Zeev's Turnips Patch-No Politics (ZEEV)

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*** Marshal Auerback commentary ***



International Perspective
By Marshall Auerback

A Clear Mandate (But Will The Foreign Creditors Go Along)
November 9, 2004

In their collective wisdom, the American people have spoken and, unlike in 2000, it is hard to make the case that the mandate they accorded to the incumbent President was unclear or ambiguous. In contrast to the previous election, Mr Bush garnered a majority of the popular vote. Indeed, he won more votes than any president in American history: a record 58.7m votes (3.5 million more than Senator Kerry), on the highest turnout since 1968. Arguably, this was an even more decisive result than the Reagan landslide of 1984, in that the GOP also increased its majorities in the House of Representatives and Senate on the coattails of Mr Bush.

The upshot is that the President now has little in the way of domestic constraint should he follow through on his pledges to implement radical reforms in social security, taxation, as well as continuing on a dramatically different foreign policy course from his predecessors. All in all, then, a good week for George W. Bush. And also for investors in the stockmarket if last week’s rally was anything to go by.

But there was one constituency that didn’t have a vote last Tuesday – namely, the country’s growing legion of foreign creditors. Arguably their collective voice is more germane to the ultimate success or failure of the Bush presidency than any state in the Union, Ohio or otherwise.

Prior to the election, we suggested that if the result was inconclusive and the country turned into another version of Litigation Central, foreign investors would take flight from the dollar. The corollary also applied: it was logical to presuppose a reasonable dollar rally, in light of the clarity of the mandate and the corresponding extension of GOP control over the legislature.

And yet this has not occurred, despite the perceived lack of legal shenanigans, the absence of hanging chads, and in spite of the potential implementation of a strongly pro-business growth agenda. The proposed privatization of Social Security (with the promised provision of a new source of buying for the stockmarket via individual savings accounts) has done much to fuel the animal spirits of equity investors, and the stockmarket has responded accordingly over the past week. The promise of making current “temporary tax cuts” permanent, along with further fiscal reform, might also yet more stimulus to an otherwise tapped out consumer.

But seen another way, these proposed domestic measures, immediately articulated by the President at his first post-election press conference last Thursday, would also have the effect of perpetuating the country’s acute economic imbalances at a cost of still larger financing requirements on the part of the Asian savings bloc. All this at a time when (as the President never ceased to remind us during the election campaign) the country is at war. Thinking through the implications of the President’s mandate (guns AND butter), the foreign exchange markets have duly taken their cue.

Ironically, the burden of dollar devaluation continues to be born by the euro, in spite of last week’s ostensibly bullish non-farm payrolls data which on the face of it, seems dollar bullish. The hapless beneficiary of dollar diversification flows, the euro hit yet another all-time high against the greenback last Friday, and the dollar index looks to have broken down decisively from a long term support level of 85 evident since the mid-1980s.

We have been fretting about America's huge current-account deficit and predicting the dollar's sharp decline for years. As The Economist has noted, the trouble with crying wolf too often is that people stop believing you. Yet even after slipping some 15% in trade weighted terms since the beginning of 2002, the most worrying aspect of America’s current predicament is the comparative lack of any real improvement in the country’s external imbalances despite this devaluation.

The last time the dollar index reached its current level in the mid-1980s, a period of substantial trade improvement ensued, largely because during much of that decade the yen, and emerging Asian currencies, rose against the dollar, and over the same period their countries mainly ran current-account deficits, not surpluses. In addition, Japan itself was booming and its combination of robust domestic demand and adherence to “voluntary” quota limits on US automobiles and electronics facilitated trade improvement on the US side. China (the largest source of today’s US trade imbalance) was also a far less significant economic player.

Things changed after the Asian financial crisis of 1997/98 when the bulk of these countries needed to rebuild reserves after the Asian crisis and were shocked by the lack of support (diplomatic and economic) from their ostensible American “protector” in the face of hostile speculative attacks against their currency regimes. This understandable paranoia against “hot money” also revived a natural proclivity toward neo-mercantilist trade policies.

Consequently this time around, dollar depreciation has been coincident with a marked deterioration in both the trade and current account deficits and this appears to be the main preoccupation the foreign exchange markets today. In the words of market commentator, Dan Norcini, “the structural defects in the dollar, namely the huge current account, trade and budget deficits, have become the complete focus of the currency markets and it appears that the entire mindset has changed. Forex traders are no longer viewing interest rate hikes as reversing the downward trend in the dollar. The structurals are now dominating.”

The collective judgement of the foreign exchange markets, and their corresponding impact on America’s capital markets, is something clearly beyond the control of the President, Congress and, indeed, the powerful US military (short of sending Special Forces units into the trading rooms of Wall Street and the City of London). The usual reply from the White House when asked about exchange rates is to say that they are set by the market. This is only half true: that there has not been an emerging markets-type currency crash is partly a function of foreign investors continuing to be lulled by the false sense of security furnished by a dollar reserve currency system, a system subject to repeated abuse by America’s monetary and financial authorities.

But in spite of the lack of perceived risk which might be more readily recognised were large portions of US debt foreign denominated, private portfolio preferences are clearly shifting rapidly away from the greenback. If the dollar’s external value were truly being set by the market – as represented by private capital – it would now be even weaker. The massive dollar purchases by Asian central banks, aimed at holding down their currencies against the dollar and pursuing neo-mercantilist trade policies, have prevented the dollar’s decline from turning into a free fall – at least against the Asian currencies.

Not so against the euro, and at some point we suspect that the export growth that has largely been driving the euroland economies will begin to fade. The ECB will then likely cry “uncle” and join the game of competitive currency devaluations. Certainly, Euroland’s political leaders have already made their concerns manifest. At a Brussels summit last Friday, Gerhard Schroeder, Germany’s chancellor, called the rise of the euro “worrying” and French President Jacques Chirac expressed “concern” about the impact on exporters. Tumbling German industrial production (which dropped 1.2% in September, compared with the previous month, and followed an equally sharp drop in August) has reinforced these jitters.

Logically, then, the burden of future adjustment against the dollar may very well fall toward Asia if there is to be any hope for a shift away from US-centric growth. The recent relative strength of currencies such as the Korean won, the yen, and Singapore dollar do suggest the incipient beginnings of a generalised Asian currency realignment against the greenback, but we are still a long way from seeing anything of the magnitude required to effect genuine trade improvement with Asia.

More to the point, a revaluation is very much at the discretion of Asia’s official sector, not American voters or the Federal Reserve. It is conceivable that the Japanese and Chinese could rally the troops and beat off another attack on the dollar, but now that the election is over, it is unclear whether Washington cares enough to play along. The new mandate, with its emphasis on getting the economy growing again, may indeed pursue a more explicit policy of dollar devaluation and export led growth (look at GE’s strategic shift as articulated a couple of week ago in the FT away from finance back to high tech heavy industry), and tax incentives to support domestic industrial investment (consider the American Jobs Creation Act of 2004 just through the House and Senate).

Currency realignment is clearly on China's mind. The Wall Street Journal has observed how Beijing has added "the need for flexibility" to their statements on exchange rate stability, though there has been no mention as to when this might occur. But it is noteworthy that one unnamed official said he thought the Yuan could increase in value by 7-10% without harming Chinese companies’ competitiveness (or presumably, the creaky state banking system).

On this point, America’s national savings (or, more to the point, the comparative lack of them) merit further scrutiny. The latest national accounts shows personal household savings down to its lowest level since 1959, excluding the month following the September 11th attacks, when the savings rate went to -0.2%. Personal savings as a percentage of disposable income went down to 0.2% this past September, down from 0.7% in August. In fact, the savings rate has averaged below 1% for the first nine months of 2004 – the first time this has occurred in seven decades. Truly, Mr Bush and his compatriots have been well-served by the kindness of strangers, in spite of the widespread disappointment on this side of the pond with his victory last week.

Then there are what former British Prime Minister Harold Macmillan termed “events, dear boy, events.” As Macmillan’s sage words suggest, external events often have a way of shredding the aspirations of America’s voters. Iraq is back on the front pages, now that the anticipated assault on Fallujah is in its launch phase. Few Americans believe that deploying 90 per cent of the troops in Iraq, suffering 90 per cent of the casualties, and paying 90 per cent of the bill represents much of a bargain, given the comparative lack of return thus far. The country’s foreign creditors have hitherto gone along, but one wonders how much longer the President can choose both guns and butter (the fatal inability from which to choose ultimately doomed LBJ’s 2nd term in the late 1960s), given the mounting bill and the increasingly adverse political backdrop.

Contrast the political environment today with the beginning of 2002, during which the United States still operated in a climate of worldwide sympathy and solidarity. A broad range of allies supported its anti-Taliban efforts in Afghanistan, and virtually no international Muslim leaders had denounced them. President Bush was still being celebrated for his eloquent speech expressing American resolve, before a joint session of Congress on September 20. By late December some 200,000 members of the U.S. armed forces were en route to staging areas surrounding Iraq. Hundreds of thousands of people had turned out on the streets of London, Rome, Madrid, and other cities to protest the impending war. Declaring that it was impossible to make predictions about a war that might not occur, the Administration refused to discuss plans for the war's aftermath—or its potential cost. In December the President fired Lawrence Lindsey, his chief economic adviser, after Lindsey offered a guess that the total cost might be $100 billion to $200 billion.

As it happened, Lindsey's controversial estimate proved far too conservative. Congress has recently been asked to appropriate a further $75 billion which, if approved, would take total appropriations for war and occupation thus far to $225bn. With more than 100,000 (far less than was estimated by experts such as Generals Eric Shinseki and Anthony Zinni) U.S. soldiers still based in Iraq, the outlays will continue indefinitely at a rate of about $5 billion a month—much of it for fuel, ammunition, spare parts, and other operational needs. All this is at striking variance with the confident assertions by Donald Rumsfeld and Paul Wolfowitz that Iraq's oil money, plus contributions from allies, would minimize the financial burden on Americans.

A full inventory of the costs of war in Iraq goes beyond what happens in that country. Before America went to war in Iraq, its military power seemed limitless. There was less need to actually apply it when all adversaries knew that any time it did so it would win. Now the limits on the country’s military's manpower and sustainability are all obvious to many, as exemplified by the country’s seeming inability to halt Iran and North Korea’s respective surge for nuclear deterrents.

All of this points to more signs of imperial overstretch. The Administration announced this summer that in order to maintain troop levels in Iraq, it would withdraw 12,500 soldiers from South Korea. Before Iraq the U.S. military was turning away qualified applicants. Now it applies "stop-loss" policies that forbid retirement or resignation by volunteers, and it has mobilized the National Guard and Reserves in a way not seen since World War II, to the extent that a revival of a national draft is now being mooted by various members of Congress such as House Democrat Congressman Charles Rangel and GOP Senator, Chuck Hagel.

Because of outlays for Iraq, the United States cannot spend $150 billion for other defensive purposes, let alone finance the President’s considerable domestic agenda. If the war in Iraq does not begin to take a significant turn for the better, to what extent can the US expect a continued unlimited overdraft facility from its largely Asian creditors? The increasingly manifest weaknesses of US undercut the ability to enforce dollar hegemony.

In his first post-election press conference, President Bush said: “You asked do I feel free? Let me put it to you this way: I earned capital in the campaign, political capital, and now I intend to spend it. It is my style…and I’m going to spend it for what I told the people I’d spend it on, which is – you’ve heard the agenda: Social Security and tax reform, moving the economy forward, education, fighting and winning the war on terror.”

Political capital, the President clearly has in abundance. It’s the economic capital, or the comparative lack of it, which may still prove his undoing if those pesky, uncooperative foreigners don’t play along. They are not going to provide a blank cheque forever, notwithstanding the mandate granted to him last Tuesday. The real campaign to retain their support – arguably an even greater challenge than the 2004 election – begins now. Good luck, Mr President.

http://www.prudentbear.com/internationalperspective.asp