A discussion of globalization triggers passionate and at times violent responses. Rarely has an economic topic captured the spirit of the public so much. What we would like to contribute to the debate is some insight on how monetary and fiscal policies affect globalization and their effects on the dollar.
Federal Reserve (Fed) Chairman Greenspan believes free trade lowers consumer prices and thus is in the best interest of consumers. He is opposed to import tariffs intended to, for example, provide a level playing field for different environmental standards (and costs) because it would open a Pandora’s box for special interests, protectionism and eventually a trade war. The ‘pure’ free trade argument postulates that regulation should be localized and market and political forces will eventually level the playing field. Beyond that, there is no reason why labor-intensive industries should be protected, as competition with low labor cost countries is a losing battle. Instead, it is important to have a flexible society so that resources can be re-deployed more productively in more competitive sectors of the economy. We also hear warnings that everyone is worse off with protectionism, just as the depression during the 1920s was more severe and longer than it could have been because trade barriers were raised. Trade barriers tend to penalize those embracing change and to block job creation, while subsidizing those who do not adjust.
Opponents of free trade tend to focus on the fallout of what is attributed to globalization. Notably, we see a destruction of the manufacturing base and jobs in the United States as corporations outsource manufacturing to Asia and other parts of the world. We see that real wage growth has difficulty keeping up with inflation. We see a growing income gap between the rich and the poor. It is human nature to resist change, and there are seismic shifts underway in societies around the world. Opponents of globalization criticize that economic interests are put ahead of human rights and political progress. As we will see below, fiscal and monetary policies have a large role to play in the negative fallout attributed to globalization.
We sympathize with Greenspan’s concern that politicians could easily cause more harm than good. However, let us start on his home turf: monetary policy. Low interest rates foster consumption, foster credit expansion and foster trade. Conversely, higher interest rates may put a damper on trade. Greenspan is allowed to control trade, but he thinks elected officials should stay out of it. To remain provocative, let us look at the dollar. What is “free” about a pegged exchange rate? Many Asian countries try to keep their currencies weak versus the dollar to foster economic growth and exports in the region. Nobel Laureate Robert Mundell argues that fixed exchange rates facilitate commerce. Money will flow to regions that are economically more attractive; inflationary pressures will be contained as long as there is enough demand to offset the supply pouring into the region. In the case of Asia’s growth, lots of money is flowing into the region. In our assessment, Asia has been importing potentially substantial inflation as growth is put ahead of sustainable economic development. The point for purposes of this analysis is that exchange rates significantly affect trade, and what we have had over the past years cannot be considered “free trade.” Recent pressures by the U.S. Treasury Department to have China revalue their currency is a double-edged sword: the reason we have had mild inflation in the US on anything we can import is precisely because Asia has been willing to subsidize its exports to the US. We use the term “subsidy” as that is what a fixed exchange rate amounts to, plain and simple.
Critics of free trade argue that tariffs should smooth out imbalances. If we have higher limits on pollutants emitted, then imports from countries with lax standards or enforcement should be penalized. If we have an expensive social security system, and much of Asia does not, we do not want to undermine our social stability and should impose tariffs if other countries do not have comparable systems. If we believe it is strategically important to have our own automotive manufacturing industry, we should have tariffs to smoothen out any ‘advantage’ other countries may ‘unfairly’ have. Following through this line of argument, you can see very quickly why Greenspan says we should have none of that. Depending on your political persuasion, you may prefer Greenspan’s line or you may think we should have barriers in place to protect our higher environmental standards, protect our social security, or go as far as protecting ailing industries. You may also vote with your feet and try to purchase only domestically produced goods (good luck doing this consistently).
Effects on job security
The Financial Times recently wrote, “In the Fed’s analysis, the drag from the trade deficit has required looser monetary policy, to stimulate domestic consumption and to prevent an unacceptable drop in US growth.” Without a doubt, the Fed is very much involved in trade policy. But there is more to it: the added stimulus has not gone without its side effects. Not only has there been a conscious attempt to increase domestic growth, but growth in Asia, where much of what we consume is produced, has also been elevated. While this sounds wonderful at first, high commodity prices are a direct result of growth at any cost. Why should you care if you are an American consumer? You should care because not only does it affect your pocket book (e.g. at the fuel pump), but also because it reduces your job security. It reduces your job security because corporate America is squeezed by high raw material prices and low consumer goods prices because of the flood of cheap imports from Asia. Another reason for low consumer prices is that consumers are heavily in debt and may not be able to afford higher prices. That leaves corporate America with little option but to squeeze maximum efficiencies out of its labor force to remain competitive. In plain English: if you are working in the manufacturing industry, expect your real wage growth to be lackluster at best, expect that your employer may outsource your job to lower cost countries.
Sensitivity to interest rates
Following the tech bubble burst after 2000 in the US, corporate America had a recession. However, US consumer spending never declined, courtesy of massive fiscal and monetary stimuli. While balance sheets of corporate America were cleaned up, US consumers were encouraged to take on ever greater amounts of debt. US government debt also rose sharply during this period. Now we are in a situation where both US consumers and the government are highly sensitive to changes in interest rates: many US consumers have taken out adjustable rate mortgages and the US government suspended sales of the 30-year bond a couple of years ago. Both of these actions lead to increased sensitivity to changes in interest rates.
Effects on growth and inflation
The recent “employee discount” program offered by automotive companies is a sign that the American consumer is ready for a break. US housing prices may also be beyond their peak, as much consumption has been financed through home equity extraction in recent years, this is another sign that we are heading for a slowdown. Even though imports from Asia have had a dampening effect on inflation, consumer prices recently grew at a rate not seen in 18 years. Even the rate that excludes food and energy is steadily climbing, making the Fed nervous.
The US economy may be slowing down, just as inflation is picking up. Worse for the Fed, because of an economy that is more interest rate sensitive, even small rate increases may cause a recession, yet not be sufficient to stave off inflation. You may have noticed that much of the talk about raising rates has been about getting rates into “neutral” territory. One does not fight inflation with a “neutral” monetary policy, especially one that we have not yet even reached. You can justify such lax monetary policy only if you believe inflationary pressures are transient. Nominated Greenspan successor Ben Bernanke earlier this year said elevated oil prices are transient – they certainly were, they did not stay long at $40 a barrel (but went up to over $60).
“Globalization” and “free trade” are blamed for many job losses. Politicians influence the speed of the transition. They accelerated this trend beyond its ‘natural’ rate through policies fostering consumption rather than savings and investment. The pace fostered by monetary and fiscal policy is causing a transition that is fast and painful, leaving the US economy vulnerable. Vulnerable economically as households are deeply in debt. Vulnerable socially as leveraged households have much less resistance to shocks: if you lose your job or have other unexpected expenses, it is easy to fall behind in your credit payments. Greenspan admires the increased “efficiency” of the US economy (if you lease or buy on credit rather than pay in full everything you consume, your monthly salary takes you much further.
The Fed’s reaction
There may well be more fallout. Greenspan and his nominated successor Bernanke have to guide US monetary policy. Bernanke promised when he accepted his nomination that he will do everything in his power to preserve American prosperity. This is laudable in principle, but confirms us in our belief that he will continue to promote consumer spending over savings and investment. Savings and investment are an essential part of a balanced economy – just as it is crucial for the success of every household. There is a lot of talk about Bernanke’s desire to target inflation. The only thing we know for sure is that Bernanke is very much afraid of deflation, that he does not like to see inflation edge too low. Deflation per se is not bad – if you have money, your purchasing power increases as prices decrease. Technological progress has allowed us to enjoy lower prices on many goods and services over the years. The Fed is afraid of deflation when it is associated with reduced consumption, as it could lead to an economic downward spiral. Deflation is also very painful when you have a lot of debt. The US has every incentive to promote inflation as it reduces the value of outstanding debt. This equation works well if you have Asia continue to sell cheap goods to the US and dampen inflation. However, inflation is not a switch that the Fed can turn on or off, it is a cancer that will spread slowly and is more difficult to fight the further it has spread; just because we do not see the symptoms show up everywhere does not mean we can be complacent.
Administration fixated on growth
This administration has been very consistent in that it promotes growth. At any sign of slowdown, tax cuts and other fiscal stimuli have been proposed and implemented. Spending bills authorized and proposed will ensure a fiscal stimulus in the coming year, independent of whether tax cuts will be made permanent or not. We are rather concerned that this stimulus in the pipeline will further escalate commodity prices and act as a wrench on the consumer. After this holiday season, we expect consumers to have a rude awakening. Regulations that have come into effect recently double the minimum payment due on credit cards; interest charges on balances carried are higher; heating bills this winter will be a shock. In what may be the perfect storm for the consumer, we expect the Fed to be more concerned about an economic slowdown than inflation. In our view, the odds are high that the Fed will raise rates far enough to let the economy tumble into recession, while not raising rates sufficiently to stop inflation from progressing.
As US consumption slows, the question is how Asia will react. Asia has been supporting US economic growth by subsidizing their exports through artificially weak exchange rates. Many economists believe that Asia must cave in soon and let their currencies rise. While this may happen eventually, let us not forget why Asia has pursued this policy in the first place. Asian leaders are interested in political stability, which they can keep as long as jobs are available. If we are stunned by the rapid transformation the US is undergoing, changes in Asia are far more radical. Globalization has allowed over a billion people to participate in the global marketplace, most of them with very modest wage demands. Countries such as China are eager to produce goods to sell to American consumers. China may be a low wage country, but it is not a low cost country; aside from bureaucratic hurdles pushing up costs, China is an importer of raw materials, squeezing Chinese corporations’ profitability. By de facto fixing its exchange rate versus the dollar, China is not only providing a stimulus to the US economy, China is also importing inflation as investments take place in areas that would not be profitable in a free market environment. The sound reaction for Asia would be to slow down growth, amongst others, by letting their currencies rise. However, we believe Asian politicians are too concerned about the fallout a serious slowdown would have. If you take away the punchbowl from an inflated economy, the resulting trough could lead to social unrest. We would not be surprised to see much of Asia react erratically as US consumption slows. Notably, we would not be surprised if Asia were to try to sell to American consumers even at a loss.
Another reaction we may see is more aggressive moves by Asia to diversify its “client base.” This means that Asia will try to sell more goods to Europe in order to reduce its dependency on the United States. Efforts by Chinese companies to enter the European marketplace or to strengthen their foothold in Europe are intensifying. Further, we would not be surprised to see China increase its Euro reserves as it diversifies away from the US dollar; China can use its “basket of currencies” as a strategic tool to guide trade.
Odds favor a recession
If we have a slowdown in US consumption, we will enter a recession unless corporate growth or government spending will take up the slack. Given that the US economy is highly dependent on the US consumer, odds favor a recession. Corporate America is awash in cash, but has been reluctant to invest. We believe this is a direct result of the global imbalances where corporate America sees that investments in any industry where Asia can also compete are an uphill battle. Not surprisingly, “new economy” companies have done very well, as these are companies focusing on industries able to thrive in this environment; however, “old economy” companies are at serious risk a situation only exacerbated by untenable pension obligations.
Effects on the dollar
It is not good for an economy to allow a current deficit to get out of proportion – no country has been able to maintain its currency with a current account deficit of 6% over an extended period. As the US economy slows, will foreigners still be willing to purchase US dollar-denominated assets at a rate of $2 billion a day? As less money may be attracted into the US, bond prices may fall, increasing borrowing costs. The United States next year is likely to pay more interest to foreigners on its obligations than it collects in interest from assets owned abroad. As borrowing costs rise, there is a chance that the current account deficit may even increase even with a slowdown in consumption. The result may be further pressure on the dollar. Unless policies are instituted to foster savings and investment, structural pressures on the dollar are likely to remain in place.
Highly accommodating fiscal and monetary policies in the US over the past couple of years have created numerous bubbles both in the US and Asia while eroding the US manufacturing base and driving the US consumer further into debt. As interest rates were declining, increased debt financed consumer spending. Now, however, as interest rates are rising, the leveraged US economy is more sensitive to rises in interest rates and consumers may soon need to cut spending.
This is not the time to be complacent as the forces of globalization affect everyone. Evaluate how secure your job is in light of globalization; evaluate whether you can cope with your mortgage payments should interest rates rise further, or should you lose your job. Evaluate whether your investment portfolio is properly positioned, whether you are diversified to be protected or even profit from the trends described herein.
Axel Merk is the Portfolio Manager of the Merk Hard Currency Fund. For more information on the fund, go to www.merkfund.com