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Transition Analytics: From Stimulus Onward, and the Dollar?

In my last article, I detailed the efforts taken by the US government to end the credit freeze and recession. I concluded that as long as these problems remain, the Treasury should run a large deficit and the Fed should print money, make loans, guarantee loans, buy Treasury debt, etc. Have you heard this before? Maybe John Meynard Keynes’ letter to Roosevelt back in the ‘thirties:
 
Broadly speaking, therefore, an increase of output cannot occur unless by the operation of one or other of three factors. Individuals must be induced to spend more out o their existing incomes; or the business world must be induced, either by increased confidence in the prospects or by a lower rate of interest, to create additional current incomes in the hands of their employees, which is what happens when either the working or the fixed capital of the country is being increased; or public authority must be called in aid to create additional current incomes through the expenditure of borrowed or printed money. In bad times the first factor cannot be expected to work on a sufficient scale. The second factor will come in as the second wave of attack on the slump after the tide has been turned by the expenditures of public authority. It is, therefore, only from the third factor that we can expect the initial major impulse.
 
But what happens when the economy starts to show some life and starts a rebound? How should the US change its monetary and fiscal policies? What should the transition strategy be? To answer this question, domestic and international elements must be considered.
 
Domestic Considerations
 
First, a brief primer on the Federal Reserve, the US central bank. Unlike other parts of the central government, the Fed does not need Congressional approval for its actions. What can it do? It can buy assets by issuing debt. Its debt is non-interest bearing – US dollars. Paulson went to the Fed to arrange the AIG (Goldman) bailout because at that time, Congress had not yet approved TARP. And since the start of the credit freeze and global recession, Bernanke has had the printing presses running. As I detailed in my last article, the balance sheet of the Fed has grown by an unprecedented 152% since the beginning of 2008. A good part of that growth resulted from the purchase of bad assets owned by US banks and Federal housing agencies. It also purchased $238 billion in Treasury notes and bonds. In short, a very significant part of the US stimulus has resulted from actions of the Fed.
 
Now, let us go back to the equation I set forth in my prior article:
 
MV = PY = GDP
 
In this equation, M stands for the money supply (M2 in the numerical work that follows), V stands for the velocity of money (how many times is it used to buy goods and services in a given time period); P is a price index; Y is real gross domestic product; and GDP stands for gross domestic product in current dollars. Here, we will focus on MV = GDP since we are not worried about inflation. Table 1 derives velocity data by dividing GDP by M2. 
 
Table 1. – US: GDP, Money, Money Velocity of Circulation
 
2006
2007
2008
2008
2009
2009
2009
2009
 
end 1st Qtr
end 1st Qtr
end 1st Qtr
end 4th qtr
end 1st Qtr
end 2nd qtr
end 3rd qtr
end 4th qtr
GDP (tril. US$)
13.18
13.80
14.37
14.35
14.18
14.15
14.24
14.46
M2 (tril. US$)
6.77
7.20
7.71
8.28
8.36
8.44
8.48
8.51
Velocity
1.947
1.917
1.865
1.733
1.695
1.678
1.680
1.699
Source: US Bureau of Economic Analysis and Federal Reserve
 
V has fallen by almost 13% since 2006. That slowdown in the pace of spending is the cause of the global recession. Now, the government has attempted to counter this by expanding M2 25% over this period via deficit finance and other Fed actions. It has not been enough.
 
Perhaps we should listen again to Keynes: in a serious downturn, expanding the money supply by making more money available to banks is not enough: The government must get money to citizens and firms via expenditures and hope they, in turn, spend it. How? Increase government expenditures and get the Fed to print money to cover it. I would add that it will help a bit if the Fed also:
 
  • Buys more assets;
  • Makes more loans and guarantees more loans; and
  • Coordinates with the Treasury to get the right level of stimulus.
 
As V grows, as manifested in higher consumption, investment, overall aggregate demand, and employments starts increasing, the government should take steps to gradually reduce its stimulatory effort – higher interest rates, less expansionary action by the Fed, less new loans, etc.
 
At some point, it will become clear the economy is recovering. My indicator for this? Monthly job gains of 75,000 net for three months running. I will deal further with this issue in a coming article but not here. But for those interested in this issue, and on how large a recovery will occur and how long it will take, a sobering must-read article has just been written by the McKinsey Global Institute
 
When it gets to a point that it is clear the economy is recovering, the Fed and Treasury have to work together to get the US back to objective of Employment Act of 1946 – full employment with reasonable price stability. The Fed can slow down the growth in aggregate demand by starting to sell some of the assets it has purchased in the last 15 months:
 
  • $970 billion in asset backed securities;
  • $165 billion in Federal agency securities, and
  • $90 billion in AIG securities.
 
The Treasury does not have the flexibility of the Fed because almost everything it does requires Congressional approval and a Presidential signature. But even without Congressional approval, it can start working to liquidate TARP. Of course, the President and Congress will have to find ways to reduce the projected unsustainable US government deficit.
 
International Considerations
 
I start with two key observations:
 
1. Any country that exports now or would like to export to the US does not want the dollar to weaken.
 
2. The loss of US manufacturing jobs has less to do with cheap labor overseas and more to do with China and Japan efforts to keep the dollar articifically strong. That strength means the US runs large trade deficits and has lost most of its manufacturing. But companies like to produce in the US – there is more foreign direct investment in the US than in any other nation.
 
A question: does it really matter if foreigners buy US government debt? What if all US debt was sold to the Fed and US citizens: – the more to the Fed if stimulus is needed, the more to citizens if the goal is to reign in demand.
 
To answer this question, it is important to understand US international transactions, as presented in Table 2. The US imports considerably more goods and services than it exports. This is manifested in the Current Account net item in the Table (the Current Account is dominated by the Trade Balance). That trade deficit, if not offset, would flood the world with dollars, forcing a dramatic weakening of the dollar. But there is an offset – the Capital Account net in the Table. 
 
Table 2. – US International Transactions (bil. US$)
Item
2000
2001
2002
2003
2004
2005
2006
2007
2008
Current Account, net
-358.78
-333.78
-394.20
-449.73
-542.77
-642.91
-712.27
-610.58
-577.71
Capital Account, net
477.70
400.25
500.52
532.88
532.33
700.72
779.44
657.33
533.97
 
 
 
 
 
 
 
 
 
 
U.S.-owned assets abroad
-560.52
-382.62
-294.65
-325.42
-1,000.87
-546.63
-1,285.73
-1,472.13
-0.11
 U.S. government assets
-1.23
-5.40
-3.34
2.06
4.52
19.64
7.72
-22.40
-534.46
 U.S. private assets
-559.29
-377.22
-291.31
-327.48
-1,005.39
-566.27
-1,293.45
-1,449.73
534.36
    Direct investment
-159.21
-142.35
-154.46
-149.56
-316.22
-36.24
-244.92
-398.60
-332.01
    Foreign securities
-127.91
-90.64
-48.57
-146.72
-170.55
-251.20
-365.13
-366.52
60.76
    Other
-272.17
-144.23
-88.28
-31.20
-518.61
-278.83
-683.40
-684.61
805.61
Foreign-owned assets in the United States
1,038.22
782.87
795.16
858.30
1,533.20
1,247.35
2,065.17
2,129.46
534.07
 Foreign official assets in the United States
42.76
28.06
115.95
278.07
397.76
259.27
487.94
480.95
487.02
    US Treasury & Other Agency Securities
35.71
54.62
90.97
224.87
314.94
213.33
428.40
269.90
543.50
    Other foreign official
7.05
-26.56
24.97
53.20
82.81
45.93
59.54
211.05
-56.48
 Foreign private assets in the United States
995.47
754.81
679.22
580.23
1,135.45
988.08
1,577.23
1,648.51
47.05
    Direct investment
321.27
167.02
84.37
63.75
145.97
112.64
243.15
275.76
319.74
    U.S. Treasury securities
-69.98
-14.38
100.40
91.46
93.61
132.30
-58.23
66.81
196.62
    U.S. securities other than U.S. Treasuries
459.89
393.89
283.30
220.71
381.49
450.39
683.25
605.65
-126.74
    Other
284.29
208.28
211.14
204.32
514.38
292.76
709.06
700.29
-342.57
 
 
 
 
 
 
 
 
 
 
Memorandum - Net Private
 
 
 
 
 
 
 
 
 
Direct Investment
162.06
24.67
-70.09
-85.81
-170.26
76.40
-1.77
-122.84
-12.28
Securities
262.00
288.86
335.13
165.44
304.55
331.49
259.89
305.94
130.64
 
 
 
 
 
 
 
 
 
 
Memorandum - Foreign Official Purchases
42.76
28.06
115.95
278.07
397.76
259.27
487.94
480.95
487.02
Source: US Bureau of Economic Analysis
 
As can be seen, the Capital Account net has offset the deficits in the Current Account net over the last few years. The remainder of Table 2 is a summary of the major items in the Capital Account. For purposes here, I direct your attention to the Memorandum items at the bottom of the Table. These items are net figures from the inflow and outflow items above.
 
Even though there is more foreign direct investment in the US annually than any other nation, the US has been investing large amounts overseas such that in the last 5 years, there has been a net direct investment outflow from the US.
 
Now look at the Securities item. For many years, foreign private investors have purchased US securities (stocks and bonds), and this inflow has been a major offset to our Current Account deficit. But note that in recent years, Americans have started to invest heavily in foreign stocks and bonds: foreign securities purchases of $170 billion, $251 billion, $365 billion, and $367 billion in the years 2004 – 2007, respectively.
 
The Foreign Official Purchase Item documents primarily Chinese and Japanese government purchases of US government securities over the last few years to prop up the dollar.
 
Okay – with this information in mind, I return to the question posed above: does it really matter if foreigners buy US government debt? It does, only insofar as it serves as an offset to the US trade deficit – foreigners use dollar holdings to buy US securities.
 
I finish this article by looking into the future on what will happen to the US dollar.
 
Alternative Scenarios
 
One obvious scenario is to assume foreigners (both government and private) buy enough US financial paper to continue to offset the US current account deficit. If so, things will go on as they have – the dollar remains artificially strong, and US manufacturing continues to suffer.
 
But consider the other extreme – the governments of China, Japan and other foreign nations give up on trying to prop up the dollar, and private investors, fearing a weaker dollar, stop buying US securities. If this happened the dollar would fall in value relative to other currencies. The result would be a spike US exports and foreign direct investment in the US.
 
What do I think is likely to happen? Just guesses:
 
1. At least the Chinese government has lost its enthusiasm for propping up the dollar. It has learned from the global recession that it can get on with lower levels of exports to the US.
 
2. Foreigners will think a lot harder about buying securities in the debt burdened US, UK, Japan, and EUR countries.
 
3. Citizens of the US, UK, Japan, and EUR countries will gradually increase purchases of securities in the low debt countries of Asia and Latin America.
  
If I am right, consider the implications for the capital account offsets to the US current account deficit discussed above. Without these offsets, the dollar will weaken significantly in world markets.


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