Kamis, 05 Juli 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.

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