Interview with Edward Hugh: The Dollar’s Demise is Vastly Overstated

Interview with Edward Hugh: The Dollar’s Demise is Vastly Overstated: "

Today, we bring you an interview with Edward Hugh, a macro economist, who specializes in growth and productivity theory, demographic processes and their impact on macro performance, and the underlying dynamics of migration flows. Edward is based in Barcelona, and is currently engaged in research into the impact of aging, longevity, fertility and migration on economic growth. He is a regular contributor to a number of economics blogs, including India Economy Blog, A Fistful of Euros, Global Economy Matters and Demography Matters. [The interview will be presented in two parts, with the first part printed below].

Forex Blog: I’d like to begin by asking if there is any significance to the title of your blog (”Fistful of Euros”), or rather, is it only intended to be playful?

Obviously the title is a reference to the Segio Leone film, but you could read other connotations into it if you want. I would say the idea was basically playful with a serious intent. Personally I agree with Ben Bernanke that the Euro is a “great experiment”, and you could see the blog, and the debates which surround it as one tiny part of that experiment. As they say in Spanish, the future’s not ours to see, que sera, sera. Certainly that “fistful of euros” has now been put firmly on the table, and as we are about to discuss, the consequences are far from clear.

Forex Blog: You wrote a recent post outlining the US Dollar carry trade, and how you believe that the Dollar’s decline is cyclical/temporary rather than structural/permanent. Can you elaborate on this idea? Do you think it’s possible that the fervor with which investors have sold off the Dollar suggests that it could be a little of both?

Well, first of all, there is more than one thing happening here, so I would definitely agree from the outset, there are both cyclical and structural elements in play. Structurally, the architecture of Bretton Woods II is creaking round the edges, and in the longer run we are looking at a relative decline in the dollar, but as Keynes reminded us, in the long run we are all dead, while as I noted in the Afoe post, news of the early demise of the dollar is surely vastly overstated.

Put another way, while Bretton Woods II has surely seen its best days, till we have some idea what can replace it it is hard to see a major structural adjustment in the dollar. Europe’s economies are not strong enough for the Euro to simply step into the hole left by the dollar, the Chinese, as we know, are reluctant to see the dollar slide too far due to the losses they would take on dollar denominated instruments, while the Russians seem to constantly talk the USD down, while at the same time borrowing in that very same currency – so read this as you will. Personally, I cannot envisage a long term and durable alternative to the current set-up that doesn’t involve the Rupee and the Real, but these currencies are surely not ready for this kind of role at this point.

So we will stagger on.

On the cyclical side, what I am arguing is that for the time being the US has stepped in where  Japan used to be, as one side of your carry pair of choice, since base money has been pumped up massively while there is little demand from consumers for further indebtedness, so the broader monetary aggregates haven’t risen in tandem, leaving large pools of liquidity which can simply leak out of the back door. That is, it may well be one of the perverse consequences of the Fed monetary easing policy that it finances consumption elsewhere – in Norway, or Australia, or South Africa, or Brazil, or India – but not directly inside the US.

This is something we saw happening during the last Japanese experiment in quantitative easing (from 2002  - 2006) and that it has the consequence, as it did for the Yen from 2005 to 2007, that the USD will have a trading parity which it would be hard to understand if this were not the case. I am also suggesting that this situation will unwind as and when the Federal Reserve start to seriously talk about withdrawing  the emergency measures (both in terms of interest rates and the various forms of quantitative easing), but that this unwinding is unlikely to be extraordinarily violent, since the Japanese Yen can simply step in to plug the gap, as I am sure the Bank of Japan will not be able to raise interest rates anytime soon given the depth of the deflation problem they have. Indeed, investors will once more be able to borrow in Yen to invest in  USD instruments, to the benefit of Japanese exports and the detriment of the US current account deficit, which is why I think we are in a finely balanced situation, with clear limits to movements in one direction or another.

Forex Blog: In the same post, you suggested that the Fed will be the first to raise interest rates. Why do you believe this is the case? How will this affect the Dollar carry trade?

Well, I would want to qualify this a little, becuase things are not that simple. In fact, as Claus Vistesen argues in this post, the ECB has rather “locked itself in” communicationally, and by  talking up the eurozone economies they now have markets expecting clear exit road maps and even pricing in interest rate rises from the third quarter of next year. But if we look at the underlying weaknesses in some of the Eurozone economies – evidently Spain, but Italy is hardly likely to have a strong robust recovery, and the German economy needs exports and hence customers to really return to growth – it is hard to see monetary tightening being applied with any kind of vigour at the ECB, so they may move up somewhat – say  to 2% – and then stop for some time.

I was also suggesting that in the short run they may do this to assist in the process of unwinding the global imbalances, since allowing the Fed to lead the world out of the monetary easing cycle would almost certainly provoke a rebound in USD, and problems for correcting the US current account deficit.

Really none of the developed economies (not even Norway) seem to be looking at the sort of really strong “V” shaped rebound some investors were anticipating, and it is more a question of who is weaker among of the weak. But if we look a little further ahead, at potential growth and inflation dynamics, then it is clear that the deflationary headwinds are stronger in Europe, while headline GDP growth may well turn out to be stronger in the US, and both these factors suggest that the Fed will at sometime be tightening faster than the ECB, in a repetition of what we saw from 2002 to 2005.

Forex Blog: You have pointed out that fiscal problems are not unique to the US. While the UK and Japan are certainly in the same fiscal boat, there seem to be plenty of examples of economies that aren’t, or at least not to the same extent, such as the EU. Do you think, then, that the long-term prospects for the Euro (especially as a global reserve currency) are necessarily brighter than for the Dollar?

Well, actually I wouldn’t say the UK and Japan are in the same fiscal boat. Let me explain. The UK evidently has severe short term problems (as does the US) with its sovereign debt, due to the high cost of resolving the lossses produced by the current crisis. But Japan has still not resolved debt problems which were produced in the crisis of the late 1990s, and indeed both gross and net debt to GDP simply continue to rise there. So I would say – as long as they can weather the present storm – the outlook for US, UK and French sovereign debt is rather more positive than it is for Japan. Indeed in the longer term it is hard to see how Japan can resolve its problems without some kind of sovereign default. This is the problem with deflation, as nominal GDP goes down, debt to GDP simply rises and rises.

But the principal reason I am rather more positive on UK, US and French sovereign debt in the mid term is simply the underlying demographic dynamic. These countries have a lot more young people (proportionately) than the Germany’s, Japan’s and Italy’s of this world, and hence their elderly dependency ratios (which are the important thing when we come to talk about structural deficits into the future) will rise more slowly.

It is also important to realise that the EU – at this point at least – is not a single country in the way the US is, and indeed there is strong resistence among European citizens to the idea that it should be. So it is impossible to talk about the EU as if it were one country. That being said, the lastest forecast from the EU Commission suggests that average sovereign debt to GDP will breach the 100% threshold across  the entire EU by 2014, so I would hardly call the situation promising. Basically some cases are much worse than others. In the East there are countries like Latvia and Hungary which are currently implementing IMF-lead structural transformation programmes, ut it is far from clear that these programmes will work, and sovereign debt to GDP has been rising sharply in both cases. In the South a similar problem exists, with Greek gross sovereign debt to GDP now expected by the Commission to hit 135% by 2011, and Italian debt set to increase significantly over the 110% mark. At the same time the future of government debt in Spain and Portugal is becoming increasingly uncertain. I would also point to the strong gamble Angela Merkel is making in Germany, and indeed ECB President Jean Claude Trichet singled the German case out during the last post rate-decision-meeting press conference for special mention in this regard. The future of German sovereign debt is far from clear, and markets certainly have not taken in this underlying reality.

So basically, and I think I have already explained my thinking on this in earlier questions, we have a structural difficulty, since I am sure the way out of Bretton Woods II will not be found by simply substituting the Euro for the USD. Europe is aging far more rapidly than the US, and the dependency ratio problems are consequently significantly greater.

1. I’d like to begin by asking if there is any significance to the

title of your blog (”Fistful of Euros”), or rather, is it only

intended to be playful?

Obviously the title is a reference to the Segio Leone film, but you

could read other connotations into it if you want. I would say the

idea was basically playful with a serious intent. Personally I agree

with Ben Bernanke that the Euro is a “great experiment”, and you could

see the blog, and the debates which surround it as one tiny part of

that experiment. As they say in Spanish, the future’s not ours to see,

que sera, sera. Certainly that “fistful of euros” has now been put

firmly on the table, and as we are about to discuss the consequences

are far from clear.

2/  You wrote a recent post outlining the US Dollar carry trade, and

how you believe that the Dollar’s decline is cyclical/temporary rather

than structural/permanent. Can you elaborate on this idea? Do you

think it’s possible that the fervor with which investors have sold off

the Dollar suggests that it could be a little of both?

Well, first of all, there is more than one thing happening here, so I

would definitely agree from the outset, there are both cyclical and

structural elements in play. Structurally, the architecture of Bretton

Woods II is creaking round the edges, and in the longer run we are

looking at a relative decline in the dollar, but as Keynes reminded

us, in the long run we are all dead, while as I noted in the Afoe

post, news of the early demise of the dollar is surely vastly

overstated.

Put another way, while Bretton Woods II has surely seen its best days,

till we have some idea what can replace it it is hard to see a major

structural adjustment in the dollar. Europe’s economies are not strong

enough for the Euro to simply step into the hole left by the dollar,

the Chinese, as we know, are reluctant to see the dollar slide too far

due to the losses they would take on dollar denominated instruments,

while the Russians seem to constantly talk the USD down, while at the

same time borrowing in that very same currency – so read this as you

will. Personally, I cannot envisage a long term and durable

alternative to the current set-up that doesn’t involve the Rupee and

the Real, but these currencies are surely not ready for this kind of

role at this point.

So we will stagger on.

On the cyclical side, what I am arguing is that for the time being the

US has stepped in where  Japan used to be, as one side of your carry

pair of choice, since base money has been pumped up massively while

there is little demand from consumers for further indebtedness, so the

broader monetary aggregates haven’t risen in tandem, leaving large

pools of liquidity which can simply leak out of the back door. That

is, it may well be one of the perverse consequences of the Fed

monetary easing policy that it finances consumption elsewhere – in

Norway, or Australia, or South Africa, or Brazil, or India – but not

directly inside the US.

This is something we saw happening during the last Japanese experiment

in quantitative easing (from 2002  - 2006) and that it has the

consequence, as it did for the Yen from 2005 to 2007, that the USD

will have a trading parity which it would be hard to understand if

this were not the case. I am also suggesting that this situation will

unwind as and when the Federal Reserve start to seriously talk about

withdrawing  the emergency measures (both in terms of interest rates

and the various forms of quantitative easing), but that this unwinding

is unlikely to be extraordinarily violent, since the Japanese Yen can

simply step in to plug the gap, as I am sure the Bank of Japan will

not be able to raise interest rates anytime soon given the depth of

the deflation problem they have. Indeed, investors will once more be

able to borrow in Yen to invest in  USD instruments, to the benefit of

Japanese exports and the detriment of the US current account deficit,

which is why I think we are in a finely balanced situation, with clear

limits to movements in one direction or another.

3. In the same post, you suggested that the Fed will be the first to

raise interest rates. Why do you believe this is the case? How will

this affect the Dollar carry trade?

Well, I would want to qualify this a little, becuase things are not

that simple. In fact, as Claus Vistesen argues in this post

http://clausvistesen.squarespace.com/alphasources-blog/2009/11/13/random-shots.html

the ECB has rather “locked itself in” communicationally, and by

talking up the eurozone economies they now have markets expecting

clear exit road maps and even pricing in interest rate rises from the

third quarter of next year. But if we look at the underlying

weaknesses in some of the Eurozone economies – evidently Spain, but

Italy is hardly likely to have a strong robust recovery, and the

German economy needs exports and hence customers to really return to

growth – it is hard to see monetary tightening being applied with any

kind of vigour at the ECB, so they may move up somewhat – say  to 2% -

and then stop for some time.

I was also suggesting that in the short run they may do this to assist

in the process of unwinding the global imbalances, since allowing the

Fed to lead the world out of the monetary easing cycle would almost

certainly provoke a rebound in USD, and problems for correcting the US

current account deficit.

Really none of the developed economies (not even Norway) seem to be

looking at the sort of really strong “V” shaped rebound some investors

were anticipating, and it is more a question of who is weaker among of

the weak. But if we look a little further ahead, at potential growth

and inflation dynamics, then it is clear that the deflationary

headwinds are stronger in Europe, while headline GDP growth may well

turn out to be stronger in the US, and both these factors suggest that

the Fed will at sometime be tightening faster than the ECB, in a

repetition of what we saw from 2002 to 2005.

4. You have pointed out that fiscal problems are not unique to the

US. While the UK and Japan are certainly in the same fiscal boat,

there seem to be plenty of examples of economies that aren’t, or at

least not to the same extent, such as the EU. Do you think, then, that

the long-term prospects for the Euro (especially as a global reserve

currency) are necessarily brighter than for the Dollar?

Well, actually I wouldn’t say the UK and Japan are in the same fiscal

boat. Let me explain. The UK evidently has severe short term problems

(as does the US) with its sovereign debt, due to the high cost of

resolving the lossses produced by the current crisis. But Japan has

still not resolved debt problems which were produced in the crisis of

the late 1990s, and indeed both gross and net debt to GDP simply

continue to rise there. So I would say – as long as they can weather

the present storm – the outlook for US, UK and French sovereign debt

is rather more positive than it is for Japan. Indeed in the longer

term it is hard to see how Japan can resolve its problems without some

kind of sovereign default. This is the problem with deflation, as

nominal GDP goes down, debt to GDP simply rises and rises.

But the principal reason I am rather more positive on UK, US and

French sovereign debt in the mid term is simply the underlying

demographic dynamic. These countries have a lot more young people

(proportionately) than the Germany’s, Japan’s and Italy’s of this

world, and hence their elderly dependency ratios (which are the

important thing when we come to talk about structural deficits into

the future) will rise more slowly.

It is also important to realise that the EU – at this point at least -

is not a single country in the way the US is, and indeed there is

strong resistence among European citizens to the idea that it should

be. So it is impossible to talk about the EU as if it were one

country. That being said, the lastest forecast from the EU Commission

suggests that average sovereign debt to GDP will breach the 100%

threshold across  the entire EU by 2014, so I would hardly call the

situation promising. Basically some cases are much worse than others.

In the East there are countries like Latvia and Hungary which are

currently implementing IMF-lead structural transformation programmes,

but it is far from clear that these programmes will work, and

sovereign debt to GDP has been rising sharply in both cases. In the

South a similar problem exists, with Greek gross sovereign debt to GDP

now expected by the Commission to hit 135% by 2011, and Italian debt

set to increase significantly over the 110% mark. At the same time

the future of government debt in Spain and Portugal is becoming

increasingly uncertain. I would also point to the strong gamble Angela

Merkel is making in Germany, and indeed ECB President Jean Claude

Trichet singled the German case out during the last post

rate-decision-meeting press conference for special mention in this

regard. The future of German sovereign debt is far from clear, and

markets certainly have not taken in this underlying reality.

So basically, and I think I have already explained my thinking on this

in earlier questions, we have a structural difficulty, since I am sure

the way out of Bretton Woods II will not be found by simply

substituting the Euro for the USD. Europe is aging far more rapidly

than the US, and the dependency ratio problems are consequently

significantly greater.

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