How We Got Here: The Weak Dollar & the Global Crisis
How We Got Here: The Weak Dollar and How It Caused the Global Financial Crisis - speech given to the Cayman Islands CFA Society on March 3, 2010.
Before, during and after (we hope) what some have termed the "Global Financial Crisis", many have written and commented quite a bit about its causes. Low nominal rates of interest have been fingered more than a few times, out of control government-sponsored organizations such as Fannie Mae and Freddie Mac have been given a lot of attention, plus some feel the moderation of real estate prices itself torched the financial system.
To me, the answer is more basic; as in the falling dollar this decade authored the crisis, thus the title of my talk. But before getting to the dollar, I should say if you haven't noticed already, I'm an American, and a proud one at that. Growing up I never understood the scorn heaped on Americans, and honestly feel some of the traditional reasons for dislike are probably overdone.
But as a keen follower of the economy, I can say strongly that we do much to create dislike around the world, but it's for reasons that most often go unspoken. My view is that the world should view us negatively, but the dislike should center on our irresponsible oversight of the dollar.
That is so because the dollar is the single most important price in the world. And to prove this isn't just my American pride talking, I'll quote Otmar Emminger, president of Germany's Bundesbank in the 1980s, who similarly once said the dollar is "the most important price in the world economy."
Now why is this the case?
It is because with so many goods and worldwide transactions either priced in dollars or priced in currencies with explicit or vague definitions in terms of the dollar, when the unit of account changes in value, market prices and investments worldwide are distorted. At present the dollar factors into 90 percent of all trades in what is a $3.2 trillion currency market. It's also the case that nearly two-thirds of the world's central bank reserves are held in dollars. Furthermore, when we consider cross-border transactions between two foreign countries with thinly traded currencies, the dollar remains the go-between currency for the majority of those exchanges. The dollar's fluctuations are global events, and to put it very simply, if we had been in a stable dollar environment this past decade, today's historic market and economic problems would not be with us.
Now, to exhibit what I think is the dollar's substantial power, I want to digress a bit and talk about U.S. equity returns going back to the 1950s. About equities, for the longest time I thought their biggest driver was the level of taxation - if taxes were going down, equities performed better than if taxes were going up.
Generally I still believe this because when we think about taxes, it can't be stressed enough that they're nothing more than a price. And when the price placed on work is increased, there's less economy-enhancing production than if the price is decreased. Still, it didn't take me long to figure out that my basic assumption about taxes and equity returns was wanting.
Indeed, in the 1950s the top rate of taxation in the U.S. was 90%, but the S&P 500 rose 253% that decade. My explanation for why is that the dollar had a strict definition of 1/35th of an ounce of gold. Markets love currency certainty, and stocks soared.
In the 1960s we actually reduced the top tax rate to 70%, and stocks did very well, the S&P hitting an all-time-high in 1966. But what's interesting here is that the S&P never rose above its 1966 high for good until 1982. In my mind, the explanation why is fairly simple: by the mid-‘60s it became apparent to investors that our commitment to a stable dollar was waning. This showed up most noticeably in the private markets for gold, which revealed a much higher price than the $35 fix. Markets hate inflation, and the S&P only rose 54% in the ‘60s.
The ‘70s are even easier to explain. In 1971 President Nixon took us off the gold standard, and in doing so he removed the world from a dollar/gold standard. In that sense it's no surprise that commodities across the board skyrocketed in the 1970s. The commodity spike wasn't the result of rising demand, just as the oil spike wasn't a function of OPEC machinations or Middle Eastern wars; instead it was a function of commodities becoming expensive because currencies were cheap. Stocks hate hyperinflation, and the S&P only rose 17% in the ‘70s.
In the ‘80s we saw a grand improvement in policy. Ronald Reagan was elected on a platform of reduced taxes and regulation, and most notably, he was a strong-dollar president. The price of gold steadily declined for the most part on his watch as the dollar strengthened, and it's no surprise that the S&P rose 121% during his presidency.
I'll skip the first President Bush now, and move to President Clinton. I thought he got taxes wrong with increases in 1993, but it should also be said that dollar policy on his watch - with the exception of the end of his presidency when the dollar became too strong - was the best of any modern President. With the dollar strong and stable throughout the vast majority of his two terms, equities rallied and rose 208% during his presidency.
All of which brings us to George W. Bush. I think he got tax cuts right in 2003, but it should also be said that dollar policy under him was nothing short of horrific, and rivaled the Nixon/Carter era for sheer ineptitude. The dollar was in freefall (as evidenced by gold's spike) throughout much of his two terms, and no surprise the S&P 500 fell 34% during his presidency.
So the rest of the world should look at us with scorn because when the dollar gyrates in value, it causes shockwaves around the world. Indeed, Japan's lost two decades of deflation would never have occurred had protectionist politicians in the U.S. not forced a much higher yen value on the BOJ (the yen tripled in value versus gold) beginning in 1985, and if we hadn't let the dollar spiral upward in value in the late ‘90s, it's fair to say that the economies and currencies of Thailand, Malaysia, South Korea, Russia and Argentina would not have collapsed as the dollar's rise made their dollar currency pegs less credible.
And the dollar's sad decline this decade I think neatly explains the property boom worldwide, along with the subsequent bust. About this, it should be stressed that the dollar debasement which drove the housing boom was the recession, the moderation of housing prices the cure.
That's why it's odd at present that some say the solution to our economic problems now is for governments to pursue policies that would enhance the housing market. I say they get their sequencing backwards. Indeed, housing anywhere in the world does not make us more efficient or productive, it does not open up new markets, nor does a thriving housing market stimulate the very entrepreneurs who drive most any economy.
Subsidies offered by governments to stimulate housing demand are actually quite cruel. That's the case because housing land-locks us, keeps us tied to a certain locale at a time when we need to be mobile. To engage in cliché, in a world where capital moves at the speed of light, we need to be able to move quickly too, but home ownership effectively immobilizes us, and makes us less able to chase the best economic opportunities wherever they might reveal themselves.
Housing is pure consumption, so a truly healthy housing market is not a frothy one that usually only exists in periods of currency decline. At best, housing is the consumptive result of economic growth. When individuals rush into the housing market they are effectively burying money in the ground versus an investment in a mutual fund or shares whereby they're supplying capital to businesses.
Put simply, the worldwide rush to housing this decade is what created our general economic malaise whereby limited capital flowed into hard, unproductive assets. So to stimulate the property market as governments are now attempting is to harm the world economy while missing what drives economic growth. The rush to housing was as mentioned earlier the recession, not the subsequent moderation as so many assume.
Now for background on what caused the property boom, many of you are likely familiar with the conventional commentary in the States and around the world about as to the "bubble's" causes.
To many, including Martin Wolf of the Financial Times and Nobel Laureate Gary Becker, former Fed Chairman Alan Greenspan's policies in the area of nominal interest rates early in this decade were the cause of the rush to housing. What's apparent is that both Greenspan and his critics have misread what drove the nominal gains in home prices in recent years.
Greenspan's critics conclude to varying degrees that his decision to reduce the Fed funds target to 1 percent, in 2003, where it remained for a year, was the cause of the property boom and that the reversal of this policy was the cause of subsequent house price declines.
For his critics to be correct, however, there would presumably have to exist historical evidence showing that low nominal rates of interest have correlated with vibrant housing markets. Very little evidence supporting such a claim can be found.
Take, for example, the aftermath of President Nixon's decision to sever the dollar's link to gold, when the cash rate targeted by the Fed began to rise. Sitting at 5.5 percent in August of 1971, it reached a high of 10 percent by the end of 1973. Despite this substantial increase in the rate target, according to economic historian Allen Matusow's book Nixon's Economy, "Housing emerged as the most dynamic sector" in the early 70s.
Moving to Jimmy Carter's presidency, from a low of 5 percent in 1976, the Fed funds rate rose all the way to 13 percent by the end of the decade. But housing hardly faltered, as George Gilder found in his 1981 book, Wealth and Poverty. Describing the late ‘70s property boom that occurred amidst skyrocketing interest rates, Gilder wrote, "What happened was that citizens speculated on their homes...Not only did their houses tend to rise in value about 20 percent faster than the price index, but with their small equity exposure they could gain higher percentage returns than all but the most phenomenally lucky shareholders." Shades of this decade?
And to show how this seemingly contrarian rate phenomenon is not unique to the U.S., we can first look to Great Britain in the 70s. Although the Bank of England moved the bank rate from 5 to 9 percent in 1972, author David Smith noted in The Rise and Fall of Monetarism that the sector which investors "chose above all others was property development." Reflecting on the pound crisis years later, the June 1978 Bank of England Quarterly Bulletin explained that "There was no other general area of economic activity which seemed to offer as good a prospective rate of return to an entrepreneur as property development." That was the case owing to the belief "that property was the inflation hedge par excellence."
Going back even further in time, we can look at what happened in Germany in the aftermath of the Great War when rates were rising as the Mark collapsed. Economist Benjamin Anderson noted in Economics and the Public Welfare, "with the mark declining rapidly the wise thing to do was to go heavily into debt, purchase any kind of real values - real estate, commodities, foreign exchange - hold them for a time, then sell a small part of the purchases and pay off the debt."
The great Austrian economist Ludwig Von Mises referred to what I've described as a "flight to the real", and indeed, that's what individuals have been doing the world over ever since currencies came into existence. When they're losing value, the only consistent moneymaking concept involves borrowing heavily in order to speculate on hard, commoditized assets that tend to rise when currencies fall. That, in my mind, describes this past decade well.
Notably, empirical evidence produced by H.C. Wainwright Economics supports the conclusion that rising rates of interest don't drive down housing prices in the way that intuition perhaps suggests they might. Indeed, nominal home prices since 1976 have increased the most when interest rates have risen over 200 basis points, and they've declined the most when those same rates have fallen more than 200 basis points.
The weak dollar was the driver of the global real estate boom, and now I'll explain why. In the U.S., while the Federal Reserve issues dollars, it's rare for a Fed official to comment on the dollar's value. That's with good reason because the dollar's value is the preserve of the U.S. Treasury, and as a result, Treasury secretaries have historically been able to move the dollar's value on world markets with simple comments about the greenback, pro or con.
Looking at this from the perspective of Treasury actions in the decade past, Secretaries Paul O'Neill and John Snow mocked or questioned the importance of a strong dollar, while Secretary Henry Paulson frequently attempted to use his outsized reputation in China to force a revaluation of the yuan against the dollar. The actions of all three secretaries were an implicit communication to the markets that a weaker dollar was in fact the Bush administration's true policy, and markets complied as evidenced by the dollar's fall versus gold and every major foreign currency.
Put simply, when the unit of account weakens, there's as mentioned previously a flight to the real. Not only is housing an asset that is least vulnerable to a falling currency, it's an asset that in fact thrives in nominal terms in times of currency weakness. So while low rates and unfortunate housing subsidies of the Fannie Mae and Freddie Mac variety certainly contributed to the property boom and subsequent moderation, the major factor has been dollar debasement that in my Wainwright colleague David Ranson's words led capital "into assets that are invulnerable" to that same debasement.
In short, for Greenspan's critics to be correct, there would have to be an historical correlation between low nominal rates of interest and currency weakness. That there's very little speaks to criticism of the former Fed Chair that's either misdirected, or unclear.
I should stress that this talk is in no way meant to defend Alan Greenspan. Indeed, I could talk for hours about the various mistakes made on his watch, but I don't feel the evidence supports the popular claim that his interest rate policies brought us to where we are. Now, what's odd is that Mr. Greenspan's recent responses to his critics have rightly failed when it came to repairing any reputation lost. More surprisingly, he's embraced the very supposition about low rates and housing vitality used by his critics.
In Greenspan's case, he's pointed to falling rates as the driver of "remarkably similar housing bubbles that emerged in more than two dozen countries between 2001 and 2006." To his way of thinking, a glut of savings worldwide pushed rates downward such that housing was the sure beneficiary.
The notion of a "glut" of savings is something that's been similarly embraced by Greenspan's successor at the Fed, but the assumption is a fallacious one. To believe in the concept of excessive saving is to assume a place in time where all human wants are satisfied such that entrepreneurs will have run out of ideas and capital would have to find another home; in the past decade's case, property. But since we'll never reach such a point due to the happy existence of entrepreneurs eager to serve infinite human wants, the idea that we hit nirvana in 2001 seems a bit farfetched.
Greenspan has concluded that "the evidence that monetary policy added to the bubble is statistically very fragile." By his lights, if there was such thing as a property bubble, it was a world event rather than something endemic to the United States.
In defending himself incorrectly, Greenspan missed the chance to prove his critics wrong. Contrary to his suggestions otherwise, monetary policy was at the heart of this decade's real-estate boom, but not in the way Greenspan's critics assume.
Mentioned earlier was the falling dollar since 2001, and the policy factors that led to its weakness. Though the nominal level of rates (in particular, low rates) is a not very predictive indicator when it comes to the value of the dollar, exogenous and endogenous factors have historically affected the dollar negatively, and did so in this decade. So in talking about monetary policy, we should say the absence of policy, particularly any policy from the U.S. Treasury meant to support the greenback's price, made the dollar's value vulnerable such that it weakened and fed the property boom.
And when we consider Greenspan's argument that real estate rallied around the world, it should be said in fairness that he makes a very important, and all too often ignored point. The housing boom was global, and it occurred in countries such as Canada and England where there's no Fannie Mae or Freddie Mac, in England's case at least there's no mortgage-interest deduction, and in Canada it's very difficult to secure a home loan at all. England and Canada alone call into question the notion that subsidies of the Fannie/Freddie variety drove the rush to housing, because if they did, the boom wouldn't have been global in nature.
The better answer in this case is to look to the dollar. Indeed, it has to be remembered that when the dollar weakens, foreign central banks frequently feel the need to devalue their currencies alongside ours. Lost in all the modern commentary about the dollar's weakness versus all manner of foreign currencies this decade is the certain truth that a falling dollar begets world inflation. Or more to the point, when we devalue it is always and everywhere a worldwide event.
Looking at currencies themselves, comparing the dollar against other kinds of money in a floating currency world involves comparing one piece of paper lacking definition to another. That's why we need an objective measure of value. Indeed, when we bring an objective benchmark such as gold into the equation, an entirely different monetary story from this decade emerges.
The story here is a basic one, and it shows that the oft-chronicled foreign currency strength since 2001 was a mirage; one that obscured the broad currency weakness that the dollar's even greater weakness helped to obscure. From mid-2001 to March of 2008, and I use March of '08 because it coincides with the collapse of Bear Stearns, the price of gold in dollars rose over 250%, and in terms of the British pound, euro and Aussie dollar respectively increased 151, 101, and 94 percent. Our neighbors in Canada saw the price of gold in their own dollar rise 122 percent.
Some in the audience might question my use of gold as the benchmark, but it's realistically the most objective measure of value that we have. And gold's rise in various non-dollar currencies reveals a broad run on paper currencies worldwide.
The "why" in this equation is that seeking to maintain some level of parity with the dollar with trade in mind, foreign central banks throughout much of this decade added to U.S. monetary mistakes by allowing their own currencies to depreciate relative to gold. And with real estate most correlative with commodities, dollar policy stateside led to a worldwide commodity boom in nominal terms that drove capital into appreciating real assets including housing. A lot has been said about the recent moderation of home prices, but the real correction in nominal terms will occur if and when U.S. monetary authorities seek to rein in dollar weakness; dollar strength certain to lead to stronger currencies worldwide.
In short, there are varying views as to the Fed's ability to control the dollar's value with its interest-rate mechanism. But for one to tie this decade's property boom to the level of rates is to defy history suggesting otherwise.
So how did the worldwide rush to housing get us to where we are?
In inflationary periods, banks chase returns too, and housing was correctly seen as a safe haven. The problem there is that the money illusion can only last so long. That's the case because inflation is and always has been an economic retardant. When all manner of capital is flowing into the proverbial ground, that means there's a great deal less flowing into the entrepreneurial, or wage economy.
Looked at from a practical standpoint, individuals around the world, but most noticeably in the U.S., saw housing prices moving powerfully higher. Witnessing this, they borrowed from eager banks in order to buy more house than they could afford on the assumption that if their mortgages ever became too hard to service, there would be a willing buyer ready to snap up the house for a higher price than the original purchase.
What the average person perhaps didn't foresee is that inflation is death by a thousand cuts. Not only does it erode the value of our existing wages (consider how gasoline prices spiked this decade), but since it creates massive incentives for people to invest in hard objects, there's less capital available for investment in the productive economy. Simplified, real wages were reduced in value, investment in the wage economy withered, and all of this occurred alongside rising mortgage payments that increasingly could not be serviced. All of this led to the defaults that eroded bank balance sheets, and those same balance sheets were made worse by government intervention that made it impossible for intrepid investors to price the assets.
Importantly, all of the above should have led to a brief correction. All manner of businesses make mistakes all the time, and historically, particularly in the United States, we've allowed businesses failures to have their assets swallowed by others. This is the price of prosperity, but it's a good price in that it shows that capitalism is working.
To put it in a very basic way, the recession was once again the rush to housing due to capital flight away from the productive economy, so when companies and banks started to collapse as a result of this inflationary flight to the real, the collapses were a sign that the economy was on the mend. In short, the marketplace was fixing our economy by ridding it of poor banking and business practices that had for several years been camouflaged by a weak-currency money illusion. Had we allowed this necessary process to run its course, the recession would have been just that. Light and short.
But sadly, this time around, there was a collective blink on both sides of the U.S. political aisle in 2008, and I believe it explains what ultimately got us here. Horrific dollar policy led to the very malinvestment that would have given us a slowdown, but our bailout/stimulus culture truly tanked the economy.
To a high degree the capitalist consensus held until the spring of 2008. It was then that Bear Stearns, a fairly minor bulge bracket investment bank, ran into trouble. With its share price in freefall heading into the weekend, officials at Treasury and the Federal Reserve effectively blinked, and a forced marriage ensued in which J.P. Morgan purchased Bear for next to nothing in return for the Fed taking on the fallen investment bank's "toxic assets."
Even though Bear Stearns wasn't a bank in the traditional sense, government involvement was defended by some as necessary to avert a collapse of the financial system. Myriad other financial institutions had exposure ("counterparty risk") to trades entered into by Bear, and absent the infusion of government capital, our system of credit would supposedly have cascaded downward, Depression the certain result.
About the notion of bank "contagion" or a "banking domino effect", it should be noted that the only scholarly work ever done on the subject was written by none other than our present Fed Chairman, Ben Bernanke, back in the early '80s. But Bernanke's fears of a domino effect with regard to banks were then, and remain pure conjecture. And assuming the domino effect is real, when we consider how whole countries have bounced back from total economic and human destruction as a result of war, it seems a reach to assume that the world economy would fail to bounce back from the demise of one or many banks.
That is so because when businesses fail, they in no way disappear. Instead, an opportunity arises for competitors to quickly snap up market share, not to mention that capital previously misused by the failed business in question is quickly redirected to those with a stated objective to deploy it more wisely.
Had Bear simply been allowed to go under, there doubtless would have been turbulent markets, but it would be hard to presume any more turbulent than they've been since Bear's collapse. More important, had the Fed and Treasury simply stood aside, Bear's failure would have been a certain signal to other teetering banks to either find new capital, or quickly find a buyer.
More important, and as we've seen very clearly since the bailouts began, government aid meant to avoid "systemic risk" creates risks far worse for the banking system. Indeed, the acceptance of government aid, rather than a bank savior, is a death sentence for the weak and healthy alike.
Those that accept government money are no longer in business for profit. Instead, they're serving political masters who don't care about profit, but who do care about "social lending" practices at light rates of interest, do care about modifying interest rate on loans to bail out the irresponsible, and do care about restricting compensation no matter these restrictions driving away top talent.
Worse, their existence is a cancer on the healthy firms in the banking system that must compete with financial institutions no longer serving profit-driven shareholders, and that must compete with fallen banks lending money not their own. Systemic risk was the excuse for shedding free-market principles, but the far more treacherous risk of government ownership was seemingly never considered by many.
Many people point to the subsequent collapse of Lehman Brothers as the true beginning of the financial crisis, but what's often forgotten is that a week after Lehman's bankruptcy, the S&P 500 was higher than it was before the bankruptcy.
Indeed, in considering the causes of the crisis, more likely culprits have been ignored. For one, was Lehman's death the driver, or was it more realistically markets having to price in even more uncertainty concerning a government that changed its stance on intervention/non-intervention on a weekly basis? Markets crave certainty, and the inconsistency offered by Leviathan drove the very uncertainty that has always scared investors.
Secondly, it must be remembered that around the time of Lehman's collapse, the SEC introduced a short-selling ban on the shares of 900 financial stocks. Hmmm. With the ban in mind, and with the "crisis" one involving financial firms, is it any surprise at all the markets cratered when a ban was put in place that would make it impossible for investors to get a true read on the true value of financial shares? Would any of you want to own a firm the price of which did not include all information, including bearish opinion?
Isn't it also true that short-selling is often part of a "long" strategy whereby an investor buys one or many company shares long, but shorts other, somewhat similar ones as downside protection? Well, amid the "crisis", this strategy was abolished.
Lastly on shorts, it can't be stressed enough that short sellers are ultimately buyers. Indeed, in order to profit short sellers must re-enter the stock market to buy the shares they previously borrowed and sold short. Short sellers as a result frequently put a floor under downward trending markets, serve investors as a form of downside protection as a result, but they weren't allowed to play their vital role at a time when suitably scared investors paradoxically needed them most.
But most of all, we must ask ourselves what's been the biggest economic theme of realistically the last thirty years? Easily the biggest one has been the triumph of free markets over markets overseen by governments from the Commanding Heights.
During this period, capital of the human, physical and financial variety has flowed to where economic freedom is most prevalent, and departed from where governments have played a more interventionist role. Stock markets have soared in countries moving toward economic freedom, and have been more flaccid to non-existent in those countries where freedom has been shunned.
In short, the crisis of two years ago wasn't the failure of banks that showed capitalism was indeed working, instead it was the natural result of a movement away from the free-market direction the world had taken, and which had delivered unparalleled prosperity wherever tried. The crisis, to put it simply, was government intervention that properly scared the daylights out of investors given the knowledge that government-led economies have regularly underperformed, while economies mostly free perform very well.
Investors had to price in a more interventionist future, and with the track record there negative, markets were necessarily in crisis. Goodness, countries around the world have recovered handily for centuries from the death and destruction of war, but a few bank failures were going to set us back? A more laughable notion would be hard to fathom, at which point the markets had to price in both a collapse of reason in concert with a rush to the "security" of government. I know, I'm being redundant there, because a rush to government IS a collapse of reason.
So as we try to figure out what ours and the world economy will look like in the future, there's plenty of scope for worry. Probably the biggest challenge has to do with a business class that has forfeited a great deal of moral authority relative to the federal government.
While the U.S. and world economies have never in modern times been entirely free, companies could at least credibly say that federal bureaucrats should keep their distance when it comes to regulation. But thanks to the willingness of certain entities to accept funds from our government minders, they'll no longer be able to push back against the encroaching leviathan with as much vigor. Instead, thanks to the original sin that involved accepting handouts, our once vibrant commercial class will have to take the bad with the alleged good in the form of greater regulation.
That is unfortunate, because as John Stuart Mill once wrote, "The only insecurity which is altogether paralyzing to the active energies of producers, is that arising from the government, or from persons vested with its authority. Against all other depredators there is a hope of defending oneself." Sadly, we've accepted the false God of government security, and with that we must now accept a certain level of paralysis that will weaken the world's entrepreneurial economy, and which will make us less prosperous as a result.