Article: Protection from a Falling Dollar

Seems like the recent fall in the dollar has finally gotten people’s radar screens blinking. See the following article from the April 27th edition of BusinessWeek for Merrill Lynch Japan’s doomsday scenario.

Protection from a Falling Dollar
By Jesper Koll

Merrill Lynch’s Jesper Koll argues that Japan, China, and Europe must focus on domestic growth and beat the U.S. at its own game

Growing numbers of analysts and economists worldwide are trying to forecast the fate of financial markets based on predictions about what will happen to economies. Unfortunately, much of this may very well be a waste of time. Often it isn’t what’s happening to economies that explains financial markets. Rather, what’s happening to financial markets is an indicator of what will happen to economies. Specifically in 2006, the issue is not whether the economic recoveries in China, Japan, or Europe warrant a stronger yuan, yen, or euro, but whether enough has been done to cushion against a collapse of the dollar.

For years, global investors put their trust in America’s future. They regarded the U.S. as the place where a combination of new technology, new entrepreneurs, and solid policy-making would most likely lead to a super productivity and growth cycle. Essentially, investors regarded America as the world’s largest and richest developing economy and emerging market.

Think about it: The U.S. economy has low savings and lots of potentially profitable investment opportunities. So return on capital must be high to attract this investment. In contrast, Japan and Europe are mature, developed economies with high savings rates, excessive domestic investment, inflexible labor markets, and large-scale bureaucratic intervention. As a result, Japan and Europe offer a relatively low rate of return on capital.

CURRENCY CURRENT. It’s important to note that China also fits this dynamic. Although clearly far from the textbook definition of a mature, developed economy, China has a domestic savings glut similar to those in Germany and Japan. And China’s record-high GDP growth rates are primarily due to relentless capacity build-up and labor force mobilization, which can bring but one result — a fall in returns and profits.

So the thesis stands: At the very core, the economies of China, Japan, and Europe are marked by dynamics that result in a low return on capital. Proof comes from the real world. Surplus savings flow from where returns are low to where they are high. This is the fundamental bull case for the dollar.

The U.S., meanwhile, has behaved more like an emerging-market economy. The U.S. has plenty of spare labor through immigration and high fertility rates. Employment growth is explosive. Unit labor costs are low and falling. Its boom has been investment-led to a much greater extent than any since World War II. Such conditions are usually found only in developing economies. And, like the developing economies of Asia in the run-up to the 1998 currency crisis, capital inflows have caused currency strength.

DOOMSDAY SCENARIO. Whether a strong dollar is in America’s best interest is debatable. Yet there can be no question that a strong dollar reflects global confidence in U.S. economic leadership. But before long, the dollar becomes overvalued and the current account deficit gets unsustainably large.

Thinking the unthinkable, the real worry for the global economy in 2006 is that the U.S. will be the last and largest country to suffer an “emerging-markets crisis.” Foreign capital inflows would turn into outflows and the dollar would collapse. To defend the currency, Fed Chairman Ben Bernanke would raise rates. Wall Street would crash. The property bubble would burst. Then what?

One prescription would be an IMF-style package for the U.S. The standard IMF approach to crisis-hit developing economies says that current account deficits must be eliminated more through deflation than devaluation. The IMF would almost certainly require the Fed to raise interest rates even further. Moreover, a fiscal austerity program would be imposed to bring about a budget surplus and cut the U.S. budget deficit.

NO BAIL. In reality, of course, the opposite is more likely to happen. If Wall Street crashes, the policy response would be clear, decisive, and ruthless. Unlike the Bank of Japan during the 1990s, the Fed would likely slash interest rates and raise dollar liquidity almost instantly. Too much has been learned about the collapse of asset bubbles and the threat that poses to the financial system. So the world would be flooded with U.S. dollars. The yen could shoot to 80 to the dollar or even higher; the euro might surge to $1.40. This would kill any hopes of a global recovery.

Clearly, the U.S. won’t lift a finger to stop the dollar’s fall. It doesn’t have the foreign currency reserves to do so. If private borrowers of non-dollar currencies go bankrupt, the U.S. government will simply allow them to default. Unlike Thailand, Korea, or Russia, the U.S. — as the world’s largest developing debtor country — can, and will, force its creditors to deal with the problem.

Specifically, if default causes problems for Japanese life insurers or European banks, their respective governments will have to bail them out. If Asian currencies get too strong, Asian authorities will have to intervene to support the dollar. China’s taxpayers would have to bear the costs of the fall in Beijing’s dollar-denominated foreign exchange reserves. The U.S. simply will not borrow from the IMF or deflate domestic demand to bail out foreign lenders.

LACK OF ENTHUSIASM. The drop of the dollar after last week’s G7 finance ministers’ meeting may be the first signal of such a powerful shift in the global economy. China, Japan, and Europe will be forced to shrink their surpluses, exporting less and importing more, while America exports more and imports less. To make up for their lost exports, China, Japan, and Europe will have to boost domestic demand. In both Europe and Japan, the necessary reflation policies may well be delayed because of the usual political and bureaucratic infighting. In contrast, China’s low tolerance for a rise in unemployment would probably trigger a swifter policy response there.

Of course, none of this will happen as long as global and U.S. investors are willing to finance the dream of America’s superior entrepreneurs, relentless technological innovation, and outstanding policy leadership. However, if the enthusiasm stops — and history suggests that the higher the expectations, the more likely the disappointment — the world’s central bankers and policy makers will have a real policy coordination problem to deal with.

The best safety net for China, Japan, and Europe would be to speed up deregulation and foster an entrepreneurial revolution that creates jobs, wealth, and a productivity explosion. China, Japan, and Europe must start beating the Americans at their own game and become emerging markets that offer high prospective returns. The more Beijing, Tokyo, and Brussels do to create domestic growth opportunities, the less they have to fear from U.S. growth sputtering and the dollar falling.

Jesper Koll is the Chief Economist for Merrill Lynch Japan. He has been researching Japan’s financial and political economy since moving there in 1986