The US Gov'ts Game Plan - Stealth Currency Depreciation = Reinflation
(snip)"As we’ve explained to readers since 1998, in 1933 the U.S. government deflated the dollar 72% against gold to produce that surge of inflation. Below we explain the mechanics of currency depreciation, how it induces inflation, even for an economy that is experiencing credit contraction and a shrinking money supply.
The U.S. as a net creditor was able to execute this policy unilaterally and in broad daylight in the early 1930s, because as a net creditor there was no risk at any time that U.S. trade partners holding dollars might retaliate by selling off U.S. debt and dollars.
That is not the case today. Another means must be used.
Going into Round Three of the inflation versus deflation debate, you’d think the deflationists would wonder how oil prices are above $70 in 2009 when demand is lower and inventories higher than in 2001 when the economy was nominally 15% smaller and oil prices averaged $22 after a very brief recession.
The answer is dollar devaluation, but not by the same crude method used in 1933. We can’t do it that way. As a net debtor, we have to follow the rules of The Game.
Rules of The Game: Re-inflation by stealth currency devaluation
In a debt deflation crisis, also known as a “balance sheet recession,” economic policy makers have four main tools to use to keep an economy out of a liquidity trap or get out of one.
1. Expand the monetary base
2. Reduce long-term interest rates
3. Run fiscal deficits
4. Depreciate the currency
Deflationist’s do not understand that even if the all other policies fail to raise inflation expectations, for a net debtor, the fourth tool—currency depreciation—is foolproof. Paradoxically, currency depreciation is also the one tool that U.S. policy makers can never explicitly admit is being pursued.
The U.S. monetary system is not on a gold standard in 2009 as it was in 1933. Instead the U.S. and the rest of the world monetary regime employ a de-facto global oil standard.
To prevent a liqudity trap via currency depreciation, instead of depreciating against gold the U.S. government depreciates the dollar against oil.
The result? Rather than oil prices falling to $16 a barrel as in 2001 after the economic contraction that followed the 2000 stock market crash, after the credit market crash of 2008 oil prices briefly fell to $36 and were back to $66 by June 2009. Oil prices averaged $100 in 2008 despite the worst financial and economic crisis since The Great Depression.
Currency depreciation, the government’s most effective tool for setting inflation expectations, once again halted a nascent liquidity trap and deflation and spiral dead in its tracks, but before a liquidity trap occurred, versus years after as in 1933.
Today oil is back over $70 and gold is up from US$720 October 2008 lows to a new high of US$1055 today.
All of this while the U.S. claims to pursue a “strong dollar” policy.
How does currency depreciation prevent or end a liquidity trap?
It’s all well and fine to assert that currency devaluation via depreciations raises inflation expectations, but how is a currency devalued this way and how does that cause higher inflation expectations to rise? Below we quote from one of several papers that we found in 2003 or earlier that influenced our forecasts of inflation.
Even if the nominal interest rate is zero, a depreciation of the currency provides a powerful way to stimulate the economy out of the liquidity trap (for instance, Bernanke (2000); McCallum (2000); Meltzer (2001); Orphanides and Wieland (2000)). A currency depreciation will stimulate an economy directly by giving a boost to export and import-competing sectors. More importantly, as noted in Svensson (2001), a currency depreciation and a peg of the currency rate at a depreciated rate serves as a conspicuous commitment to a higher price level in the future, in line with the optimal way to escape from a liquidity trap discussed above. An exchange-rate peg can induce private-sector expectations of a higher future price level and create the desirable long-term inflation expectations that are a crucial element of the optimal way to escape from the liquidity trap.
In order to understand how manipulation of the exchange rate can affect expectations of the future price level, it is useful to first review the exchange-rate consequences of the optimal policy to escape from a liquidity trap outlined above. That policy involves a commitment to a higher future price level and consequently current expectations of a higher future price level. A higher future price level would imply a correspondingly higher future exchange rate (when the exchange rate is measured as units of domestic currency per unit foreign currency, so a rise in the exchange rate is a depreciation, a fall in the value, of the domestic currency). Thus, current expectations of a higher future price level imply current expectations of a higher future exchange rate. But those expectations of a higher future exchange rate would imply a higher current exchange rate, a current depreciation of the currency.
The reason is that, at a zero domestic interest rate, the exchange rate must be expected to fall (that is, the domestic currency must be expected to appreciate) over time approximately at the rate of the foreign interest rate. Only then is the expected nominal rate of return measured in domestic currency on an investment in foreign currency equal to the zero nominal rate of return on an investment in domestic currency; this equality is an approximate equilibrium condition in the international currency market. That is, the current exchange rate must approximately equal the expected future exchange rate plus the accumulated foreign interest (the product of the foreign interest rate times the time distance between now and the future). But then, at unchanged domestic and foreign interest rates, the current exchange rate will move approximately one to one with the expected future exchange rate. If the expected future exchange rate is higher, so is the current exchange rate. Indeed, the whole expected exchange-rate path shifts up with the expected future exchange rate. Thus, we have clarified that the optimal policy to escape from a liquidity trap, which involves expectations of a higher future price level, would result in an approximately equal current depreciation of the currency.
Clearly the Fed has succeeded in its bid to increase inflation expectations via currency depreciation. They did so without ever explicitly devaluing the dollar. To be explicit violates the rules of The Game.
The rules require that all U.S. trade partners tolerate ongoing dollar devaluation via depreciation because if the policy is not pursued the U.S. economy risks falling into a liquidity trap.
The Game versus the Law of Unintended Consequences
By deflating the dollar against oil, U.S. policy makers have created a new problem. We are experiencing inflation in areas of the economy that are sensitive to energy costs and deflation in areas of the economy that remain open to cheap imported labor. Food gets more expensive while clothes from China get cheaper and wages fall. China will likely take the position Japan took and allow its currency to gradually appreciate against dollars. Asset price inflation only works as long as the policy succeeds in producing low long term interest rates; if 30 year mortgage rates rise to 10%, the so-called "recovery" of the so-called housing "market" will shut down.
Bottom line, our standard of living here in the U.S. is declining as the purchasing power of our savings and income falls while our government pursues its anti-liquidity trap policy of currency depreciation. This is the opposite of the policies pursued by Japan since the early 1990s when the yen appreciated, wages inflated against goods and services, and living standards improved.
Will a $1.3 trillion budget deficit help to increase the exchange rate value of the U.S. dollar? Not likely.
No deflation spiral.
No Japan-style so-called “lost decade” of stag-deflation.
Instead we will suffer a steady decline in living standards as the purchasing power of our income and savings falls.
All the while, the risk of a Sudden Stop hangs over the U.S. like a Sword of Damocles. The Game can't be played forever.
"(snip)
Re: The US Gov'ts Game Plan - Stealth Currency Depreciation = Reinflation
^^^^ Where is the "strong dollar" policy ? I'd love to see one. Geithner has done nothing, zip, zero, nada to support the greenback. When Maria Bartiromo interviewed him last week and asked him what he was going to do about the declining dollar he offered NOTHING except a few platitudes about the Administration's desire to maintain a strong currency.
Re: The US Gov'ts Game Plan - Stealth Currency Depreciation = Reinflation
^^^ as the author points out, all of this fits the 'Rules of the Game' ... i.e. the US gov't actually pursuing a 'stealth' policy of weakening the currency while conspicuously avoiding any official admission to that effect. But as we and the rest of the world know, spouting platitudes in mainstream media about a desire for a strong US dollar need not have any basis in economic reality.