Communism and Economic Structure

Yesterday's New York Times has a wonderful article on McDonald's two-decade drive to build a supply chain in the communist Soviet Union and then Russia, which they have finally just completed.

Read it here:
http://www.nytimes.com/2010/02/02/business/global/02mcdonalds.html?hp

Strong Dollar

Aside from some short-term notes from the Wall Street analysts, there's been a consensus for a while now that the dollar needs to weaken significantly to eliminate the global imbalances in the economic system. Generally, the argument goes that America has a large and unsustainable trade deficit, which foreign central banks are financing by buying US Treasury bonds. If the foreigners tire of financing our trade deficits (the 2007 version is "profligate consumption" but this seems not to apply so much anymore), they will dump US assets and the dollar will weaken. The only way to bring things back into balance is for the dollar to weaken in order to make US goods more competitive on the global market. Exploding US budget deficits only increase the required adjustment. I don't think it's going to happen this way.

In the near term, it's true, as many Wall Street analysts have pointed out, that a renewed downturn in the global economy could lead to dollar strength when investors flock to quality assets such as US Treasurys. But this isn't what I have in mind. Instead, I think we're going to see a new secular trend of dollar strength combined with narrowing global imbalances, for a number of reasons.

1. Rising U.S. savings. American households are tapped out debt-wise. Corporations don't want to borrow to invest because they have so much spare capacity. That means Americans want to buy US securities instead of importing foreign goods and energy. So this is a large new source of demand for dollars -- if the personal savings rate rises from 0% to 10% this is $1 trillion in extra annual demand for dollar securities right there. Not all of this is new demand for dollars since some of it is replacing demand for US goods, but a lot of it is.
2. Fiscal issues are worse other places. Sure, the US needs to get its fiscal house in order. But the budgetary and demographic situation in Europe and Japan is *far* worse than it is in the US. Let's face it, a basket of AUD, CAD and BRL is simply not going to become the world's new reserve currency, and neither is the yuan. China is a country that is not so politically stable and has had two revolutions, a civil war, and an occupation by a foreign power in the last century. The legal system is not exactly conducive to foreigners enforcing their property rights. In the nightmare scenario, do you want to have your money in renminbi?
3. Demographics mean foreign savings rates will fall. At the vanguard of this movement is Japan, where the savings rate has already fallen into the low single digits as the population ages. As this continues, Japanese retirees will liquidate their savings to purchase imported goods, and Japan will become a trade-deficit country, reversing a half-century trend. Europe is not far behind. The emerging economies have a different issue: as they catch up to the West, they will want to consume more and save and invest less. That will lead to a preferences-driven increased taste for imports, weakening their currencies.
4. Deflation or disinflation in the US. The US is in a balance sheet recession. (Read "The Holy Grail of Macroeconomics" by Richard Koo if you don't know what I'm talking about.) A long period of weak demand growth will lead to subdued inflation or perhaps even outright deflation. That will keep a floor under the dollar.
5. The dollar is already cheap by PPP standards. There's only so far it can go before Toyota and Mercedes start opening factories in the US instead of abroad -- oh, wait, they already have!

I hope to post a lot more on this theme in the future. But we shouldn't be surprised if several years from now, dollar-euro trades at parity and the yen is back in the 130-140 range. Only sterling is about right at $1.60 to the pound.

Asset Prices and Inflation

We've seen a lot from the more right-leaning economists over the last few years about how asset prices increases are inflation, because increases in the price of assets represent increases in the price of future consumption. I've been thinking about this, and I think they've got it backwards.

Money is a claim on the future production of society. If the government prints money and mails it to people, those people feel richer, because they can consume more. The money is a claim on future productive capacity of the society, and when more money is printed, the price of the money declines in terms of real goods declines. The claim is debased.

Government bonds, if one thinks about it, are the same way. A government bond is a claim upon the productive resources of society. When the bond price declines in terms of real goods (which is usually the same as it declining in terms of money, since bond prices are so much more volatile than consumer prices), the claim is debased. This is like inflation.

Typically, we think of central banks controlling inflation with the interest rate, which is the price you will be paid to delay consumption if you are holding assets. If you are holding money, however, rather than being paid, you must pay the inflation rate to delay consumption.

Rising interest rates, which depress bond prices, are therefore essentially equivalent to inflation. To this way of looking at it, when the Fed raises rates, it is simply channeling inflation into debasing bond prices rather than money.

This is a new idea, at least to me. I'll have to explore it further.

Initial Claims Forecast

I forecast that initial claims will rise this week to 454,000, well above consensus which is expecting a fall to 440,000.

Deflation on the Way

Today saw the release of inflation numbers for December, and something weird is afoot. Despite the housing bust and widespread price declines of housing nationwide, rent (and owner's equivalent rent) in the CPI has barely declined at all!

Here's the price index for urban rents, which is off only 0.3% from the peak in June:

The story for owner's equivalent rent is identical.

But according to Reis, asking apartment rents were down 2.3% nationwide in 2009, and 0.7% in the fourth quarter. That hasn't shown up in the CPI at all yet.

Given that rent and OER together are about 30% of the CPI, and have so far shown almost no price declines, it would appear that there is some significant reported deflation on the way. This isn't exactly a prediction -- the events have already happened, it just hasn't shown up in the data yet.

Interesting Note on the US Trade Report

One interesting tid-bit in the US trade data, which came in worse than expected today.
The trade deficit widened $3.2 billion in November from October. Of this, $0.5 billion was in nonmonetary gold and $0.7 billion was in artwork, antiques and collectibles. So Americans are importing more things that are stores of value, meaning the trade deficit change is somewhat overstating the borrowing we are doing for consumption.

Are Holiday Sales Really So Good?

The holiday sales numbers, +2.9% for chain stores, are being touted as evidence of a recovery. But this is off of last year's extremely depressed levels, and actually represents a significant drop in real demand since inflation for non-durable goods y-o-y was 4% in November and possibly as much as 7% in December.

No doubt the price increases are good news for corporates and show declining economic slack, but we're making and selling fewer products.