Default, devalue or deflate

Faced with a country bent double under a mountain of debt, US monetary policymakers are allowing the dollar to devaluate rapidly. But that may not be enough to prevent the US from defaulting on its debt.

Recent economic indicators have provided the clearest confirmation yet that the US economy is in recession, a view we have held strongly since December.

The problem is that Federal Reserve policy (aggressive base rate reductions) is also boosting near-term inflation and threatening to make matters worse not better! It is unusual for the political cycle and economic cycle to be so far out of kilter. Most commentators and, judging by the reaction to Dr Bernanke's recent pronouncements, financial market operators too, tend to the view that all that is required are a series of aggressive base rate reductions, coupled with a limited fiscal stimulus.

After a brief hiatus, during which the 2.25% (so far) Fed Funds reduction from Sept 18th 2007 works its way through the real economy the lights will switch from red, through amber to green and all will be well. What many still seem to find difficult is to marry a traditional monetary response with an exhausted economy bent double under the weight of a mountain of private sector debt.

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We know that the Federal Reserve dances to a different tune than does the European Central Bank or the Bank of England. It aims to maintain base rates at such a level as to ensure sustained economic growth and ensure low levels of inflation. What it is actually doing is reducing real incomes and destroying the economy's ability to recover by maintaining a policy of neglect towards inflation.


Basically there are three ways in which economic policy makers can deal with excessive debt; none are particularly attractive, all have significant side-effects and all require strong nerve. Simply, an economy can either default, it can devalue or it can deflate. Historically, governments faced with this problem have opted for devaluation and domestic monetary deflation (we're thinking here about the Asian response during the 1990's, but also Britain during 1990-1992).

Devaluation and dollar weakness

The US, by contrast, thinks that it can get away with a simple devaluation. Dollar weakness has been hitting the headlines of late and whilst we believe that the currency has further to fall against a basket of currencies we suspect that the leitmotif for the rest of the world is that the US is likely, at some point in the future, to default on its debt. Remember that running a substantial trade deficit requires an equally aggressive surplus on the capital account.

The US has benefited from c$3/4 trillion of new capital inflows each year. In such circumstances, relying on continued overseas largess strikes us as dangerous and that maintaining more than half an eye on the US election process, should not preclude the US authorities from presiding over the destruction of the probity of its currency.

We have argued in previous publications that to ignore food and energy prices in the calculation of inflation misses the prevailing point and that focusing monetary policy on the basis of an underlying measure excluding the two actually exacerbates the problem because the US economic woes are actually encouraging global investors out of the dollar and into commodities.

Rising commodity prices are already taking their toll in China and India where overheating is a very real concern. The producers of food and energy products are driving prices higher, forcing Western populations to pay more for food and energy products resulting, in prevailing conditions, in lower real incomes and reduced levels of disposable income.

As the second chart shows, the US authorities' denial of consumers' need to consume less and save more has resulted in producer price inflation hitting a 26-year high. What this means is that if the US economy does avoid the recessionary shoals over the next six months then inevitably base rates would have to be tightened aggressively in due course raising the risk of a second, far worse, downward lurch in activity comparable to that which took place in 1980 and 1982.

However, we do not believe that this outcome will play out. Bear in mind that inflation is already significantly higher than the rate of income growth, house prices are continuing to collapse (now down c57% year on year) and deflation is happening through the back door as household balance sheets are destroyed.

Bailing out Wall Street

There is another, unstated, agenda for Fed policy makers too; bailing out a crippled Wall St. By cutting base rates the Fed is attempting to address the twin problems of liquidity and solvency. There is no question that the injection of liquidity is an appropriate policy action, however, we continue to take the view that the banks remain less than forthcoming regarding their exposure to toxic waste, the inevitable fall-out from the credit crunch. Although the banking sector reporting season has passed over and investors have breathed a collective sigh of relief that it went much less badly than many, ourselves include, had thought it might, we are absolutely not out of the woods.

It is estimated that there might be c$600bn total write-downs required before investors can feel that confidence is on the way to being restored. Currently the "writedownometer" stands at c$160bn. The sooner the financial sector truly admits to its legion of exposures, the sooner bankruptcies are confirmed, the sooner we will know where the toxic waste is buried and the sooner "normal service" can be resumed. Until that point markets will remain characterised by high levels of volatility and low levels of visibility.

By Jeremy Batstone-Carr, Director of Private Client Research at Charles Stanley