Big Government frequently makes for amusing reading but today, during a discussion of David Cameron’s ‘Big Society’, one contributor came out with this gem

“My Dad though, who is Hungarian, and born during the 2nd World War, has witnessed terrible happenings.So many suffered and families were decimated and fragmented.He always has that comparison.

But one thing he does say, even in the communist era,
EVERYONE was entitled to basic life commodites, like accomodation, bread and milk. People were not left to starve on the streets.”

Put like that life in communist Hungary sounds like ‘How Green Was My Valley’.

My uncle, however, was also born in Hungary, in Budapest in 1938. When he was a young lad his dad didnt come home from work one day. After a few more days my uncles mum baked a cake in a metal bath tub for my uncle and his brother to live on while she went out to look for their father. She came back a week later none the wiser.

Two years later, out of the blue, my uncles father finally returned home. He had been picked up off the streets by the secret police for counter revolutionary activity (though he was never told what this was supposed to have been) and shipped off to a labour camp in the Soviet Union for two years.

Still, at least people werent left to starve in the streets…

As Thomas Jefferson could have told our rose tinted Labour friend, “Government big enough to supply everything you need is big enough to take everything you have”

The causes and consequences of a falling dollar

On July 15th both sterling and the euro gained on the dollar, the latter hitting a two month high. Why is the dollar losing its value and what will be the consequences if it continues?

The exchange rate is simply the price of one currency stated in another currency. So an exchange rate of £1 = $1.54 means it takes one pound coin to buy a dollar note and fifty-four cents or vice versa. Put this way its easy to see why currencies rise or fall in value. Price, like an exchange rate, reflects relative supply and demand pressures. If supply rises relative to demand or if demand falls relative to supply then the price will fall. If, on the other hand, supply falls relative to demand or demand rises relative to supply the price will rise.

Yesterdays fall was, apparently, caused by a fall in demand relative to supply. The Federal Reserve issued a fairly gloomy prediction for the prospects of the US economy over the next few years, notably forecasting that “the unemployment rate was generally expected to remain noticeably above its long-run sustainable level for several years”. But this demand side issue is only half of the story. The other half is the supply side.

The supply of dollars has exploded in recent years. Alan Greenspan, who became chairman of the Fed in 1987, inherited a reasonably tight monetary policy from his predecessor Paul Volcker who had raised the Fed funds rate to choke off the double digit inflation of the 1970’s. Almost immediately Greenspan was faced with stock market crash of October 1987 and responded by slashing interest rates to boost the economy and keep it from recession.

It is important to bear in mind how this works. Interest rates are just the price of money and are as bound by supply and demand pressures as is any other price including the exchange rate. To push this price, the interest rate, down, the Fed increases the supply of dollars. It worked in 1987 and recession was avoided but Greenspan pulled the same trick in 1998 when the Asian financial crisis struck and again in 2000 when the dotcom bobble burst. This technique of using floods of dollars to cushion downturns became known as the ‘Greenspan put’ and his successor, Ben Bernanke, has tried it again in the face of the bursting of the housing bubble and the resultant credit crunch.

But each of these injections of liquidity have piled upon one another. According to the Federal Reserve Board of Governors between 1987 and 2006 the amount of dollars in circulation, on the M3 measure, increased from about $3.5 trillion to over $10 trillion. One analyst, Adrian Van Eck, estimated that $3 trillion dollars were created between 2003 and 2006 alone. In early 2006 the Fed stopped counting M3.

So, coupled with the short term ‘demand shock’ of the Fed’s report yesterday we also have the longer term pressure of rapidly increasing supply on the value of the dollar.

What are the potential consequences of all this? To answer this we must first answer another question; why hasn’t this tidal wave of dollars created rampaging inflation as almost every school of economic thought suggests it should?

The answer lies on the demand side. As fast as the Federal Reserve has been able to pump dollars out America’s trading partners have been sucking them in. From the late 1980’s onwards large swathes of the planet embraced economic liberalization, most notably China, and began to trade. China sent cheap goods to the United States and the United States sent dollars to China. China accumulated over $1 trillion and the dollar holdings of Abu Dhabi, Saudi Arabia, Kuwait and Qatar were estimated at $2.1 trillion.

Inflation is caused by the growth of the money supply relative to the amount of goods and services in an economy. The entrance of emerging markets into the global economy increased the amount of goods and services available and offset the growth of the supply of dollars. Instead of staying at home and pushing up inflation the dollars printed in the US went abroad.

This brings us to the consequences of a falling dollar. As the Fed pumps out more and more dollars to revive the American economy the dollars value falls. This pushes down the value of these foreign dollar holdings. At a certain point the sheiks or politburo members will wonder just how long they want to hold onto a depreciating asset. And when they decide they no longer want to an awful lot of dollars will head back to the one place they can be redeemed; the United States.

With demand for dollars falling its exchange value will collapse. The dollars flooding back into the US will cause inflation as the holders of foreign dollars repatriate them and try to cash their depreciating dollars in for other American assets. Anything not nailed down between Cape Cod and Honolulu will be bought and shipped abroad. There are 8.9 million mobile homes in the US so perhaps shipping these off to Beijing and Bahrain could ease the housing glut.

How likely is this doomsday scenario? As we’ve seen, like all else in economics, it depends on supply and demand. On the demand side if foreign holders of US debt are content to keep hoovering up dollars its value will be maintained. There are reasons to think they might. A collapse in the value of the dollar, beyond the creaking seen yesterday, would see the value of dollar holdings decimated. Also, China might find the leverage it now has over the US useful in any future dispute over, say, Taiwan. The threat of currency mayhem could castrate a United States response.

Other factors work the other way. The continuing weakness of the US economy, as highlighted by the Fed, will give foreign dollar holders pause for thought as will the Fed’s policy of creating dollars if continued beyond some point. Then the dollar will fall and inflation will follow.

On the supply side it is clear that the more dollars the Fed creates the greater a tumble in its value prompting an exchange rate dive and inflation. The Fed can only influence the demand side indirectly. The supply side is in its own hands.