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“If the economy were not in the throes of writing down bad debts that were caused by a massive decline in asset prices, it is possible that the money supply (M2) in response to this increase in reserves could have expanded by $4 trillion, or 96%. According to the late Nobel prize winning economist Milton Friedman, an increase in M2 of that magnitude would have been highly inflationary. However, M2 did not explode. Instead, in the past twelve months this aggregate has risen only 3%. This is less than 1/2 of the average growth rate over the past fifty years (Chart 2).

“If, as Friedman assumed, the velocity of money is stable (MV=GDP) then nominal GDP expansion in the ensuing quarters can be expected to grow about 3%. If prices rise about 1.5%, then real GDP growth would also rise about 1.5%, which is far below the level of growth needed to employ new labor force entrants and existing unemployed or to more fully utilize our present unused capacity in our factories. In the last six months the growth rate of M2 has slowed to near zero. If this pattern continues, it would be rational to expect GDP to grind to zero with no change in the price level.”

                             Van R. Hoisington and Lacy H. Hunt

FX Trading – Dollar, Debt and Dominance
Last week when I touched upon the US dollar’s technical pattern, and the near-term potential for it to roll over a bit, I made mention of the lingering debt problem in the US. Especially when it comes to the US dollar, US debts are a growing concern that keep many analysts US dollar-bearish.

Most all reasonable analysts can accept the fact that, as we believe, the US dollar can rally based on money flow as its driven by risk – capital leaving risky assets in search of safety, i.e. the US dollar. We resurrect an article from the September/October 2009 volume of Foreign Affairs for (now common) reasoning behind this dynamic:

“If reserves are not readily convertible into cash, they cannot easily be deployed into market operations – hence the appeal of the market for US Treasury bonds: it is the single-most liquid government bond market in the world, as reflected in its high turnover and the narrow spreads between the bid price and the ask price. This liquidity is partly a function of the US economy’s sheer size, but it is also a self-reinforcing feature. Foreign investors undertake their transactions and concentrate their holdings in US markets because these markets are liquid, and that activity, in turn, makes them more liquid. As in politics, in the competition to be a leading international financial center and to hold the top reserve-currency status, incumbency is an advantage.”

It’s died down recently, but for a while there was heavy talk about the need to replace the US dollar with a new reserve currency. Oddly, though, throughout the recurring rhetoric there has been little change made to accumulation of US Treasuries by foreign investors.

The chart below shows that growth in securities held at the Federal Reserve on behalf of foreign investors has not slowed over the last four years. The above excerpt from Foreign Affairs plays a large role in explaining this picture:

Weekly Marketable sec held in custody by FRBs foreign off & intnat acc total (average)

This picture also seems to suggest the lack of any viable alternative to the US dollar as reserve currency. I refer to another piece from the Foreign Affairs article:

“The euro area, which comprises the 16 members of the European Union that have adopted the euro currency, possesses the requisite scale: it has a GDP comparable to that of the United States and, at least for the moment, and even greater ratio of debt to GDP. But the euro area’s stock of government securities is heterogeneous, with bonds of different governments offering different risks, different returns, and different degrees of liquidity.”

China is not nearly capable of taking on the role of world leader and the responsibility of managing a reserve currency. In fact, the next few years could bring them further from that potential, rather than closer to it. Japan and its yen won’t fill the role. The UK and its sterling are not an option. There are far too many hurdles for some type of SDR to fulfill the role the US dollar plays in world markets. And as we’ve discussed many times before and the above passage aptly conveys, the Eurozone does not possess the right make-up to take on such a role.

So, despite the glaring deficit/debt problems in the US, the dollar has still got a lot going for it.

But what about in the long run? As one Currency Currents reader responded on Friday by asking: WHAT IS YOUR RATIONAL FOR WHY OUR DEBT WILL NOT CAUSE THE USD TO WEAKEN?

Everything I just mentioned above plays into our view as to why debt (at this point in time) may not prove to be the burden on the US dollar as many believe it will. But as I said on Friday, if things don’t change and the trend to debt continues then over the next decade there may be a continued, and increasingly worrisome, decline in the US dollar. We won’t deny that.

But what’s happening right now?

Government spending has not been cut back yet. A new proposal to raise the US debt ceiling just graced the US Senate.

Ouch! Someone should be shouting “WRONG DIRECTION!”

What this does, for now, is deter private foreign investors from putting money in the US. Again, this is not a healthy trend if it lasts. But as the chart above showing Fed custodial holdings, foreign central banks and governments have not been deterred.

Something else to keep in mind, the current account deficit has improved in the wake of the global credit crunch. And still, foreign central banks and governments have not been deterred.

Quarterly Total

And speaking of central banks, they’re pumping their fair share of money out … only to watch it fall on deaf wallets. Without money changing hands, money supply cannot grow …

M2 Money Supply

Source: Van R. Hoisington and Lacy H. Hunt,
Quarterly Review and Outlook – Fourth Quarter 2009

There is deleveraging happening in the US. It is impacting global imbalances and should impact the direction taken by economies. Perhaps the US can get the message and use the opportunity to make some changes to its bearings.

US Gross Capital Formation; Fixed Investments

Based on the chart immediately above, it would help if that measure improved – investment into productive resources needs to pick up. No longer can we sustain growth built around uber-consumption; consumers and their changed-ways are telling us that. We need to become well-rounded … not immediately, but over time.

Because frankly, tweaking monetary policy and drunken fiscal policy cannot spark healthy growth. It is not appealing to investors – foreign or domestic – to see a whole bunch of fluff and a whole bunch of red.

Consider this comparison:

MacDonald’s is THE king of fast-food restaurants – their Big Mac the reserve burger, if you will. Their share price has done nothing but rise in the last 35 years, minus a blip in the early 2000s. The Big Mac is a commonly-cited index in The Economist. Mickey D’s continues to dominate the industry despite calls that they don’t do business right; that they deliver a bad-for-you product; or whatever else they’ve dealt with over the years.

Yet they continue to be number one because they know how things work. For now, they will stay there … until a major shift takes place that gives rise to Tofu World soaking up the fast-food market share. At which point, if MacDonald’s doesn’t make major changes to align themselves with the changed market, they will cross the line into failure.

We don’t view the US as having crossed the line yet; still far from it, actually.

Paraphrasing a different article from that same September/October 2009 volume of Foreign Affairs discussed at the onset:

“The US boats the largest economy of any country in the world (by far); the US spends the most on defense (by far) and boasts the largest Navy; the US claims 17 of the top-20 and 39 of the top-50 universities; the US is home to the highest level of per capita income in the world; US spending on education and Research & Development outmatches several world powers, especially China.”

Debt won’t stop the dollar unless the debt never stops.