American habits and the falling dollar: No one likes to go hungry

Rob Creekmore

monroe street journal

Before he was the Chairman of the Federal Reserve, Ben Bernanke spoke of a "global savings glut," and the fact that the US was the exception. Frankly, it was difficult for Americans to see what he was talking about. The US had experienced negative private savings since 1995 and record public spending deficits since 2000. Therein lay the problem. America could seemingly borrow in perpetuity. With the dollar propped up by China's artificial currency peg, Americans could continue to buy foreign goods cheaply. And with low interest rates fueling the housing bubble, there was even more borrowing against home equity. How long could it last? How big of a fall were Americans setting themselves up for?

Fast forward a few years and the Fed finally raised interest rates throughout 2005, taking away the punch bowl. Only then did the dollar begin to recover against the Euro, but the effect was only temporary. In 2006, we saw the dollar continue to fall, down a staggering 35% against the Euro since 2002. Did Ben Bernanke decide to raise rates again? No - in fact the Federal Reserve lowered them by a half-point. Why did Ben "flip-flop?" Well, with higher interest rates, we saw more expensive home equity loans triggering the collapse of the housing bubble. In combination with the increased use of adjustable rate mortgages (ARMs), higher interest rates also led to record setting default rates of subprime mortgages. While some hedge funds have bet against these subprime lenders, others took huge losses. Banks quickly became hesitant to loan each-other money, fearful of being left holding the bill. Mr. Bernanke's recent action to lower short term interest rates by half a point has eased the credit crunch, but at what cost? What flexibility does the Fed really have at this point? Now that the music has stopped, will America be left standing without a chair? To get an informed perspective, we met with several faculty members at the Stephen M. Ross School of Business and the University of Michigan, Department of Economics.

At a basic level, we have all heard that savings equals investment. The US has negative private savings, negative public (i.e. government) savings, with the majority of investment coming from overseas. What does that mean for the account deficit in the long term? How can it be so imbalanced?

Professor Linda Tesar, Professor and Chair of the Department of Economics at the University of Michigan, joined us to comment:

Tesar: "Keep in mind that savings does not equal investment in an open economy - only in a closed economy."

One fear that some of us have is that a sudden drop in the dollar could cause foreign investors to "puke their positions" and pull out of the US market because it has gone beyond their tolerance for risk. And if that is possible, in its move to diversify its $1.3 trillion foreign currency reserves into a basket of currencies and private investments (ala Blackstone), could China's sale of T-bonds trigger a run on the bank?

Professor Minyuan Zhao, who teaches a class on World Economy as an Assistant Professor of Strategy at the Ross School of Business, generously lent us her time.

Zhao: "China has been divesting itself of its position in the market, but slowly. It's simply not in China's best interest to move quickly on this, because it will only devalue its dollar holdings. China is divesting for a few reasons. As Europe consumes more of China's exported goods, China will not be so nervous about the depreciation of the dollar. Second, China is diversifying because ultimately the dollar may not be entirely risk-free."

Zhao: "Think of it this way: American consumers are buying its toasters, microwaves, textiles, etc, and China is simply getting IOU's in return. China is basically giving out loans to sell more goods and services. Now, historically, the US has had a very high credit rating. But as we have seen with some large companies that start out with high credit ratings, they do not always keep them high. Likewise, the US credit rating may gradually go down."

That would seem to explain why the Fed has been raising rates in 2005 and 2006, even after the housing market was in clear decline, presumably to keep foreign investment flowing into the US, slow the rate of foreign central banks divesting US holdings, and keep the exchange rate from dropping too rapidly.

Professor Jagadeesh Sivadasan, Assistant Professor of Business Economics at the Ross School of Business, also joined us to speak about Federal Reserve policy and the trade deficit.

Sivadasan: "The Federal Reserve is focused on keeping inflation low. In theory, they don't really care about exchange rates; only in so much as they affect the overall health of the economy. Let's take India for example. It used to be that India's trade was highly regulated and the only major import was oil. In fact, a large portion of the nation's oil was imported. If the currency drops, the price of oil goes up, but the demand for India's exports also goes up. In the long run, there is an indirect effect on inflation. We may see that here in the US, but I am not sure the impact will be very large since the US has a relatively low trade to GDP ratio."

Rob: So what was Bernanke thinking when the Fed dropped interest rates by half a point? If the Fed is just concerned about inflation, didn't he just boost direct inflationary pressures and at the same time discourage the other central banks from holding onto their T-bonds?

Zhao: "He is in a bind. But the risk in my view is not a drop in the dollar. The risk is in giving Wall Street the impression that a bailout will occur after a bout of poor investment choices. In the next boom cycle, they will take even more risks if they think another bailout will come."

Rob: What is not clear to me is why at the very same time Bernanke cut interest rates, we see Greenspan in his new book, "The Age of Turbulence," talking about the Fed having to raise interest rates into the double digits in the next decade. Obviously rates that high are not entirely new, but it has been a long time since the US has had to deal with that. Is he actually saying inflation risk will be that high?

Zhao: "He's talking about going hungry. Once you eat a big meal, you have to go hungry for a while. But no-one likes to be hungry, so most likely it is going to happen involuntarily. Eventually, we will see the reluctance of foreign investors drive up the interest rate and drive down the value of the dollar… so fewer Americans can afford to buy McMansions or expensive foreign cars." Professor Zhao was talking about the rising cost of capital - the fact that with inflation taken into account, real interest rates have risen 4% in the last year, from negative 1% between 2001 and 2005, to 3% now. "At the same time, American goods and services will be in higher demand overseas, which corrects the imbalance."

Rob: It's just mind boggling to think that the US trade deficit, negative since 1979 and growing every year, will reverse course.

Tesar: "According to this figure, it has already begun to change course [in late 2006]."

Zhao: "The currency will drop until the trade deficit comes into balance. If you look at the Asian financial crisis of 1997, the Korean currency [Won] lost 60% of its value. The Thai Baht lost 60% of its value. That won't happen in the US. It is a large and robust economy, a diversified economy. Part of the reason that the Dow Jones is doing so well right now is that it is mostly made up of multinational companies, which are diversified in terms of revenue sources in a variety of currencies. A weaker dollar ultimately means that foreign profit translates into more dollars. A soft landing would be a weaker dollar and that the US imports less foreign goods." (A hard landing would presumably be a recession and high interest rates.) "It's going to be somewhere in-between."

Rob: Where does this leave American business with respect to foreign investors? Could they get nervous and pull out?

Tesar: "If the current account is in deficit because other countries are making highly productive investments in the US, then there is little cause for concern. Where will investors go if not to the US? Despite our problems, the investment climate here appears to be healthier than anywhere else."

Sivadasan: "Capital will flow so long as foreign investors continue to see value for their money. As long as American companies continue to come up with innovative ideas and create intellectual capital, it can continue. What's curious is why Blackstone bought Hilton as opposed to somebody like Disney."

Our distinguished guest Robert McKee may have been onto something at this year's Ross Leadership Initiative, when he declared, "There are no hotels in China!" Regardless, there is no need to worry. With inflation solid at 2%, don't expect to see people pushing wheelbarrows of cash or buying cab rides with Marlboro's and Smirnoff. The expert consensus at Michigan is that we will continue to see the dollar drop until consumption and investment habits change to bring our capital account and trade deficits into balance. Make no mistake, this is good for US business, but some Ross grads may get sticker shock at their next visit to the BMW dealership.