A reader sent this note by AIG’s Bernard Connolly, which is surprisingly blunt for a sell-side analyst:
In saying today that the housing price correction must be allowed to proceed, Paulson is in effect calling for a massively weaker dollar – athough he probably does not realise it.
Of course it is true, as Paulson is now prepared to say, that the housing boom was unsustainable in any fundamental sense. But, as we keep on stressing, all asset values, not just housing prices aer distorted upwards by the current level of real long rates at 1%. A fundamental equilibrium would involve real long rates close to 3%. That would devastate no just the housing market but all other US asset and credit markets. Domestic demand would crash, unemployment would soar, deflation would set in, there would be very widespread capital default and the financial system would be in very serious danger of collapse (that is, the US would face the problems that are more or less unavoidable in the euro-area cad countries). In such circumstances, the only possible source of sufficient offsetting support for the US economy would be a massively weaker dollar.
To us that means, quite simply, that fundamental equilibrium in now unattainable. And Paulson continues to intone that a strong dollar is in the interest of the US. If he believes that, he must attempt to restore a Ponzi game. But if he does that, it makes no sense to argue for “price discovery” in the housing market. Unless he is prepared to advocate 3% real long rates, a violent stock market crash and enormous dollar depreciation, he is being inconsistent in saying that the housing correction should be allowed to proceed.
Now I have always viewed strong dollar talk as just that, talk, which must annoy to our trade partners as we continue to debase our currency.
Connolly’s note in effect says that there is no pretty way out of our current conundrum. And I am not certain if a massive deprecation of the dollar would in fact stave off a very deep recession. The US is largely a service economy; we’ve ceded a great deal of our former manufacturing base to foreign competitors. Even if the dollar is trashed, I doubt that their are enough export opportunities to offset the loss of demand on other fronts. It isn’t as if the US can become the call center for India.
The other factor that makes the end game unclear is the dollar’s standing as reserve currency. A dollar collapse wipes out a lot of value in the hands of foreign central banks. Thus they won’t be too keen for this scenario to play out, but whether that makes any difference on a practical level is awfully hard to assess.
Finally, I don’t yet believe Paulson’s latest pronouncement. Just as with his palaver on the dollar, actions speak louder than words, and so far, his actions have been to prop up markets, as witness the rescue of Bear. This may simply be posturing before the upcoming Senate hearings on the JPM-Bear deal.
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“A fundamental equilibrium would involve real long rates close to 3%”
How does he assess that? I know that might be a huge topic… but can anyone point me to where I can understand the logic behind that figure?
“Domestic demand would crash, unemployment would soar, deflation would set in, there would be very widespread capital default and the financial system would be in very serious danger of collapse (that is, the US would face the problems that are more or less unavoidable in the euro-area cad countries). In such circumstances, the only possible source of sufficient offsetting support for the US economy would be a massively weaker dollar.”
I don’t understand how the dollar would become weaker in this situation. It seems like all of those things would lead to it strengthening greatly, or am I missing something?
From today’s NYT
“Mr. Paulson said that ‘any regular access to the discount window’ should involve ‘the same type of regulation and supervision’ to which commercial banks are subject.
But Mr. Paulson said in effect that investment banks should not count on regular access to the window. ‘Despite the fundamental changes in our financial system, it would be premature to jump to the conclusion that all broker-dealers or other potentially important financial firms in our system today should have permanent access to the Fed’s liquidity facility,’ he said.”
Since I am confident that Paulson is well-aware that commercial banks do not have “regular access to the discount window,” this comment seems like fluff for the financially illiterate. If IBs have access to the discount window in crises — and it’s clear they do — then they have the same access as commercial banks.
If Paulson really wants IBs to get special treatment, he should ask Congress to pass a law forbidding the IBs to access the Fed’s discount window.
To Mikkel:
What you’re missing (as far as I can figure) is badly-explained definitions of inflation and deflation. Deflation, as Connolly is writing about, is a reduction in asset prices which would be normal following a correction of a massively inflated asset market. A weak dollar is when the dollar loses value relative to other currencies, which happens when the US government prints more money to bail out IB’s, speculators, and deficit-spend its way to a net positive GDP.
What most people miss is that both of these can happen at the same time. The misnomer in my opinion is calling asset price correction “deflation”, when the dollar can (and will) clearly buy less of commodities and foreign imports over time. We are likely to experience a reduction in the purchasing power of the dollar relative to non-bubble correcting assets (such as commodities, foreign currencies, etc.), which would colloquially constitute a weaker dollar.
His last statement is that modern economic thinking says that massive inflation (weakening of the dollar) causes businesses to invest in production rather than horde assets. Of course, this is flawed in the modern global economy, since investing in US production is less profitable than investing in foreign production, which accomplishes the same goal while sidestepping the domestic inflation problem (leading to higher returns). If this happens, it’s bad times for the USofA.
Hope that helps.
a very far fetched connection, and bad analysis
An ironic thought I’ve been dwelling on some as of the last few days is this: for decades I have detested the notion of ‘free markets.’ Now, when I read McCain or Bush or Paulsen talk of allowing the free market to correct the housing, etc. problem, I cheer. Of course, its just talk. The pendulum swing (once again) back to (nation) state intervention and away from ‘free markets’ is now just getting underway. But the stress of the federal deficit (growing as tax revenues decline) and current account deficit leaves the success in this swing back to greater emphasis on state intervention in doubt, unlike in the future . . . due (among other reasons, but perhaps primarily) to a weakening dollar that is also the global currency.
The dollar being the global currency has been a reflection of US global hegemony. Now it is an anchor, weighing down US ability to arrive at a state interventionist solution. That global currency status will further weaken US global hegemony (combined with other factors, such as the Iraq occupation, over reliance on an expansive US global military presence, etc.). Furthermore, this swing away from ‘free markets’ will expose the ideological bankruptcy and engender greater legitimation crisis for the state, as the state takes on more burden and fails in providing solutions, thus generating weakening mass loyalty to the state as it now functions politically.
That the Bush admin. wants a weak dollar contrary to what it says is obvious. Paulson’s talk of free market solutions is also just talk. Yes, the Bush admin. and Congress will get behind some form of taxpayer subsidy to cushion the recession – this being combined with the Fed’s magic wand waving to cushion the financial crisis. But that combined with an increasingly weak dollar, and the fact that a massive taxpayer subsidy will further weaken the dollar, sets up a conundrum: the state’s fiscal subsidy can’t work unless there is adequate support from foreign governments/central banks in buying Treasuries, thus continuing to prop up US debt as that debt grows ever larger. But as the dollar weakens their resolve to continue buying Treasuries itself weakens. Their incentive to continue buying Ts also slide due to US economic conditions: as the US goes into a deepening recession and no longer provides the dumping grounds for excess production of consumer goods from other countries, especially Asia. This should set up a very interesting development, one which I suspect will be the key/big one in the next 1-2 years.
“Domestic demand would crash, unemployment would soar, deflation would set in, there would be very widespread capital default and the financial system would be in very serious danger of collapse “
That pretty much sums up the situation we are currently faced with. Maybe we should try to put a solid foundation under this economy. We continue doing what caused the mess in the first place. I fail to see the value of the last 2 pct rate cuts. It actually seems to have destabilized the mess.
Well said: add treasuries to the list of bubbles.
“No asset left behind”
2yr auction went fairly well. BOE jawboning about an ease and Trichet holding his ground. Poland, romania lift rates and hungry on the cusp. Have to love how cutting rates and injecting money into the system has gone from open market operations to creative “solutions.”
Anon of 7:01 PM,
Connolly is probably referencing prior work; I can ping the chap who sent this and see if I get the basis for his view.
But in general, a bond investor will need a premium over the rate of inflation. Those premia were much lower in the 1960s when we had had more than a generation of price stability. Investors now expect (more accurately, ought to get) a premium over the inflation rate to reflect the risk that inflation might rise higher. And while I don’t pretend to know what that premium ought to be, 1% at ten years does sound light.
The US is of course a big exporter of agricultural commodities, and in that sense the commodities bubble has been helpful in boosting the value of exports/reducing the trade deficit. The weak dollar hasn’t hurt either.
Connolly’s note in effect says that there is no pretty way out of our current conundrum.
To say the least.
Too much debt, too little saving. A nasty deflationary recession is in the cards.
Paulson had a dream he couldn’t stop a runaway train on a downhill track.
After he awakes he has an epiphany about housing and notes the housing sector must be allowed to correct.
In the meantime, lowering interest rates for loans in between banks concerns the banks only and has nothing to do with Joe-6-pack. In fact foreign entities are demanding like 12% short term for use of their funds that any US company might ask for.
With that going on, a new Fed window opens up for non-banks where they exchange bags of trash for bags of money in all likelihood never to have to be paid back other than through the taxpayer (us) hence the US$ is losing value everyday that new window stays open and the US$ may never recover but for a long long period of time passing.
This is what’s happening and is the best case scenario. Forget about the US$ gaining value and plan accordingly.
This Paulson is the same genius that stated on the record in mid-2007 that the global economy was the strongest that he’d seen in his entire business career. He is also the same genius that stated on the record in mid-2007 that the housing market had hit bottom.
Nice call bonehead. How do guys like him make it to become the CEO of Goldman Sachs?
Paulson was in Investment Banking Services, which means he sold Goldman’s services to large corporations. So he’s been a shill for most of his career, useful training for his current role.
Paulson as a career shill; doesn’t _that_ peg him in a well-oiled hole, yes.
On our troubles, here’s the box. It has four sides; three long, one short; the power elite controls two.
—# 1: The US banking system as a whole is insolvent, or very close to it.
The distribution of losses is asymmetric, though. Most of the big boys are flesh-eating zombies, or becoming such. Many of the middies are only hurting, however, tho’ they’ll be howling when commercial re tips over.
—# 2: The $ is sucking vacuum.
We need the best part of a terabuck per annum of capital inflows from foreign money to keep our economy level; a little less in an economic downturn but still plenty money. Now, though, we have private foreign capital _outflows_ to the tune of tens of billions per month; perfectly sensible and rightly so in present circumstances. Foreign central bank and sovereign capital is still coming, evidently, but _proportionately less_ than in the past and building down, and even then only into the best assets. They all want out, sovereign and private, and each are acting according to their nature.
—# 3: We are entering a severe recession in the US.
By next year, we may be pronouncing its name with an initial consonant that is an occlusive rather than a lateral. Consumers aren’t spending ’cause they’re busted and bummed, and business won’t spend if consumers don’t, in addition to which credit is hellish hard to get and even intermittently unavailable (see # 1). Shill and bloviate all they want to, those mediaots, reality is what it is, and it bites when stepped on.
—# 4: The US is engaged in an ongoing, multi-front, military adventure in SW Asia which is a political cancer abroad and at home, a fiscal tapeworm, and a moral crime not least in that we continue to kill by the thousands a people who never asked for our presence or sought us harm.
I may also add that, independent of moral and practical issues, the conduct of grand strategy in this adventure is so colossally inept—on a world historical scale of crepitation—that one must seriously doubt the mental stability of the political executives, current and future, who pursue it with our name, credit, lives, and ambitions.
Now, nothing can be done about # 3. It is a cyclical process which will run its course, with home values a principal driver, though job losses can and probably will overtake that impetus in time.
We can control # 1. Swift public receivership of actually or nearly insolvent banking institutions, plus public credit to other players gone wobbly can at this point keep the US banking system going. It will look a great deal less fat, arrogant, and rich a few years on than it does now, but we need it, we can keep it solvent, so we must. (Barring a derivatives blow-up: that’s the boojum we may hope never to meet.)
We can, in principle, resolve # 4. Our present political executives refuse find that unthinkable (though be it said it’s plain they don’t think to much). I think it’s even money that the boys stay there until their paychecks bounce. It’s hard to root for _that_ eventuality, but . . . . Still, it is, daily, within our power to end this particular march of folly.
# 2, however, is now out of our control. The $ has been, in effect, a Ponzi scheme through the last thirty years: we create more credit in $, one way or another than we produce, and have now saved so little it’s hard to see how we could ever cover our chits. More to the point, it’s hard to see how the game can keep going regardless of what we want. We could try to monetize that debt; that’s the nuclear option which will only drive off our remaining sovereign creditors. Asset deflation _will_ help, maybe, in that our debts will get discounted and our credit truncated, bringing things rather violently back into line. Everything priced in $s is _over_priced. Managing this asset deflation . . . well, good luck. This has happened (and will happen) to other countries: they’re still here, and some of them are doing alright by themselves, now. We are NOT to big to get a spanking and a bath. What I suspect will happen, this being true, is that our creditors will ‘hold a conference and then announce their terms.’ This won’t happen this year unless the banking system does a China Syndrome thing. But the power advantage has shifted, we are incapable of resolving our currency issues alone, and are perhaps incompetent to resolve our currency issues alone since we’ve grown accustomed to our overvaluation and don’t know how to play with other rules. Other players will ultimately ‘solve the problem’ for themselves. Then, it’ll be dicker or drop the Big One, and I don’t think we’re crazy. Just spoiled rotten.
Welcome to the 21st century. : )
That comment by a wasn’t by the usual a.
I’ve been thinking about the actions the Fed have been implementing and feel the debasement of the dollar is the correct policy. Does it mean that there will be a bunch of pain to many Americans? yes. Does it mean that we will fall into a depression? yes. Does it mean its the end of the world? no.
The fundamental problem in the U.S. is the lack of high quality jobs too support the economic growth of the past ten years.
Invest in a company and they ship the jobs to India and China. This is about to come to an ugly end. Whether they like it or not. India and China are third world countries and once our economic downturn blows into their impoverished people, a whole lot of heads will be rolling.
At some point the pain of manufacturing in these countries will be so severe they will have no alternative than come home to where people do work for a bigger car. They don’t do that in China or India. There a 2 billion people in those 2 countries, most have not reaped any benefits from the growth in there economies and when the inflation monster hits them governments will fall.
So don’t be pessimistic, the U.S. is heading into a growth period and the jobs will be coming home. Remember this is the only place in the world where wages are falling. To a business that means something.
Addendum to my previous post:
What is really going on the the theft of the entire trade deficit from China to the U.S. Trust me, when the dust settles the U.S. will be sitting pretty with a positive trade balance and there will be a bunch of people starving in India and China. They do not have the things needed to maintain their economic growth. Those things are founded in Napoleonic law and stable governments. They have neither.
There is a balancing process going on and it is organic. There is nothing the Fed can do to stop it. The Ying and Yan. Economic growth and free markets seek that balance and the boom in the U.S. is nothing in comparison to the boom that has occurred in China.
Predictions:
Growth in nationalism in U.S. like happened in the 30’s to Germany.
Growth in Made in America economy.
Punishment of any U.S. Company that ships jobs over seas.
It is a balancing process, so to get ahead of the game in the market is to invest in U.S. only employers, because protectionism is on the rise at the dinner tables of America and any business that isn’t listening to the American people will be hurt.
All those manufacturing jobs that went to China et. al. . . . they are gone, and are _never_ coming back. Moreover, they were going to go regardless of what we might have done; ‘shipping them’ only moved them faster, and to the profit of our own shippers. Look, the decline of labor intensive manufacturing in high wage countries is a largely fixed process. There exists tons of historical experience and material in Europe on this, it’s just that Americans think that the experience of others somehow doesn’t apply, here. Not so. I don’t say this as an advocate for what was done; I’m more an anarcho-syndacalist than anything, and I loath most of those who have profited from deindustrialization. I also do history, use my eyes, and use my head.
There is no way high wage labor can compete with low wage labor for the same value added. The problem in the 70s and 80s was called ‘de-industrialization’ because this had specifically happened in Europe; consider the Dutch example. Smarter countries chose areas where they could remain competitive in manufacturing, and bolstered them as a specific act of policy. For workers in other areas, efforts were made at retraining, with admittedly mixed results. In our country, we elected Reagan. That didn’t strike me as a competitive strategy, nor did it prove to be so.
The time to make an optimal transition for lost manufacturing jobs has passed; the window closed on that, ten years ago at least, probably longer. Now, we get pinched hard by the lack of opportunities between restaurant servers and money masseurs in cubicles. We will have to come up with a national retraining and industrial development policy from a disadvantageous position, starting from scratch. Doesn’t look good, gonna take ten years and several administrations even to get current on this one.
I know! We’ll all become musicians and sell video clips of our performances to eachother, hey. Oh wait, you say nobody pays for digital products? . . . Scratch that.
“There is no way high wage labor can compete with low wage labor…” German labor competes pretty well with anyone.
richard: what effect does a very cheap US dollar have on whether US wasges are considered “high” or “low” in comparison to other nations?
Richard,
I hear you, but wait until things get really tough. Your going to have have true nationalism in America, just like the America first policies during the depression. Multinationals will be ham-strung by it.
Just look back at the depression or any other major economic down-turn. The public will find some-one to blame for their plight and it will not be pretty.
Just a warning. The winds are turning on free trade, because it has cost joe-six pack his american dream. So good luck stopping the wind.
To a re: Deutsch labor: Germany focuses on highly specialized manufacturing in niches where their products remain superior so their market share stays. They can afford the higher costs because their products have a competive advantage which outweighs price _dis_advantages. In addtition to which, one of Germany’s major markets for such specialized manufactures has been the US . . . with our inflated dollars allowing us to purchase their comparatively expensive products. This is _exactly_ what the French and Germans are screaming about with the decline of the $, that their higher costs will now seriously impact their sales to a major customer.
—But China will save them. (Maybe.) European-Chinese trade exceeds American-Chinese trade. Some of this is certainly high-value equipment and product exports from Germany. If the yuan comes up some, China can buy more: the lightbulb on THIS deal will go on before long, and China will increasingly work a ‘virtuous’ leverage with Europe, while the US flounders with its (appropriately) depreciated currency.
It is totally in the econominc, political, and military interests of the rest of the world for the $ to decline, and for them to stop funding our guns and chocolate economy. —Except they are still wedded to the export strategies of the last 60 years. But . . . the lightbulb WILL go on. Nobody really talks about this, but we are going to get to live it out, and soon.
To Anon 1:
The $ will never get cheap enough to compete straight across with low-wage countries—unless we’re nuked into Fourth World-dom, and then we have other issues. Be serious: We’re going to compete with someone making under $.25 an hour in Bangladesh? How many people do you know _personally_ who would go work 10-12 hours a day on a backbreaking assembley line with few benefits for the equivalent of $1.00 and hour or less? . . . How many who aren’t convicts?
Anon 2:
Joe Six Pack is a dope, he gets played by the media and the pols year in and year out, he is outnumbered at the polls by _many other interest groups_ so his influence is A LOT less than his self-inflated interpretation of his status and relevance in society.
But that issue asside, Joe Six Pack doesn’t have anyone in the game to vote for, and won’t get anybody to vote for, ever. ‘Cause Joe isn’t the one to do the leg work to organize his class interest, natch. The Wolf, the Hound, and the Bitch are all sold to free trade; tweaked a little (to make the big boys better dough), but they are not slapping up sky high tariffs. Not one of them. We had a couple of faux populists in this recent campaign; how did they do? Low single digits, and that even in states _loaded with Joe Six Pack-ers_. This ‘political revolt’ concept is soooo overblown. Is Joe gonna vote for the Mutt [Nader] if he’s in, the only candidate who would actually push Joe’s go-cart for him? Of course not: “He’s an egghead, and a finger-wagging wuss.” Congress can stew all it wants, but their heart manifestly isn’t in it, and you have to get this one by the Political Exectutive, too. No go there. Fuggeddaboudit.
Joe Six-Pack loves to sound off, but then he shuffles into line, drops the ballot his boss filled in for him in the box like any other housebroken pooch, and goes to the bar where he buys a pitcher and sounds off to anyone who stops walking about how much we need a fence on the Mexican border. I’d love for Joe to get an actual political education, but education, see, isn’t his strong suit. And he likes it that way, ’cause ‘he knows he’s right.’
*hmmmphh*