Last night I had the strangest dream....

Last night I had the strangest dream. I was back in 2007, worrying about things that seemed so significant then but now seem like the slightest of trifles. Remember 2007? That was the last year that we went skiing in France, the last year that we could actually afford to go to Courchevel. Hard to believe that it was more than three years ago; it seems like it was only yesterday.


Remember what they told us when the dollar went to hell? About how it was actually a blessing in disguise, how American companies were going to be able to sell into markets where they’d never done so before? About how it was going to safeguard American jobs, how jobs would be coming home from China and India?

Man, these politicians never tell the truth, do they? (As an aside, do you think the Congress will really try to repeat history and impeach President Clinton for perjury?) I’m not sure what’s worse: that they didn’t tell us that gas prices were going to $5/gallon by the end of the decade....or that they didn’t know.

Anyhow, that Chevy Dreadnought 4x4 that I had just became too expensive to drive, even though it was a hybrid. I loved that car, and the day that I sold it was one of the worst of my life. I guess now I know how my Dad felt when he had to sell the Eldorado back in ’79. There’s one thing for sure, though, and that’s that the kids know how I felt waiting in line for an hour in the back of my mother’s car at the gas station back in the 70’s.

It’s been a couple of years, but as I remember it the dollar was finally let go in the first half of 2008. I seem to recall that the stock market did OK, since everyone talked about how great the foreign profits were going to be. Really, it wasn’t until Hurricane Patrick hit in September ’08 that things started to get really bad.

That’s when gas went from $4 to $5 and the economy went into recession. They’ve been saying for a year that things are getting better. Me, I don’t know. I mean, a guy like me can always find work, always take care of me and mine. But I’ve got plenty of buddies who are still worse off than they were in 2007, even those that have managed to find work again.

Back then you could afford just about anything you wanted, and borrow to buy if you didn’t have enough scratch in the bank. Hmmph, banks. Maybe the only good thing about the last few years is that at least there are fewer banks these days, fewer of these Wall Street jerks and their fancy Italian sports cars. Plenty of good people got ripped off on their mortgages by those guys, so it’s good to know that what goes around comes around, eh?

Anyhow, where was I? Oh yeah, the recession. So the dollar tanked after China and the Middle East quit pegging to it. They made a big deal about it on the news, but things seemed to muddle through OK until the hurricane. After that, everything went kaput. Sure, the Fed cut interest rates, and I mean hard, to try and support the economy.

For some reason, it didn’t seem to work. That bearded guy in charge kept talking about ‘no traction’, like he was driving a car with bald tires or something. I’m not really sure what he was talking about, to be honest. What I do know, though, is that the dollar kept falling...and eventually, so did the stock market. What didn’t fall, though, was the cost of living and the cost of borrowing.

I’m not an economist, so I don’t really understand these things. Maybe you can explain them to me. After the dollar peg broke, the cost of everything imported went up. By a lot. In the paper they said something about “firms protecting margins” or something like that. Anyhow, we all figured that if the cost of buying stuff from China rose, we’d just make it here in the good old USA. Funny enough, though, it hasn’t happened. I just can’t figure it out.

Anyhow, inflation just kept rising and rising, and it made it more or more difficult to maintain a good standard of living. Sure, we got a bit of a raise every year, but with a recession on you have to be careful not to push The Man’s buttons too much. Still, I seem to remember 5% raises being a good thing, not meaning that every Thursday before payday is Spam Night.

In the good old days, we would have just maxed out the credit cards or taken out a home equity loan. But Jesus, have you seen the rates they’re charging these days? It’s 30% now on my credit card, and it’s not worth mortgaging what little equity I have left in the house at 12% rates. I dunno, maybe that’s what that bearded fella meant about “no traction”. The news kept saying that he was cutting interest rates, but all I know is that every time that I look at borrowing, the rate goes up, up, up.

And the damnedest thing is that the jobs still haven’t come home from China. Turns out that even though it costs a lot more than it used to import things from China, it’s still cheaper than it is to make ‘em here. So we still have a trade deficit: what a bummer!

But hey, I’m a patriot. The Toyota Yaris that I bought when I sold the Dreadnought was made right here in America. Trust me, I really wanted to buy from Detroit. But I’m not exactly flush with cash at the moment, so I’ve gotta make every penny count. And the Toyota gets better mileage and is more reliable than anything made by GM or Ford. I’m not counting Chrysler, not since they were bought up by Guangzhou Auto and China Investment Corp.

So yeah, I kind of wish that it was still 2007. Hell, I wish it could be 2007 forever. Instead, I’m stuck here in 2010. Crappy job, crappy paycheck, crappy TV. I mean, it’s a four year old 42” plasma! I can’t remember the last time I had a TV that old in my family room, and I certainly can’t remember the last time all my stuff was this far behind the latest technology. I guess my only consolation is that none of my buddies have gotten a new TV, either. No one can really afford it. For the first time in our lives, we really have to worry about saving.

Still, it’s not all doom and gloom. A couple of months ago I treated the wife to a nice weekend away while her folks looked after the kids. Who’d have ever thought that Clemson would win the NCAA tourney last year? But hey, with 75 bucks on them at 50-1, I’m not complaining. Yeah, I know $3750 is chump change these days, but at least we could afford two nights at a pretty good Holiday Inn and a nice dinner at Applebee’s.

It’s all kind of weird, though, when you think about it. Most of us have never been outside America, never seen how the rest of the world lives. I suppose we all just assumed that a weaker dollar could bring nothing but more jobs and more money. But I guess when you buy a lot of stuff from the rest of the world, a weaker currency makes it more difficult to afford things.

So, too, when Hillary threatened China with those tariffs. Who’d have thought that some guy ten thousand miles away could make a decision that would make it more difficult to borrow money here in the Heartland of America. Not me, that’s for sure. I have to say one thing, though. I felt a little burst of nostalgia when Hillary started the Whip Inflation Now program...it really took me back to my childhood.

Well, I suppose that’s enough of my yakking. I’d better get back to work. It’s more than my job’s worth if this report doesn’t make it to Abu Dhabi by tomorrow morning.
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bionick
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November 19, 2007 at 10:34 AM ×

It will not be as funny as you describe. Severe economic downturns unleash all sorts of calamities that sate people normally consider not worth undertaking. The country is full of guns and is armed to the teeth. The kind of inflation you depict is exactly what transpired during the collapse of Soviet Union in the 1990s. In that case, manufacturing ceased because people lost incentives to work and stopped working; in the present, manufacturing became unprofitable and was dismantled.

And those working for Chrysler should’ve gotten a clue what would happen to them when they got bought by something called Cerberus! (http://en.wikipedia.org/wiki/Cerberus)

What’s a fine dinner in 2010?

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Macro Man
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November 19, 2007 at 10:50 AM ×

In fairness, this dystopian vision isn't really my base case. And the Russian parallel is a difficult one because the economy was already tanking hard under Gorbachev, partially as a result of the move from a command to a mixed economy.

Still, you you really be surprised if Cerberus sold Chrysler on to Guangzhou Auto in a few years, obvisuly after implementing the three-headed restructuring of layoffs, wage cuts, and beenfit cuts?

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Anonymous
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November 19, 2007 at 1:02 PM ×

I Like it though I would expect stocks rally in a more extreme scenario, e.g. Zimbabwe recently.

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Macro Man
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November 19, 2007 at 1:21 PM ×

RE: Zuim, bear in mind that there really is no equity market per se, so the prices that you read about are untradeable at the prices you see on a screen. Also bear in mind that the Zim dollar is literally worthless, so any apparent local currency gains are, again, untranslatable into hard currency. Zimbabwe is the latter day equivalent of the Weimar republic; while nominal equity prices appear to be rising, in real terms they haven't.

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Anonymous
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November 19, 2007 at 3:13 PM ×

Le Homme de Macro:
I hereby crown you the Bruce Springsteen of financial bloggers.
Peace,
Lumuba

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bionick
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November 19, 2007 at 3:57 PM ×

Actually, the vision was to fold production and become and a middle man for Chery… Chery .. ha ha. Selling would allow the Chinese a direct assess to the market.

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"Cassandra"
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November 19, 2007 at 4:50 PM ×

Thanks MM. I owe you one! You must have a read your share of Dos Passos, Steinbeck, or Studs Terkel, for your recount has an earthy and genuine feel.

Personally, I am still-wrestling with whether "its over". I am contemplating that the fed for all that I might hold it culpable, is not the primary villain, but merely the enabler and co-conspirator, and that the deflationary forces of credit rationing and a return to accurate pricing of credit risk of existing capital, the housing bust and all the consequential systemic de-leveraging it brings may simply overwhelm any official efforts such that not only won't their actions be inflationary, but the resulting deleveraging (at first) cannot help but be deflationary. Fed actions then will be palliative, directing traffic and rescue crews to the site after the train wreck, rather than heli-flationary. All the tell-tales are pointing there from real-estate, copper, industrials, transports, and more importantly, bond prices.

Even if I am wrong, the sentiment pendulum should eventually swing towards the deflationary side (as in 2002) before the palliative helicopter fires up. The benefits to this course of action are systemically numerous, though not without casualties. But its better in the long run, if he plans to eventually retreat, to appear to seriously engage, take the hits and casualties, at least to give the breathing space for an orderly retreat.

Long-term the dollar may be toast, but the status quo may yet be resilient in the absence of Plan-B for downside to most revolutions, is that they rarely have anything better to supercede what they;ve destroyed.

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RJH Adams
admin
November 19, 2007 at 5:42 PM ×

MM,

Deeply, deeply flawed piece: the Tigers win the NCAAs in 2009?

Yours,

Disgusted on the Net,

R

PS/Please have MM Most Jnr submit a currency analysis regularly.

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Macro Man
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November 19, 2007 at 5:58 PM ×

I hope the Springsteen comparison isn't meant to suggest that I'm past my sell-by date!

C, My take is that Bernanke has done a lot of work on 1930's de-liquidifcation of the system and a concomitant goods and asset price deflation. As such, it strikes me that that is the outcome that's least likely.

I rather see the situaiton more akin to the 1970's, wherein policy is kept too easy for too long in the name of the economic cycle while there are greater forces at work. AMong these, of course, include Voldemort, et al. One wonders how PBOC will conduct monetary policy should the China equity bubble burst; I mean, if they're this easy when things are going full bore, what will they do when there's a legit roadbump? To me, it all looks like too much money and not enough stuff, though there can of course be the occasional high flier that discovers that its wings are made of wax, e.g. housing, structured credit, etc.

R, I tried to conconct a fantastical outcome for the NCAA's; for I refused to suggest my alma mater because they are regularly in the hunt and universally loathed by all save alums. And surely you can agree that there is no more outlandish suggestion for NCAA glory than Clemson?

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Macro Man
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November 19, 2007 at 5:59 PM ×

Oh, and suggestion noted re the nipper. I'm still trying to devise anotehr case for Holmes as well...

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David Pearson
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November 19, 2007 at 6:23 PM ×

Macroman,

Thanks for brilliant post. I would include a bit about how, "man, and I was really surprised that they could actually make those income tax surcharges retroactive!"

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November 19, 2007 at 7:44 PM ×

Cassie,

I am with Macro Man - I don't find the deflation/recession/depression path plausible in the medium to long term. In the short to medium term, it is not only plausible but likely. Those who can predict the resulting irregular cycle can certainly profit quite handsomely. (Sadly I am not one of them.)

The DRD path is not economically plausible because it is not politically plausible. Andrew Mellon is nowhere to be found. "Liquidate stocks, liquidate labor, liquidate farmers." Instead we get what - Federal guarantees for "jumbo loans"? I find even Macro Man's 30% interest rates unlikely - when we have a monetary czar who has already spoken favorably of the Fed buying out on the curve.

The ultimate cause of the Great Dilution, which fudged numbers and the march of technology have transformed into the Fed's "Great Moderation," is political instability. Modern governments do not have the political strength to subject their citizens to anything even remotely like a bout of Mellonian liquidation. This is especially obvious in the case of China, but it is perhaps even more true for the pampered and apathetic voters of the West.

And the market understands this. And because the market understands this, and because it knows that any symptoms of recession will be treated with more indiscriminate dilution, traders who have been successful in the past are those who, while they may time the market short term, treat deflationary events as a cue to make longer-term bets against the dollar.

These events are real. We live on a little blue marble on which there are 800 billion actual dollars, and a pile of assets priced, on the basis of their power to return future dollars - an asset they cannot produce, but only receive in exchange - at something like 100 times that number. And everyone believes this is absolutely normal and sane.

Any glitch in the Rube Goldberg system of Federal guarantees, formal and informal (FHLB, anyone?), that keeps this pile from falling over can result in remarkable fluctuations. I certainly would not be a buyer of equity in financial institutions. However, the ultimate guarantee is, while informal par excellence, ironclad - because the survival of the pile, and the survival of the political entity with the monopoly power to print its Monopoly money, are intimately linked.

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OldVet
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November 19, 2007 at 10:30 PM ×

It's not so bad in my hovel. I use my old dollar to wipe my "nose" and then re-use it to light a fire. And I got a medical release to work past 85 from the Health Department. Now I greet Chinese shoppers at the real estate office, having learned a couple of phrases.

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Anonymous
admin
November 20, 2007 at 3:16 AM ×

Appropos of some of the discussion above:

BCA Special Report by Martin Barnes
An inflection point in the debt supercycle
http://www.beearly.com/pdfFiles/BCAsep07_05sr.pdf

Peace,
Lumumba

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Anonymous
admin
November 20, 2007 at 3:30 AM ×

I liked this post a lot MM.

Any comment about this one.

Thinking about the dollar
I have to do some teaching on the subject of the falling dollar and whether it’s recessionary. So herewith some ruminations. WARNING: FAIRLY WONKISH.

First, we need a model. My starting point is to think of the Fed as setting “the” interest rate (more on that later), and facing two tradeoffs. On one side, the lower the interest rate the higher is employment. On the other side, the lower the interest rate the lower the dollar. In normal times the Fed tries to set the interest rate so as to achieve more or less full employment, and lets the dollar fall where it may.

Now along comes a change in investor expectations that makes the dollar weaker at any given interest rate. This also, with some lag, makes the economy stronger at any given interest rate, because a weaker dollar means stronger exports and less imports.

So what would we expect the effect of changing expectations that weaken the dollar to be? We’d expect it to lead to a weaker dollar (duh) and also higher interest rates — but the latter effect would happen only because the Fed is trying to offset the expansionary effect of that weaker dollar. It shouldn’t depress the economy at all.

OK, so how do we make this story more pessimistic?

One way is to argue that the Fed will have to raise interest rates more than is necessary to stabilize employment. The usual reason given is that the falling dollar will be inflationary, so the Fed will have to support the dollar with higher interest rates to ward off this inflation. OK, this could be right, but I have a hard time making the numbers look big enough to get worried about: imports are only 16 percent of GDP, and exchange rates are much less than fully passed through into import prices. The big dollar fall from 1985 to 1988 wasn’t notably inflationary.

Another argument I used to make was that a dollar plunge would pop the housing bubble, setting in motion a rapid fall in domestic demand that would outpace any rise in exports. But the bubble popped all on its own, so I don’t think this is still valid.

Finally, there’s a fairly subtle argument about term structure and timing.

You see, the Fed only controls short-term interest rates, while investment spending depends on long-term rates. Meanwhile, the effects of a weak dollar on exports take a while, maybe as much as two years, to take full effect.

So there’s a story that runs something like this: a plunging dollar will eventually be very expansionary, and will force the Fed to raise rates to cool off the economy — not now, but a year or two from now. But the expectation of this future rise in short-term rates will push up long-term rates now, causing a recession even if the Fed does nothing.

This story depends on the effect of interest rates on demand working faster than the effect of the exchange rate on exports.

I guess this could work. But it’s a fairly tricky story, and a lot subtler than the alarm I’ve been hearing.

There’s always the possibility that I’m missing something big, but right now that’s where my thinking is.

Thank you

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Macro Man
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November 20, 2007 at 2:22 PM ×

Anonymous...to fully address the issues you raise would require a time and space more fully akin to a book than a blog post. However, I'll do my best to offer up a few thoughts.

Ultimately, I think the impact of the dollar on the economy is too complex to be encapsulated in a model. Indeed, to accurately reflect the various feedback loops of dollar movements on the econ omy would cause a wave of 'circular reference' errors in an excel spreadsheet.

In the near-to-moderate term, we need to consider a couple of things. Because foreign firms do not change their prices instantaneously, a weaker dollar can lead to a bigger trade deficit via the J-curve effect. In the more medium term, once hedges roll off and a currency move becomes more "entrenched", firm pricing can change and US firms can gain market share domestically and abraod, thereby lowering the trade deficit.

Of course, there are larger forces at work as well. A weaker dollar should ultimately be good for the trade deficit....perhaps unnless such weakness becomes so pronounced that it impacts commodity prices via the invoice currency effect. It seems pretty clear, for example, that commodity prices are rising at least partially because the invoice currency, the dollar, has fallen so sharply. A few of the investment banks have done causality tests on the issue and found that much of the rise of oil, for example, can be explained by dollar weakness. In this case, the weakness of the dollar has had, in aggregate, a much lower impact on the trade deficit than one might have thought by looking at the TWI. The non-oil trade deficit is collapsing....but the aggregate deficit is showing only a mdoeerate improvement. How/when/where a trend in the dollar feeds into the invoice effect is very difficult to answer.

The feedthrough into import prices is also debatable over long periods of time. yes, import prices showed little pass through in the 80's and 90's....but there sure as shinola was a lot of pass through in the 70's. More recently, the correlation between import price inflation and core inflation measures does seem to have picked up a bit, so perhaps the coeeficients change when commodity prices trend.

Then there's the portfolio effect. An orderly dollar decline can improve US corporate earnings and trade. Thats why a weaker dollar generally implies easier monetary conditions. However, if dollar weakness becomes sufficiently ingrained in expectations, there can be quite a notable TIGHTENING of monetary conditions if investors demand higher risk premia to purchase US assets. That certainly seems to be the case amongst the private sector now. Indeed, an insight into the effect of foreign CB asset buying is to observe the relative price moves of the stuff they buy (UST, Agencies) and the stuff they don't (credit turds.) Obviously, there's a pvt-secotr safe haven aspect as well, but I still think it's noteworthy.

In any event, if a private sector strike forces rates higher for government, corporate, or household borrowers (the last two currently the case), then there is pretty clearly a restraining impact on activity.

How it all falls out depends on the relative weights one gives to the various factors, the feedback lags one assumes, and, frankly, probably a random number generator dummy variable that exerts different influences depending on whcih side of the bed it gets up on.

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