When regular loans

Don't earn enough to suit us

Maybe bad loans will.

I'd never heard of Haiku until a Wall Street Journal article in the early 1990's described a large group of financially strapped Japanese businessmen gathered in an auditorium taking turns singing the blues, as it were, in classic Japanese Haiku. It was sad–sad and lonely–and eloquent.

I looked it up, but decided Haiku was too sophisticated for a country boy, with its rigid syllable count, its absence of rhyme, but the presence of an undefinable zen quality. Not rhyming, I'm told, is sophisticated in the same sense as art that doesn't look like anything. I can imagine enjoying it, but how would you judge it? I can at least imagine learning the rules of rhyming, but what are the rules of not rhyming? Not everyone agrees, you might be surprised to learn, that rhyming is low-brow. I think it was Robert Frost–no Bubba–who said that writing prose was like playing tennis without a net. But my first Haiku, like Buck Owens acting sad and lonely, came naturally:  

 Japanese Haiku

Is too sophisticated

For a country boy.

What stirred all these memories up was another WSJ article about the financial blues expressed in verse, but these blues were made in the USA.  What is it about financial distress and poetry? As the current subprime crisis developed, my mind did turn to a poem from my early years that dealt with risk management and moral hazard. Its author, Joseph Malins, describes a town's dilemma over what to do about a dangerous cliff that had already claimed a number of lives.  The question before the community was whether to build a fence at the top of the cliff or place an ambulance at the bottom. Here is the first verse of A Fence Or An Ambulance:

'Twas a dangerous cliff, as they freely confessed,

Though to walk near its crest was so pleasant;

But over its terrible edge there had slipped

A duke and full many a peasant.

So the people said something would have to be done,

But their projects did not at all tally;

Some said, "Put a fence around the edge of the cliff,"

Some, "An ambulance down in the valley." 

It was a close vote, but they finally chose the fence with the following rationale:

"To rescue the fallen is good, but 'tis best

To prevent others from falling."

Sometimes a rhyme can capture the essence of mundane business matters like, say, Sarbanes-Oxley, or, in this case, the endless "attesting" requirements of COSO.  Those attesting requirements were anticipated by Ogden Nash in The Python.  See if you don't agree: 

The python has, and I fib no fibs,

318 pairs of ribs.

In stating this I place reliance

On a seance with one who died for science.

This figure is sworn to and attested;

He counted them while being digested.

Ogden Nash understood banking and finance.  Banks current reluctance to lend, except under ideal circumstances, was captured by his poem, Bankers Are Just Like Anybody Else, Except Richer. Bank customers probably appreciate it more than bankers, however.  Here is an excerpt: 

Most bankers dwell in marble halls,

Which they get to dwell in because they encourage deposits and

 discourage withdralls,

 And particularly because they all observe one rule which woe

 betides the banker who fails to heed it,

Which is you must never lend any money to anybody unless they

 don't need it.

Texas style cowboy poetry has fewer references to evil bankers and other money lenders than one might expect since running money is a lot like running cattle. In both cases it pays to look back occasionally to see if the herd is still with you. Investors can learn an important lesson in herd behavior that cowboys already know: If you are following a cow, chances are it's following a cow too. 

I've seen one cowboy poem devoted to the contemporary issue of collateral, but I can't find it. Anyway, it starts of with the banker requiring collateral from a cowboy–his cows–for a small bank loan. The cowboy was insulted by the implied lack of trust and the banker's unwillingness to make him a character loan. So, when the cowboy paid the loan off, on time, and the banker urged him to keep his deposit account in his bank, the cowboy asked the banker what he would be using as collateral. Life does have its small satisfactions. 

I'll leave you with one more subprime verse: 

My house is under water, for sure,

And my car is upside down, you bet,

But I'm going to get me a consolidation loan

And finally get out of debt.

It's not Haiku, but it'll do. After all, as Ogden Nash put it so eloquently,

Purity

Is Obscurity

Happy New Year Everyone! 

                             Bob McTeer

Sorry about the delay.  I haven't been on the Canadian border arbitraging books in U.S. and Canadian dollars as I had threatened to do.  Instead, I participated in a Forbes/NCPA Investor Cruise through the Panama Canal.  Very nice.  Good folks; interesting program.

But the program left me in a bit of a funk.  I had friends on opposite ends of the optimism/pessimism spectrum speaking with passion and absolute certainty about current and future economic prospects.  At one end, my friend Gary Shilling said we are going to hell in a hand basket, things can only get worse, the Fed is behind the curve and has much more easing to do.  He didn't honey coat his doom and gloom. 

All the other speakers were less pessimistic than Gary, most particularly, Brian Westbury, another friend, who focused on inflation rather than the subprime crisis. He said, very emphatically, that the Fed shouldn't have eased at all to deal with the subprime fallout and certainly shouldn't ease more.  He had some rather colorful unkind things to say about our beloved central bankers; I don't think he expects them to go to central banker heaven.  Having sat around the FOMC table with Alan Greenspan for 14 years, including 3 with Ben Bernanke, my knee twitched a bit, but didn't go into full jerk mode.  Since I'm long gone from the Fed — well, just over 3 years now — I'm not sure why I still feel unfair criticism — or partially unfair criticism — in my gut. On the other hand, maybe I was just suffering from the motion of the ocean.  (See my posting: "The Blame Game.")

My funk resulted partly from the fact that either Gary or Brian could be right, but I didn't know which one.  Like an old-line Texas politician, "I can argue it round; or I can argue it square."  That's about where I am these days, hearing all black and white and coming out grey.  I've always avoided the two-handed economist approach, which drives listeners mad and harms my self esteem.  Splitting the difference and taking a middle-of-the-road approach isn't satisfying either, especially in Texas where they say the only things found in the middle of the road are yellow streaks and dead armadillos.  Remember the old cowboy movies where the bad guy in the black hat always called the good guy in the white hat "yellow"?  A yellow streak is not good.

Actually and unfortunately, I'm forced to go with grey, bland shades of grey.  Nobody wants to hear it, but I expect the economy to do better than the pessimists expect, but not as good as the optimists expect.  Not in the middle of the road, but the middle of the optimistic half of the road.  I'll admit that's based more on a hunch and hope than on rigorous analysis.  But my hunches are educated hunches, if I have to say so myself.

I'm not alone in my uncertainty.  The dirty little secret is that economists just aren't good at forecasting.  They know it and most will admit it, but the public, employers of economists, and talking-head interviewers all expect forecasting; so, in good Keynesian fashion, demand creates its own supply.  Smart economists have figured out, however, that, if you must forecast, it's best to do it late and often. The FOMC recently caught on and promised release of quarterly rather than semi-annual forecasts, cutting their average embarrassment time in half.  They also foolishly expanded their forecast horizon to 3 years out, revealing in their 2010 forecast a very pessimistic view of productivity expectations and the growth potential of the economy.  (See my previous blog posting: "The FOMC's Enhanced Transparency Reveals Old Paradigm Pessimism.")

I recall the last time the Fed and Fed watchers were on recession watch.  It was late 2000 and all of 2001.  Each quarter would produce a barely positive real GDP number — not good enough for anything else, but good enough to avoid the dreaded two consecutive negative quarters that would constitute a recession.  We kept dodging the bullet until 9/11 tipped the third quarter into negative territory, the first one.  Everyone expected, a more-negative 4th quarter, but surprise, surprise, thanks largely to zero interest auto loans, the quarter was positive. The 4th quarter of 2001 was the beginning of the current expansion, which is now six years old and counting.  The 3rd quarter of 2001 was the only negative quarter!  No recession!  No recession that is until the National Bureau of Economic Research later decided retroactively that a recession began as early as March 2001 and bottomed out in November.  The recession was ending about the time we thought it was beginning.  Makes you think, doesn't it?

I don't think that will happen this time, since 3.8 percent and 4.9 percent real GDP growth in the 2nd and 3rd quarters of 2007 would be hard to revise to zero or below.  But many talking heads started talking about a 1 percent 4th quarter number as early as October, months before the Bureau of Economic Analysis releases their first forecast of the 4th quarter. 

This morning's newspapers (December 26) "confirmed" the expectations for a weak Christmas season.  Not so if my mall is any indication.  Besides, we will join millions of smart people in the coming days buying on sale what was full price through yesterday and using all those new gift cards, which apparently don't count in official retail sales numbers until they are spent on merchandise.

The early and unexpected bounce back in economic activity in the 4th quarter of 2001 was only one of several convincing pieces of evidence of the remarkable resilience of the U.S. economy in recent years.  We seem to have a Timex economy: it takes a licking, but keeps on ticking.  The proven resilience of the U.S. economy, my friends, is the main reason I don't expect extreme pessimism to win out.  Not very scientific, is it?  Sorry Gary.

But neither can I be as optimistic on the economy, and as worried about inflation, as Brian Westbury.  Maybe too many seeds of inflation have fallen on fertile ground and will have to be dealt with eventually.  But given the balance of risks that most people see, including me, I can't imagine that the FOMC will risk looking back on 2007-2008 and admitting that it let the sub-prime crisis get out of control while it fretted about inflation.  They won't be fiddling while the economy implodes, and if the economy turns out to be weaker than they expect, it will dampen inflation on its own.  Of course, either way, the Fed will be criticized for the downside of the choice it makes as well as the downside of the choice not made.  Time will tell and reveal the final verdict on Ben Bernanke's performance.  I'm betting on him.

Happy Holidays.

Transparency is a good thing if you like what it lets you see. In the making of monetary policy, that's a big if. Transparency is Mom and Apple Pie these days, but I think the exuberance is, if not irrational, at least excessive. This little rhyme, repeated from my previous posting, reflects my skepticism:

Transparency is a current central banker cause
But it reminds me too much of sausages and laws
I think translucence, like my shower door, is a good compromise
It lets in the light, but keeps out the flies.

If you must forecast, I've learned, it's best to do it often. Increasing the number of FOMC member forecasts from two to four per year was a clever idea. It is more transparent, but it's also easier. You get to adjust an errant forecast twice as often and in half the time.

The FOMC's mistake, in my opinion, was extending the forecast horizon out to three years.  Given each member forecaster's assumption of "appropriate monetary policy," however they define it, three years is long enough for policy to do all that policy can do. It's long enough for initial adverse conditions to be overcome. What's left in that third year forecast is the FOMC's implicit view of the best it can do, or the limits of the economy — it's capacity to produce without causing inflation to accelerate. I call that a mistake in part because their view, revealed by their latest forecast, is so dismal. I can't find a Goldilocks economy anywhere on their horizon.  

Their range of forecasts for real GDP growth in 2010 is a puny 2.2 to 2.7 percent, with a central tendency of 2.5 to 2.6. That growth rate is assumed to produce an unemployment rate of 4.7 to 4.9 percent, above the current rate, and a core PCE (personal consumption expenditure) inflation rate of 1.6 to 1.9 percent.  The core PCE forecast is about the same as today, although they also have the number for the headline rate the same, which is lower than the current number, but that doesn't mean food and energy prices come back down. It just means they aren't expected to continue rising as fast.  If 2010 is Goldilocks, as Lyle Lovett might describe her, she's ugly from the front.

A 2.5-2.6 percent growth rate in 2010, which can be interpreted as the FOMC's  estimate of the economy's growth potential, can be expressed as the sum of labor force growth (hours worked) and productivity growth (output per hour worked).  The labor force typically grows about 1 percent per year.  That means that productivity growth is expected to slow to around 2 percent per year.  Why so low?  As I used to say prior to the late 1990's productivity revolution, trees grow faster than that.

The natural rate of unemployment implicit in the forecast has risen to almost 5 percent. Since both growth and unemployment are currently more favorable than their 2010 growth and unemployment estimates, it's no wonder the FOMC is concerned about inflation.

These numbers mean we're already over the speed limit for monetary policy. If they try to enforce such a low speed limit, they could create a self-fulfilling prophecy. That possibility, to me, calls into question of public forecasts by policymakers.  The path they've outlined is one of managing slack in the economy to hold down inflation.  I'd rather see them control inflation through growth — disinflationary growth.

We had this debate in the late 1990's, and the optimists won out (until June 1999).  Because of that, an artificially low speed limit wasn't enforced, and the result was faster real growth, faster employment growth, lower unemployment, and lower inflation.  I hope we aren't back to underestimating the U.S. economy.

Chairman Bernanke this morning announced further steps in the Fed's long march toward greater transparency in monetary policy and gave the rationale for it.  Since each step toward greater transparency is almost always universally applauded by those to follow such things, I suppose they must be on the right track.  Everyone can't be wrong, can they?

        Yet, a little voice in my head keeps asking, rather pointedly if I may say so, whatever happened to the argument that an element of surprise is sometimes needed for the Fed to have a significant impact on the market. That was once conventional wisdom, but it's rarely articulated any more. In fact, I've only heard the surprise argument made once in the last several years.  Fortunately, from my point of view, it came from a cracker-jack economist for whom I have the highest regard:  Russell S. Sobel, an economics professor at West Virginia University and co-author of Economics: Private & Public Choice.

        When I sat around the FOMC table, I didn't actively resist steps toward greater transparency, but I did keep reminding my colleagues against going too far too fast, and that we may need an element of surprise some time. Since my more serious efforts bore no fruit, I wrote the following little poem and let it go at that. It's already on my web site under the "Rhymes with No Reason" section.  I reproduce it here for your convenience and enlightenment.

Translucence: Measured Transparency

Transparency is a current central banker cause  But it reminds me too much of sausages and laws I think translucence, like my shower door, is a good compromise

It lets in the light, but keeps out the flies.

(Part II of Dollars and Sense)

Q: Does inflation cause the dollar to decline?

or

Q: Does a declining dollar cause inflation?

A: Yes!

Q: Does a declining dollar stimulate our economy?

or

Q: Does a declining dollar make us poorer?

A: Yes!

No sooner had the Fed acquiesced in the markets' desire for a substantial ease in monetary policy on 9/18 (and further ease on October 31) than the hand-wringing began over the resulting acceleration in the decline in the dollar. If it's not one thing, it's another.

As the apparently contradictory answers to the questions above suggest, the dollar is a tricky topic after having been out of the limelight for several years. Beginners should exercise caution.

Ben Stein's father, the excellent economist, Herb Stein, is alleged to have said that if something is inevitable, it will happen. He probably should have added, "sooner or later," since a decline in the dollar has been inevitable for many years. Economists have forecasted a decline in the dollar for so long without result, that they finally gave up. Financial journalists too young to remember road runner cartoons were taken by surprise and had some difficulty sorting it all out.   

As some of you will recall, the roadrunner in those cartoons would skid to a stop at the edge of the cliff as Wile E. Coyote, in hot pursuit, overran the cliff.  But, miraculously, the Coyote continued running until he finally looked down.  Apparently, what happened to the dollar was that someone finally looked down.

Those of us over a certain age learned in Econ 101 that the supply and demand for dollars in the foreign exchange markets derived primarily from trade in goods and services, with equilibrating or balancing capital flows financing whatever current account deficit or surplus emerged. But, in recent years, capital flows increasingly became "independently motivated" and took on a life of their own. We know that, but we still have difficulty grasping the idea that trade deficits might just as well be thought of as financing capital inflows and that trade surpluses may be thought of as financing capital outflows.  

What we do know is that the overall balance of payments always balances by the Grace of God, double-entry bookkeeping, and by definition. Total debits always equal total credits.  Debits in a country's balance of payments give rise to a home currency demand for foreign exchange.  Credits give rise to a foreign exchange demand for the home currency.  So, just as debits and credits are always equal in an accounting sense, so is the quantity of foreign currency demanded and supplied, and bought and sold, on foreign exchange markets.

Whether this accounting identity may or may not (probably not) represents "equilibrium" depends on whether market participants are satisfied with the outcome.  If not, their actions will move the balance of payments and exchange rates toward equilibrium through all sorts of interdependent changes.   

Can policymakers ignore the declining dollar and the current account deficit?

Yes, benign neglect has been the unofficial policy for years and the sky hasn't fallen-although Chairman Greenspan might say it's been measurably weakened. If strong capital flows into the United States resume, the dollar could be stabilized or even appreciate obviating a need for narrowing or eliminating the current account deficit.  This must be what the talking heads have in mind to order up a strong dollar without acknowledging any need for more balanced trade in goods and services. With this outcome, the continued capital inflow will continue adding to foreign claims on U.S. assets with whatever future problems that may pose.

What if capital inflows aren't sufficient to stabilize the dollar or cause it to appreciate?

Then the current account deficit that requires financing by capital inflows will have to continue shrinking through some combination of reduced imports and increased exports.  That may require further depreciation in the dollar, although the impact of the depreciation that's already occurred has likely not been fully realized yet. It takes time for the relative price changes associated with exchange rate changes to affect the level of imports and exports along with the shifting of labor and capital resources into export industries and industries that compete with imports.

What would it take to attract enough capital to match the current account deficit without further dollar depreciation?

Remember that the amount of capital inflow required will diminish as the depreciation that has already taken place continues to shrink the current account deficit.  The lower level of the dollar stimulates exports and diminishes imports.  With respect to capital inflows, the level of the dollar is less important than expectations of what is likely to happen to the dollar during investment horizons.  The fact that the dollar is currently "cheap" shouldn't attract capital unless investors expect it to become even cheaper after they invest in the U.S.  The incentive to invest will increase as the dollars decline begins to give rise to expectations of its reversal.  We may or may not be near that point already. However, efforts to "talk up" the dollar, if successful could keep foreign investment at bay and ironically lead to the greater depreciation needed to support it through trade rather than through investment.

Can benign neglect work in more than the superficial sense of accounting identities?

Yes, not only does the balance of payments always balance in an accounting sense, it tends to move toward equilibrium in a more fundamental sense of imbalances being self correcting.  To a very large extent, more imports lead to more exports and more exports lead to more imports.

When we import goods and services (or make unilateral transfers abroad) foreign exporters and gift recipients get dollars that can (and ultimately will) be used to purchase U.S. goods and services (or assets).  It probably won't be the foreign exporter that uses the dollars to import from us, but his newly acquired dollars will be sold in the foreign exchange market to those who need them for that purpose. 

By the same token, our exports, by earning us foreign exchange, give us the wherewithal to import more.  The argument is the same as above in reverse.  The point is that, left alone, import and export balances are self correcting.  Residual trade deficits or surpluses are tiny compared to the total trade and result from voluntary transactions affecting our capital accounts.  The exchange rate and other variables keep changing until market participants are satisfied with the outcome of millions of decisions to import, export, borrow and lend.

What about jobs?  Won't the trade balance affect jobs?

I'm glad you asked that question.  Most critics of free trade don't ask it; they just (incorrectly) assume the worst.  In other words, they associate a trade deficit with a loss of jobs.

Before answering in the context of this discussion, let me digress a moment and point out that the number of jobs we have roughly equals the number of people in the labor force willing to work.  If wages are too high for certain skill levels, potential workers will bid them down to become employed, i.e., if minimum wage laws don't become air tight.

The answer to the question of whether trade deficits cause unemployment is parallel to the discussion in previous paragraphs.  If imports beget exports, then jobs lost to imports will be matched by jobs created in export industries.  And, vice versa.

If restricted trade is suddenly freed up, the reallocation of production and consumption will be according to the law of comparative advantage.  In other words, trading countries will be better off, because greater specialization in each country's area of comparative advantage raises total output from a given level of resources.  Some workers will have to change jobs, and perhaps even change locations, but, after initial frictions, they will be moving into areas of comparative advantage.  But this should be a topic for later.

Sum up please, my brain hurts.

Okay.  Talking heads who call for a strong dollar without saying how they propose to bring that about are implicitly assuming that capital inflows will increase enough that the current account deficit doesn't have to shrink.  The most likely and least painful route to that outcome is for the dollar to continue declining until it raises expectations of investors that it's bound for a rebound.  We may be near that point for all I know.  Or not!

If we aren't on the verge of renewed strength in capital inflows, we have to accept the internal adjustments necessary to shrink the deficit.  Those internal adjustments can most painlessly be triggered by further declines in the dollar that raises the prices of imports to us and lowers the price of our exports to out trading partners.  If we somehow prevent further dollar depreciation, the incentives for the necessary resource reallocation will involve domestic disinflation, deflation, and possibly recession.  Not a better alternative.  Worst still is the option of restricting trade.  This is why I've said publicly several times that while I like a strong dollar, by Jingo, a weaker dollar may be the least-worst way of dealing with our foreign imbalances.

Now my head hurts too

I don't feel finished with this important topic, but I have joined the ranks of my few gentle readers who've enjoyed about as much of it as they can stand.  Maybe more later.

In the last section of my September 13 posting — Some Thoughts on the Credit Crunch — I made the case for front-loading monetary policy when it's changing direction, which would be the case at the September 18^th meeting of the FOMC.  That argument is especially strong when an element of financial crisis is present, as was the case.  In effect, I called for a 50 basis point cut in the fed funds rate (and discount rate), and concluded that posting as follows: "Under present circumstances, shock and awe is warranted."

The FOMC's bold move accomplished its purpose:  it calmed markets and bought some insurance against a severe recession.  While some additional insurance may be warranted tomorrow, it need not — and should not — be bold.  Healing has begun and a quarter-point follow-up should be sufficient to indicate the Fed is still awake and on the case.  In fact, the more we know about the nature of the credit crunch, the less the Fed's tools seem relevant.  If lenders are afraid to lend because they are afraid they won't be repaid or because they can't trust the collateral, a small difference in short-term market interest rates hardly matters.  This is going to take time.

Another consideration likely to loom larger tomorrow by many commentators will be the decline in the dollar and possible Fed reluctance to contribute further to it.  My educated guess is that that won't be a major consideration in the FOMC's deliberations. They are happy to have flexible exchange rates reconcile what they regard as proper policies for the internal economy to the external world.  Sure, they would prefer a stronger dollar, as would I, but when it comes down to trade-offs, the dollar will not be the highest priority.  To them, protecting the value or purchasing power of the dollar means keeping its domestic purchasing power — not purchasing power of foreign currencies.

Guests on financial talk shows frequently say they prefer a strong dollar as if they can order one off the menu as an appetizer along with an entrée of rapid growth and a dessert of price stability.  That restaurant is not in my neighborhood.  If the markets have finally decided that the unsustainable current account deficit really is not sustainable, and that the alligator finally has to be paid, then the realistic choices are:  hold up the dollar and let the economy sink far enough to curb import demand (in other words a sharp recession) or try to keep both the economy and the dollar strong by backsliding on free trade and investment.  Over time, maintaining a strong, and perhaps more importantly, an economy with excellent prospects going forward, is the best that policymakers can do for the dollar.

Most people miss an important distinction between the role of the dollar in trade and the role of the dollar in foreign investment.  For trade purposes — a one-shot transaction — the level of the dollar matters.  The lower dollar makes imports more expensive to us and our exports less expensive to our trading partners.  But for foreign investors contemplating investing in the U.S. — a two-shot transaction — the important thing is what happens to the dollar during the investment period.  Once the dollar becomes cheap enough for investors to conclude that appreciation is more likely than further depreciation, then they have an incentive to invest here, even if the dollar is still "low."  That point may be near (or here already) for all I know.  If so, the capital inflow that offsets a large current account deficit could return and keep the alligator at bay a while longer.

Let me close with a quote from the Flatlanders:

It might be sooner
And it might be later
But one thing's for sure
You gotta pay the alligator.

Who is harmed by the decline in the dollar?

As consumers, we are all harmed by the decline in our purchasing power.  Import prices go up directly, as everybody knows, but there is also an indirect increase in the prices of domestic goods and services that are also exported or potentially exported.  In addition, some of us are hurt as producers or workers:  people in the import business (foreign car dealerships for example).

Who is helped by the decline in the dollar?

Producers who are exporters or potential exporters at the more favorable exchange rate will experience an increased demand for their products.  Also helped are domestic producers who compete with imports, which will become more expensive.

Why is the dollar declining?  What is the problem?

The dollar is declining because of pressures on our balance of payments.  Some combination of our current account deficit being too big and creating an excess supply of dollars on the world market and our capital inflow (and demand for dollars) becoming inadequate to offset the deficit.

So, what is the relationship between our balance of payments and the market for dollars?

I'm glad you asked that since the connection between the two is key to understanding either one of them.  When we import goods and services or purchase foreign stocks or bonds, or real estate, those transactions are debits in our balance of payments.  When foreigners do those things, they are credits in our balance of payments.  Debits give rise to a supply of dollars and demand for foreign currencies.  Credits give rise to a supply of foreign currencies and a demand for dollars.  To a great extent these debits and credits balance out and so does the demand and supply of dollars and foreign exchange.  So, essentially we pay for our imports with our exports as do our trading partners.  However, it is unlikely that the balance will be perfect; so, there will likely be a small imbalance in trade that will be "financed" or offset by an equal imbalance in capital flows.  I just lost you with that last sentence; so, let me elaborate.

How is it that net trade balances and capital flows are exact mirror images of each other?

When I buy a BMW, I give the company a check on my bank.  If they deposit my check in their U.S. bank and leave the proceeds there, they have "loaned" money to a U.S. bank, which will be recorded as a capital inflow. Their increased bank balance is a capital inflow (credit in our B/P) that just matched my import purchase (debit in our B/P).  They may sell their U.S. dollar balances in the foreign exchange market for a Euro balance in a German bank in which case our dollar obligation is to a foreign bank instead of a foreign company, but the capital inflow remains the same and equal to the BMW import. You don't have to follow all that; just remember this basic point:  Every increase in our debits (from imports) is matched either by an increase in credits elsewhere in the B/P or by an offsetting reduction in debits elsewhere.  Double-entry bookkeeping keeps total debits and credits in balance as well as the dollars bought and dollars sold in the foreign exchange markets.  The balance of payments always balances.  Thus any net deficit or surplus in the trade portion of the B/P is always precisely matched by the opposite in the capital portion of the B/P.

So, what was the background to the recent decline in the dollar?

For several years we have had a large and growing deficit in our trade (goods) balance and our current account (goods, services, unilateral transfers) balance. It grew to more than 6 percent of our GDP, a very large imbalance in trade.  By itself this was supplying excess dollars in the foreign exchange markets.  By "excess" I mean more dollars that were being used to buy U.S. goods and services.  The current account deficit and the associated excess dollars were offset by an equally large capital inflow (surplus) which "mopped up" the excess dollars.

For years a huge trade deficit seemed unsustainable to most U.S. economists and for years they forecasted a decline in the dollar to correct the trade imbalance.  Another way of saying that is to say they didn't think the outside world (especially Europe) would continue lending us large amounts of money to finance our huge trade imbalance.  But year after year those forecasts never came true.  Finally, economists threw in the towel and stopped talking much about it.  (A watched pot never boils.)

Over the past year the U.S. growth has slowed largely in response to the housing situation while the world economy, even including Europe, became more robust.  As we ceased, at least temporarily, being the engine of world growth and as prospects here dimmed relative to prospects abroad, the capital inflow in combination with what was going on in trade became inadequate to sustain the dollar at past high levels.  Theoretically, the dollar will continue adjusting to bring our balance of payments into an internal balance consistent with world economic realities.  That doesn't necessarily mean until our trade becomes balanced, but it probably does mean that the deficit will be reduced.  That process has already begun modestly as our monthly trade statistics have improved of late.

What is the big picture of what's going on with our B/P and the dollar?

Like a family during the process of running up their credit card balances, our large current account deficit means we have been living beyond our means as a country.  We have been absorbing (consuming, investing, etc.) more goods and services than we have been producing. This isn't necessarily bad — you can use a credit card for worthy purposes — but it probably was unsustainable and it is the opposite of what one would expect of the world's richest large economy.  The "normal" pattern is for capital to flow from rich countries to poor countries, where presumably its return is greater.  The reverse has been happening.  Capital has moved to the richest country from poorer countries, presumably because our institutions and policies compared to our trading partners more than offset other factors.

What has to happen for "equilibrium" to be reached?

Our exports need to rise relative to our imports.  Resources will need to move from other industries into export industries.  The declining dollar will provide the needed price incentives by making our imports more expensive at home and our exports less expensive in foreign currencies.  Another way of saying that is that the exchange rate will raise the price of traded goods relative to the price of non-traded goods.

Is there an alternative to a declining dollar?

Yes, but they probably would involve more friction and more pain.  If the dollar is somehow prevented from falling, the needed adjustments would be the same in terms of exports needing to grow relative to imports, or imports needing to shrink relative to exports.  But with no change in the exchange rate, downward pressure on domestic income would push down domestic goods prices relative to international traded goods.  Our imports would have to shrink not because of higher import prices, but because of lower domestic incomes. If internal prices and wages were as flexible as the exchange rate, it would make little difference which is used.  But internal prices, and especially wages, tend to be sticky in a downward direction, so unemployment would be the likely result.  In effect a recession would be needed.

With inflexible exchange rates the temptation would be very strong to avoid the internal adjustments by restricting trade.  Our free trade policy would be in jeopardy.

So, McTeer, are you "dissing the dollar?"

I'm saying that, if adjustment is necessary, a decline in the dollar is probably the least-worst way of achieving it — less worse than domestic recession and less worse than trade restrictions.

Of course, an alternative might be to prolong the status quo ante by reinforcing the factors that made us a strong magnet for foreign capital despite being the most developed of the developed countries.  We could become more business friendly and attract capital keeping the tax cuts we already have and cutting capital gains and dividends taxes to zero, drastically reducing business taxes, etc.  This would postpone painful adjustments, but probably not forever.  However, those policies are needed on purely domestic grounds as well.

Aren't policymakers, especially the Federal Reserve, charged with protecting the value of the dollar?

Yes, but that commitment has always been understood to mean protecting its purchasing power over goods and services not over foreign currencies.  Even with the higher import prices coming from dollar depreciation, overall price indexes can be held down.  Of course, to the extent that a stronger dollar could limit the pressure on import prices, the rest of the job would be easier.

What do you expect our policymakers to do about the dollar?

They will continue to pay lip service to a strong-dollar policy, but deep down they will be grateful that the market is taking care of a potentially more difficult problem for them.  They know they will be criticized later for presiding over a shameful dollar decline, but they are less likely to be criticized for a prolonged recession or a reversal of our free trade policy.  And they will console themselves with the fact that if Congress would just listen to them we could have greater prosperity today and for years to come and leave correction of the trade deficit for a future generation of policymakers.

Naturally I bought the Maestro's book, Alan Greenspan, The Age of Turbulence, early on September 17, the day it came out.  I wanted to see if he said anything about me.  There was just one sentence on page 212.  Whew!  What a relief!

The price on its dust jacket was $35 in the U.S. and $43.50 in Canada, the 24 percent difference presumably reflecting the exchange rate between the U.S. and Canadian dollars.  The Prince of Darkness by Robert Novak had come out a little earlier with a 27 percent difference.  My other September book purchases had similar differentials, the lowest being 21 percent near the end of the month.  I buy a lot of books. I don't necessarily read them.  But I buy them.

Since book purchases are the main way I keep track of the U.S./Canadian dollar exchange rate, you can imagine my surprise to learn that before September ended, the Canadian dollar had climbed to parity with the U.S. dollar.  Or, perhaps I should say the U.S. dollar had declined to parity with the Canadian dollar.

Isn't it interesting that when the two dollars trade one-to-one, the U.S. dollar is called weak and the Canadian dollar is called strong. I guess what have you done for me lately is a question for currencies as well as for people.

If you don't hear from me for a while, don't worry. I'll be somewhere up north buying books with U.S. dollars and selling them across the border for Canadian dollars, which I will use to buy back U.S. dollars. Or, is it the other way around?  I hope I don't get confused.

If you've got the money, honey, I've got the time.
— Lefty Frizzell

We all know that time is money. When we are young, most of us have more time than money, and we're eager to exchange the former for the latter. As we reach a certain age — as time becomes scarcer and more valuable to us and money more plentiful — the opposite trade works better for us. We become more willing and better able to buy time with money.

Most of us value the certain present over the uncertain future, in other words we have what economists call a "positive time preference." But we differ on the degree of our positive time preference. Some of us must be compensated highly to forego present consumption for future consumption. Others of us are natural savers and can be bought off more cheaply. The trade-off is captured in the question of whether you'd rather have a fifth (of spirits) on the 4th of July or a quart — a fourth — on the 5th of July. Most Americans would probably choose a fifth on the fourth; most Chinese would probably choose a fourth on the fifth. Other things equal, this means that interest rates would likely be higher in the U.S. than in China, at least on the 4th of July.

An equilibrium constellation of interest rates implies that those rates just balance out our varied time preferences. At the margin, the relevant interest rate just compensates the most reluctant saver for deferring consumption. At that level of rates, some of us are compensated more than necessary while others aren't compensated enough to get them to save. Of course, equilibrium rates will change as circumstances change. Bad news on the horizon, or just greater uncertainty about the future, will cause equilibrium rates to rise.

This is not to say that interest rates are the only determinant of saving, or even the most important. Income is probably more important, but we are assuming that income and other relevant factors remain constant while we focus on interest rates.

The future has changed a lot recently. We have gone rather abruptly from a benign view of the future to a more uncertain view. The benign view generated low rates on average and little difference to reflect differing circumstances and outcomes. In other words, the spreads were small — the spreads between government debt and private debt and the spreads faced by private debtors of different circumstances.

The spreads were probably too low before, although they did a lot of good for a lot of people. They will probably end up too high now and cause unnecessary pain. But they will settle down soon and reflect our collective view of the future and our willingness to embrace it. Markets aren't perfect. They are just better than all the alternatives.

*Appeared in the Wall Street Journal on September 17, 2007.

The blame game has started. I refer to recent charges that former Federal Reserve Board Chairman Alan Greenspan caused the current financial market turmoil by pushing interest rates too low, touting variable-rate mortgages, and bailing out Long Term Capital Management.

I don't think so. Policymakers use cost-benefit analysis in making decision. They choose between likely alternatives A and B by comparing the expected benefits of each to the expected cost of each. Choosing A doesn't mean there were no benefits of B or no costs of A. It just means A's expected benefit/cost ratio was higher than B's.

Critics may later "discover" the chosen alternative A had costs or downsides. Well, of course it does; the point is they were deemed to be smaller relative to benefits than the B alternative. B's costs, however, remain invisible and are ignored because B wasn't chosen. Even so, alternatives are still relevant to evaluating outcomes.

Mr. Greenspan's Alternative A was to allow short-term interest rates to decline to very low levels when disinflation threatened to degenerate into outright deflation. Alternative B was to ignore that risk and take our chances. He was too good a student of Austrian economics to assume no costs to such low rates, and he often warned of the dangers of the dramatic lowering of risk spreads that accompanied low rates.

The chairman didn't give deflation a high probability of occurring, but he did expect the consequences of any such occurrence to be severe enough to justify preventative action. One might argue that the low rates required to sustain aggregate demand in 2003 were themselves evidence of the seriousness of the threat.

A more important point in his defense, however, is that disinflation and falling interest rates were a worldwide phenomenon. To attribute them to Alan Greenspan is parochial in the extreme. As the threat of deflation diminished, the Federal Open Market Committee (FOMC) raised its target Fed funds rate in 17 consecutive quarter-point steps over a two-year period. During that period of rising short-term rates, long-term rates remained flat or declined worldwide, not just here. That "conundrum," as the chairman famously called it, eventually was attributed to the extremely high saving rates of newly emerging economies worldwide.

As indicated above, the flattening of yield curves was accompanied by a dramatic decline in risk spreads worldwide, against which the chairman cautioned frequently. A memorable milestone of that period was the Mexican sale of peso bonds for less than 9 percent when not long before they couldn't get that rate even in dollar-denominated bonds.

When rising short rates failed to pull up long rates, the chairman, at least internally, focused on the impact on the 10-year bond yield. Dissection of its 10 implicit one-year tranches revealed that rates rose on the first few tranches, but actually fell in the out-years. Again, the conundrum of rising short rates and falling long-term rates and risk spreads was worldwide. As powerful as the Maestro was, it's still a stretch to blame him for single-handedly inverting the world's yield curve.

Now, what about the chairman luring unsuspecting consumers into adjustable rate mortgages they couldn't afford? The origin of this charge is his speech on Feb. 23, 2004, to the Credit Union National Association. In a technical discussion of "Mitigating Homeowner Payment Shocks," the chairman noted fixed-rate mortgages had the advantage of allowing homeowners to prepay debt when interest rates fall but don't require higher payments when rates rise.

His research indicated, however, that this advantage was probably overpriced by the market. "Homeowners pay a lot of money for the right to refinance and for the insurance against increasing mortgage payments. Calculations by market analysts of the 'option adjusted spread' on mortgages suggest that the cost of these benefits conferred by fixed-rate mortgages can range from 0.5 percent to 1.2 percent, raising homeowners' annual after-tax mortgage payments by several thousand dollars. Indeed, recent research within the Federal Reserve suggests that many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade, though this would not have been the case, of course, had interest rates trended sharply upward."

Somehow, I doubt the chairman's geek speak sent Joe Six-pack running off to apply for an ARM he couldn't afford. Affordability, let's remember, is primarily a matter of income. At the Economic Club of New York a week later, the chairman, asked about his earlier remarks on ARMS, emphasized that their focus and applicability was limited to a very small segment of households.

Finally, the Fed was not a party to any bail out of Long Term Capital Management, unless inviting its creditors to use the New York Fed's board room constitutes a bail out. LTCM's major creditors bailed themselves out in mid-September 1998 by adding good money after bad, leaving the original investors only a few cents on the dollar. I doubt they felt bailed out by anybody.

In addition to the charge of a specific Fed bailout, the Greenspan Fed is also accused of easing monetary policy to help LTCM even though its three quarter-point easing moves from Sep. 29 to Nov. 17, 1998, came after the resolution of LTCM by its creditors in mid-September and was motivated by the market impact of the Russian debt default and devaluation on top of the ongoing Asian crisis.

Insurance against Asian contagion seemed reasonable at the time and still does to me. Ironically, when pre-emptive policies work as intended, it makes them seem unnecessary in retrospect. But we should always remember that the way things turn out is not the only way they could have turned out.

*Appeared in the Washington Times on September 16, 2007.