reductions -- the more savage the cuts, the more likely that austerity will work to reverse the world's economic woes...

marmico said...

give the private sector a chance to work its magic

Real private nonresidential investment in equipment and software is working just fine. Should they build more structures that would remain empty?

Joe said...

Actually, what is needed at a time where the top 1% have increased their share of national income and whealth as last seen in 1929 is a sweeping demand-side policy. The problem is the lack of demand and why invest in anything if nobody can buy the stuff? First we need a massive redistribution of income and whealth, so we have again enough buying power by the masses, which lost real income for about 15 years now. As per the long-forgotten Marriner Eccless:
"As mass production has to be accompanied by mass consumption, mass consumption, in turn, implies a distribution of wealth ... to provide men with buying power. ... Instead of achieving that kind of distribution, a giant suction pump had by 1929-30 drawn into a few hands an increasing portion of currently produced wealth. ... The other fellows could stay in the game only by borrowing. When their credit ran out, the game stopped."

Scott Grannis said...

Joe: you are infected with the Keynesian demand-side virus which has caused the world's major economies to falter. You can't spend your way to prosperity. Today's problem is not a lack of demand. Billionaires don't have bags of money sitting around idle that can be redistributed to the poor. Every dime that is earned is always spent by someone, ultimately. Either the person earning it spends it, or he must in one way or another give the unspent portion of his income to some else in the form of a loan or an investment, and that someone ends up spending it.

The only way to increase the size of the economic pie is to produce more with the same scarce resources. That involves investment and risk taking and hard work.

Joe said...

Scott: this seems too ideological and can IMO be disproved by a simple test with history. We know that 1929 and today income and wealth is heavily concentrated with the rich. In between these two points in history, a low for this concentration was reached in the later 1970s. In both cases 1929 and 2008, a deflationary collapse resulted. At the opposite point in time, the 1970s, an inflationary crisis resulted.
Therefore, I I gree that around the late 1970s was the right time for supply-side economics. Too much money was concentrated with average Joe = too much demand and too little with the rich = too little supply. The result was stagflation.
Today, however, we are at the opposite extreme, so we need an opposite policy. The key is to apply the right kind of policy at the right situation and not become ideological.

Scott Grannis said...

The correlation (if correct) you cite between wealth concentration and subsequent collapses does not proved that wealth concentration caused the collapses. Milton Friedman and Ben Bernanke would say that the Depression was caused by bad monetary policies. Others cite a global trade war as a cause. Still others cite bad fiscal policy (raising taxes and spending too much money) as a cause. Wealth concentration is more like an endogenous variable (i.e., the result of other things) than an exogenous variable (the driver of other things).

But I reiterate that there is never any such thing as "too much demand" or "too little demand." Obama's "stimulus" bill was a grand experiment in Keynesian pump-priming and it was a complete failure.

randy said...


Interesting comments. In your opinion, what were the key govt policies that resulted in the fluctuations of wealth distribution? It sure seems reasonable that the growing divide isn't right. Are the ill effects of that solved by simple redistribution - taking cash from rich and giving to the non-rich? Is that accomplished by refundable tax credits? If that cash is spent on more and better consumables is America really better off?

randy said...

PS. What I mean by "better off"... will our children, and their children, have more opportunities and a better life, if we redistribute more wealth.

Benjamin Cole said...

It is sad to see GOP orthodoxy become dogma---that somehow money is "loose."

Too many on the right conflate "tight money" with restricting the growth of the federal government (the latter I concur with, more so than the current GOP does).

Inflation and interest rates are at record lows---this is not loose money at work, by any standard that makes sense.

As for the exchange rate of the dollar, I do not want parity with the yen. The Bank of Japan is zealously asphyxiating their economy. Who wants to imitate that?

Other nations may follow money policies that are too loose or too tight, and we should not seek parity. We should look at out fundamentals---inflation, asset values, interest rates---and we will see that money is now tight.

What is crazy about this is that the GOP likes to say it is a business-like party. Any businessman would leap at a chance to monetize debt with no ill consequences---like right now. Evidently, the economy (global economy remember0)is so slack we can monetize trillions in debt with no inflationary pressures, and release our children from financial burdens unwisely assumed. It may be a once-in-a-lifetime opportunity being squandered by GOP and D-Party nitwits.

So far, QE1 and QE2 has resulted in extremely low inflation rates and record low mortgage rates, while property and equities are dead in the water. This is not the hyper-inflation predicted by the hysterics. The inflation scaremongers have simply been wrong.

Indeed, plotting QE1 and QE2 against gold prices shows gold breaks when we started QE 1/2. What does that tell you? That gold prices have little to do with USA monetary policy.

I wish I had a party to vote for.

McKibbinUSA said...

@Benjamin, the Libertarian Party is at least intellectually honest -- more at:

PD Dennison said...

One of you Lefties example to me how taking wealth from productive people and distributing it to non-productive people is going encourage wealth creation?

Demand is down because the wealth creators are being targeted by the Maoists regime in Washington. Obama brought the recession and it will end when he is gone.

John said...

"example to me how taking wealth from productive people and distributing it to non-productive people is going encourage wealth creation?"

PD, I couldn't agree more. Some of the most non-productive people I ever ran across in the work place were senior managers, protected by more vulnerable middle managers who actually worked on projects and had their asses on the line.