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Recent U.S.
economic data, such as the modest drop in the unemployment rate and the
massive expansion of consumer credit, have suggested that the American economy
is finally recovering. Opposite conclusions are being thrown at Europe, where
many are convinced that recession is returning. Not surprisingly then, the
dollar is currently hitting a multi-year high against the euro. The strength
of the dollar itself is often held up as one of the major proof points that
the U.S. economy is "improving." But the data points that I believe
really matter continue to suggest an economy on life support. I believe that
the dollar is rising for reasons that have nothing to do with America's
economic health.
The ongoing
sovereign debt crisis in Europe is unquestionably the center ring in the
current economic circus. Given the difficulty of setting policy across
borders and national interests, the negotiations in Europe have been messy,
acrimonious, inconclusive, and conducted under the glaring lights of global
media scrutiny. The action has diverted attention away from America's
problems, which in many ways are even greater than those in Europe. In
contrast, America's ability to print the world's currency at will, and the
nearly seamless agreement of policy between the Administration and the
Federal Reserve, means that the United States has been able to virtually
ignore the issues that Europe has been forced to confront. This relative calm
has been mistaken for strength, and the dollar has beckoned as the ultimate
safe haven currency.
The fact that
the dollar is perceived as a safe haven acts as a self-fulfilling prophesy.
Investors flee the euro and pile into dollars. The dollar then rises to
reflect the demand. The increase validates the decision to buy in the first
place, and the rising dollar then attracts even more buyers looking to profit
from its appreciation. It's a nice ride while it lasts.
Most
"safe haven" dollar purchases are directed toward U.S. Treasuries.
As a result U.S. interest rates are far lower than they would otherwise be
without this inflow of spooked liquidity. But objectively speaking, the U.S.
and Italy, for instance, have very similar national debt profiles. Yet
interest rates in Washington are currently 600 basis points lower than they
are in Rome. This means that Americans can borrow and spend much more. The
result of all this extra debt financed consumption is a boost in employment
and GDP. The positive economic impact makes the dollar even more attractive,
thereby perpetuating the cycle.
If rates in
Italy (or Spain for that matter) were as low now as they were two years ago,
those countries would not be experiencing the problems they are today. Their borrowing
costs would never have risen and their budgets would still be manageable.
Similarly, higher interest rates in the U.S. would completely take the shine
out of our economy. Imagine what would happen here if rates were just 200
basis points higher, let alone 600? U.S. consumers, homeowners, corporations,
and governments are particularly dependent on cheap financing. As bad as
things are in Europe, they would be even worse here.
In other
words, contrary to popular belief, the problems in Europe are helping, not
hindering, the U.S economy - at least in the short-term. Over the long term,
borrowing and spending more money to finance consumption and government red
ink will not help the U.S. economy achieve a sustainable balance. If safe
haven flows were to reverse (which could result from an improvement in
Europe), the dollar would fall, interest rates and consumer prices would
rise, and the U.S. economy would be right back in recession. The only
"good news" is that such a positive development in Europe appears
unlikely in the short-run.
All
self-perpetuating virtuous cycles are vulnerable to a sudden break in the
positive feedback loop. When reality rears its ugly head, and the spell
breaks, the reverses can be vicious. It happened with dot com stocks, it happened
with real estate, and I believe it will happen with the dollar and
Treasuries. Even if Europe does not resolve its problems, the day of
reckoning will still eventually arrive. The unfortunate truth is that the
longer it takes, the worse it will be, as we will have that much more debt to
reckon with.
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