Eco-Economy: Argentina, Not Japan
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Argentina, Not Japan
by Marshall Auerback
June 17, 2003
A country with an unsustainable external debt burden, an overvalued exchange rate leading to increasingly large current account deficits, a huge and deteriorating fiscal position: Argentina 2001 or the USA 2003? For all of the persistent talk of the need for the US to avoid a "Japanese style deflation", we think the more instructive parable is Argentina prior to the abandonment of its dollar-peso pegged rate monetary system at the end of 2001.
We have examined this parallel before in the context of trying to assess how the US extricates itself from its current mess. Like Argentina, the country’s fiscal surpluses are now well and truly dissipated (and the stimulatory effects of such actions are highly questionable, given the back-loaded nature of the Bush tax package). The expedient of dollar devaluation is difficult, given the existence of a fixed exchange rate policy – in this instance, the pegging regime being China, as opposed to the US itself. The ultimate effect, however, is comparable because by keeping its currency tightly aligned with the dollar, China perpetuates the cost advantage it has over the United States as a manufacturing center, thereby minimizing the improvement to America’s external account position.
Like Argentina, the attempt by American authorities to engineer a controlled devaluation of the dollar is a highly dangerous option for a country with substantial foreign creditors (true, the debt held by foreigners is dollar-denominated, but this has simply lulled these creditors into a false sense of complacency given its sheer magnitude). And the recent decision (in all but name) to abandon the strong dollar policy is indicative of the lack of good policy choices left.
Yes, its incontestable military might gives the US leverage over its fellow government creditors to a degree unavailable to Argentina at the time the decision was made to abandon the fixed exchange rate monetary regime. But private sector agents are a different matter. If these speculators have been ‘herded’ by aggressive pro stock and bond market policies by the Fed and other government bodies, then it is a market with less than a stable basis. Its drivers may well be weak hands who will reverse their position on any failure of the bull trend.
To a limited degree, this may already be occurring. Recently released data show that foreigners finally became sellers of U.S. equities in the first quarter of this year. And the apparent explosion in official holdings of dollars since then suggests that, if anything, the foreign private sector has become a more intense seller of U.S. assets and, presumably, that extends to U.S. equities.
Even if one acknowledges the potentially coercive power of America’s military (in relation to its leverage with a growing list of foreign governments), this tacit recognition obscures a deeper problem: namely, that the huge resources absorbed by the Pentagon invariably place constraints on the conduct of fiscal policy. Despite the money lavished on it, the endless chatter to be "smarter", "reform-oriented", and "more efficient", the Pentagon has always demanded more – even before the attacks of September 11, 2001. As an example, consider the Clinton budget for FY 2000 which called for the replacement of arguably the most successfully designed fighter plane ever made, the F-15, with the F-22. The air force wanted 339 F-22s at $188 million each, three times the cost of the planes it was replacing (of which there were already over 1,000 by 2000). The last Clinton budget also included funds for yet more nuclear-attack submarines, despite the existence of a so-called "peace dividend". By the time President Bush introduced his first budget, the Pentagon was again appropriating the equivalent of 4.5 per cent of GDP.
The Pentagon’s methods of procurement mean that the costs of weapon systems are increasing much faster than the funds allocated each year for the national defense. Its own bookkeeping system is in shambles; despite federal legislation mandating this, the Defense Department has not had a proper audit for over a decade. Consequently, putting more money into the defense budget today reinforces the runaway cost growth already embedded in the system.
These insatiable demands invariably limit discretionary fiscal policy, insofar as the requirements for a huge stimulus are largely set aside until the voracious needs of the defense establishment are first satisfied. In the words of Pentagon strategist, Franklyn "Chuck" Spinney: "The year 2010 is a little bit less than a decade away, and the aging baby boomers are going to drive up federal expenditures. If we throw money at the Pentagon today, it's going to put us on an evolutionary pathway straight into a budget war with America's old people." What Spinney’s remarks demonstrate is that American fiscal policy already starts with a huge handicap: it has a military budget more suitable to the needs of empire, but no "colonies" in the classic meaning of that word, from which the authorities can "exact tribute". This was a problem that Argentina did not have.
Despite these limitations, the fiscal lever is now being deployed in an all-out attempt to keep the bubble afloat. The administration has used the upcoming fiscal package to introduce a host of market support measures.
1) dividend taxes have been cut
2) capital gains taxes have been reduced
3) tax policy now impedes the lending of stock to short sellers
4) margin interest can now be deducted against short term capital gains, providing a new tax incentive for leveraged stock speculation
Concurrent with these efforts by the Treasury, members of the Federal Reserve have talked incessantly about unconventional measures. While market participants have found the Fed’s intimations of future unconventional measures credible (judging from the huge recent rally in the bond market), we have viewed these persistent promises to expand open market purchases of longer-term government securities – in sizeable quantities if necessary – more as a sign of desperation. These trial balloons constitute a tacit admission that orthodox monetary and fiscal policy is no longer working.
Given this policy cul-de-sac, how much further can the bubble be sustained? Although the market’s recovery has gone further than many of us felt possible, there are still a number of commentators with a very free market bent who argue that the bubble cannot be reignited, and that history bears this out. They are wrong: Although no developed country central bank or government has ever tried to reignite a bubble, in one country – Kuwait – a government did precisely that, as Allianz/Dresdner global strategist Frank Veneroso recounts based on his own experiences in the country. Visiting the country as an advisor of the IFC in the wake of the first flood of oil income into Kuwait (which sparked a bubble in the domestic stock market), Veneroso describes the anomaly of this small, oil producing country now in possession of the third largest stock market in the world:
" On our way back to the central bank it dawned on me that, behind much of this third ranking stock market cap in the world, there were only a few cement and clinker plants, a slaughter house or two, and quite a few shell games. One could not even speak of valuation. The usual parameters of valuation---price earnings, price book---simply did not apply. For those companies with real assets, revenues and incomes their market capitalizations bore little discernable relation to any such underlying values. And, of course, for the shell companies on the Souk their market prices had no grounding whatsoever in any fundamental values.
Speculation on the Souk al Manakh was financed with a curious type of informal margin credit. Speculators who wish to buy shares with borrowed money usually go to their broker for a margin loan or their bank for a personal loan. In the Gulf at the time such speculators borrowed from other individuals and these borrowings took the form of post-dated checks. So rapid was the rise in the Gulf stock market and so great were the demands of speculators to buy stocks on margin that postdated checks paid an interest rate of 100% per annum or more. Margin financing reached unimaginable extremes; one speculator, who had been a clerk two years earlier, had at the peak $14 billion in stocks financed with $14 billion of margin debt.
What caused such an unimaginable bubble in stock prices? Many of the market’s participants were successful businessmen in the region. This part of the Middle East had an old mercantilist culture. In their day to day traditional commercial activities, these people were usually shrewd traders with a strong sense of value. No doubt many market participants were fully aware how absurdly overvalued Gulf shares had become. My central bank colleagues realized this to some degree. But everyone believed that the rise in share prices would continue as long as the flow of funds from the region’s oil income continued. The surge in Middle East oil income was no doubt the first cause of the bubble; it came in waves as the oil price climbed from 1973 to 1980. It created a demand for domestic assets, yet opportunities for productive investment were scarce. This fueled the initial almost unimaginable rise in prices on the organized Kuwaiti exchange. The rise in both the oil price and the Kuwait stock market over so many years bred unrealistic euphoric expectations of endless oil income and an infinite appreciation in share prices. These expectations gave rise in turn to the over the counter market---the Souk...
The bubble began to burst twice, once in 1977 and again in 1980. In both cases the government intervened and successfully supported the market. However, these repeated bailouts of stock speculators created such entrenched moral hazard that the two years after the second bailout saw the most extreme bubble in the history of stock markets. By the time that super extreme moral hazard, melt-up developed, the innocents were gone. Only the cynics were left in the casino. When that preposterous bubble finally burst, policy could finally do no more. The cynics all knew the game was over. There were no bids and the market suddenly simply stopped trading." ("The Souk: The Greatest Stock Market Bubble of them All")
As the example of the Souk al Manakh demonstrates, in principle a bubble can be reignited but will the Fed and Administration go as far as the government of Kuwait? It is hard to know what will inhibit American policy makers, given Fed Governor Bernanke’s confession of the dirty little secret at the heart of modern monetary policy: in effect, a government/central bank operating under a fiat currency system in which its own currency remains at the apex essentially faces no real constraints to doing whatever it wishes to do.
We think Bernanke understates the limitations to some degree. Were it essentially a self-financing economy, the constraints faced by the US today would be negligible. But in an open economy with a large current account deficit and a huge net external debt and thereby a huge dependence on foreign investors, the non-stop use of the "electronic printing press" can signal a future depreciation of the currency. This can precipitate sales of domestic assets by foreigners, which may entail yet more monetary expansion to offset the impact of the resultantly higher yields at the long end. Ultimately, it should lead to domestic investors selling bonds as well. The result can become almost unmanageable as the financial crisis of 1997/98 demonstrated.
A key variable is China, which has hitherto gone along for the US dollar devaluationist ride. Last week a "Bridgewater Daily Observations" discussed the apparently often forgotten fact that a sustained decline of the dollar (down 17% in the past 12 months basis the Dollar Index) in theory tends to cause $- denominated commodity prices to rise. In fact, even though the dollar depreciation has accelerated in the past few months, import prices are not soaring. They did poke back into positive territory briefly, but by April and May had reversed back down again.
We suspect that the Chinese peg has had a major impact here. In theory, dollar depreciation should improve the U.S. trade deficit, although with a lag, since a falling dollar exchange rate means higher dollar prices for imports. This initially deepens the trade deficit, until domestic consumers, wholesalers, and producers react to higher import prices by either curtailing their purchases of imported products or switching their expenditures to domestically produced substitutes. If foreign producers lower their prices in their home currencies to offset the currency effect to the final purchaser of their products (as China effectively is doing by virtue of pegging the Yuan against the greenback), then there is no effect, and no particularly strong rise in import prices (which would otherwise induce a substitution back to cheaper domestic manufacturers of goods). Indeed, dollar devaluation under these circumstances simply exacerbates the problem.
The Chinese will let the peg go on for as long as it suits their interests, which are oriented around mercantilism, stability, and working through the myriad of financial and social problems they face. When they make the break from the dollar tie, it is highly conceivable they will have stockpiled a huge amount of gold to back their unit (which may also explain why the Chinese government has been so reticent to provide full disclosure on its official sector purchases of gold over the past decade). Once they feel they have those in order, then they make a play toward becoming the Asian region's reserve currency and ultimately the world's preferred currency.
The notion of the remnimbi-based Asian currency union may seem far-fetched today, but so too did the idea of a European currency union seem but 15 years ago. In many respects, an Asian monetary union predicated on the RMB would face considerably less difficult obstacles than the euro. In contrast to "Euroland", an Asian currency union predicated on the RMB would start with the presence of one dominant country, China (both economically and culturally), thereby facilitating the adoption of an existing currency, as opposed to the creation of a new one and the concurrent abolition of a multiplicity of national currencies. There is also a huge Chinese Diaspora in the emerging Asian countries; consequently, many of the traditional linguistic and historical barriers that pertain in the EU do not apply to anywhere near the same degree in Asia. There is a common, cultural Confucian ethic throughout the region. There is also a natural predisposition toward saving, making the region the largest repository of global reserves. If such reserves are backed by a large chunk of gold holdings (now being perversely leased or sold by countless Western central banks), then the notion of China at the epicentre of an Asian monetary union becomes eminently more credible.
What this means in relation to America is that the latter, like Argentina circa 2001, no longer controls its own economic destiny. In the case of the United States, the Sword of Damocles is not the IMF, but China. The death knell for the US economy may well be when the Chinese elect to float their currency because at that stage, many of the other Asian central banks (with the possible exception of Japan) may well find yet another compelling alternative to the US greenback, thereby sending the latter into free fall, creating untold damage to the US credit system. American policymakers, who persistently call for the Chinese remnimbi to be floated, ought to be careful what they wish for. It could well be the precipitating event for the final denouement in this extraordinary period of financial history.