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In a commentary about a month ago, I described how the economic world seemed to be drifting into two opposing camps: the Washington-based "Stimulators," who insist that more government debt is the best means to end the financial crisis, and the Berlin- and London-based "Austerians," who argue that debt is the crisis itself. If recent economic data and currency movements can be considered votes of confidence, then the Stimulators should be sweating. Moreover, these recent signals should provide economic analysts and investors with a road map for the future.
To start, the latest economic news for the US has been bleak. Although 2Q GDP figures show the economy to be "expanding" by 2.4%, the pace is little more than half the average rate over the previous two quarters. What’s worse, US debt levels are expanding faster than GDP.
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As everyone with a credit card knows, it’s easy to expand spending if you charge it. But even this borrowed growth has failed to make a meaningful dent in persistent US unemployment. The just-released July payroll report shows the American economy shed another 131 thousand jobs, marking three full years of private sector layoffs.
Almost lost in the news is the disappointing reversal of US trade flows, which in May unexpectedly widened to the highest level in 18 months. In other words, the weaknesses that pushed our economy into crisis in the first place show no sign of abating.
In countries which have decided that further government economic stimulation will produce more harm than good, the story is markedly different.
Spurred by robust exports and strong corporate earnings, the German economy is experiencing a bona fide recovery. This comes despite stringent fiscal moves by the anxious German government. Unemployment there has fallen back to almost pre-crisis levels.
In China, 2Q GDP figures show that the country has likely passed Japan to become the world’s second largest economy. Strong earnings and stock market performance seem to confirm that China’s efforts to rein in debt have been effective.
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Meanwhile, just this week, the Stimulators in Washington got some moral support from St. Louis Federal Reserve President James Bullard, who was formerly known as a monetary hawk. Bullard issued warnings that unforeseen negative shocks could lead to an inescapable deflationary quagmire. In such a scenario, warned Bullard, the Fed must be willing to buy up to $2 trillion of government debt in a process academically known as quantitative easing — and popularly known as money printing.
With the monetary cards now so clearly on the table, currency traders have placed their bets, and the smart money is quickly running away from the greenback. If current trends hold, we are facing an eighth consecutive weekly decline in the Dollar Index.
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This week the Japanese Yen hit a fifteen-year high, with the dollar now buying fewer than 86 yen. The yen is up more than 10% since the beginning of May. The euro, after being written off for dead in the days of the Greek currency crisis, has staged a similar rally, and is now up 11% from its June lows.
As a result of the falling dollar, the commodities market has reignited.
Gold has rallied 2.5% in the last week, after declining 6.5% in July (a pullback that had some pundits loudly chortling about the popping of the gold bubble).
But the oil market holds far more near-term significance. On Monday, oil busted through the $80 price ceiling that had held since May. Any additional breaks to the upside would be extremely significant and could potentially send crude up to the mid-$90s before another correction takes hold. The danger for the dollar is that rising oil prices could be considered one of the unforeseen negative shocks of which Fed President Bullard warns, triggering a new round of inflation.
If the government fears the recovery will be derailed by higher energy prices, then look for quantitative easing to become the driving force of our economic policy. The Fed will perversely argue that rising oil prices are deflationary, as they will cause cash-strapped consumers to reduce spending on other goods. In reality, higher oil prices are merely evidence of the inflation the Fed itself has been creating. Instead of solving our problems, quantitative easing could tip the dollar into a death spiral.
The only thing that could prevent a devastating decline in the dollar at that point would be foreign intervention from the Chinese. But given that China is already slowly but steadily reducing its purchases of US Treasuries, it is likely not interested in playing crutch to the US forever.