Fed Slashing the U.S. Dollar, The Economic Future is Ugly

By: Mike_Whitney

The Fed has has hinted that it will launch a second round of quantitative easing (QE) sometime after its November 2 meeting. The anticipated intervention has been widely criticized, but for all the wrong reasons. Fed chairman Ben Bernanke knows that adding another $1 to $1.5 trillion to bulging bank reserves will likely have little effect on aggregate demand. Nor will it lower unemployment now hovering at 9.7%. It will, however, send a message to trading partners (re: China) that the Fed is serious about reducing destabilizing trade imbalances that siphon-off domestic stimulus, increase unemployment and keep the dollar perilously overvalued. In other words, the Fed's action is the first volley in what is likely to be a protracted currency war that leads to the final demise of Bretton Woods 2.

Here's a summary of this weekends IMF meetings of Finance Ministers in New York from Bloomberg:

"Leaders of the world economy failed to narrow differences over currencies as they turned to the International Monetary Fund to calm frictions that are already sparking protectionism….

“Global rebalancing is not progressing as well as needed to avoid threats to the global economic recovery,” Geithner said. “Our initial achievements are at risk of being undermined by the limited extent of progress toward more domestic demand-led growth in countries running external surpluses and by the extent of foreign-exchange intervention as countries with undervalued currencies lean against appreciation.”

So, what does that mean in plain English?

It means the US is determined to stave off deflation by forcing China to let its currency appreciate. It also means that the Obama administration finally realizes that its attempts to reduce unemployment or spark a recovery will continue to fail as long as stimulus is effectively negated by the surge in imports.

Here's a blurp from Angry Bear which explains what's going on:

"Last quarter real domestic consumption rose at a 4.9% annual rate. That was an increase of $162.6 billion( 2005 $). But real imports also increased $142.2 billion (2005 $). That mean that the increase in imports was 87.5% of the increase in domestic demand.

To apply a little old fashion Keynesian analysis or terminology, the leakage abroad of the demand growth was 87.5%. It does not take some great new "freshwater" theory to explain why the stimulus is not working as expected, simple old fashioned Keynesian models explain it adequately." (Trade in the national accounts, angrybearblog.com)

So, the stimulus--that would have been generating jobs and demand within the US--is being exported to countries that want to keep the dollar propped up to maintain the present arrangement, that is, they want to continue to expand their manufacturing base and keep unemployment low while the US languishes in a permanent recession.

Bretton Woods 2, by the way, is the arrangement under which the US willingly runs large current account deficits with the assurance that trade partners would recycle the proceeds into US Treasuries, Agencies and equities. Naturally, this turned out to be a real boon for Wall Street as surplus capital has helped to fuel massive bubbles in all manner of garbage bonds that enriched the principles at the big brokerage houses.

So, what is Bernanke's strategy?

First, we have to understand what the Fed is doing and the effect it's having on global finances. Here's an excerpt from the Wall Street Journal which provides a good summary:

"Emerging-market economies from South Africa to Brazil to Thailand are bearing the brunt of easy-money policies in the developed world, as money flows to higher-yielding markets, pumping up currencies and complicating economic policy.

The Fed is flooding markets with liquidity, Japan is flooding the markets with liquidity and the U.K. is flooding markets with liquidity. The trouble is, a lot of that money isn't staying where it was put," says David Carbon, an economist at DBS in Singapore.

Investors borrow money at near-zero interest rates in the struggling economies of the developed world, and shuttle it to countries such as Indonesia, Brazil and South Africa, where interest rates are higher and growth rates more robust....

"The current policies of the developed countries are leading to very significant capital flows into some of the emerging countries. This is putting upward pressure on exchange rates," said South African Finance Minister Pravin Gordhan, chairman of the Group of 24." (Easy Money Churns Emerging Markets, Alex Frangos, Wall Street Journal)

Bernanke's zero-rate policy and the prospect of ongoing rounds of quantitative easing have put finance ministers everywhere in a frenzy. Some countries--notably South Korea and Brazil--have already taken steps to slow capital flows. As yet, the effectiveness of these measures remains unknown.

Naturally, capital seeks the best rate of return, which is why it is exiting the US (which is in the throes of a long-term slowdown) for greener pastures in China and emerging markets. That movement drives up the value of local currencies and creates lethal asset-price bubbles. The Fed is intensifying this process (via QE) to break the back of Bretton Woods 2 and force the dollar down. Eventually, the flood of liquidity will force foreign trade partners to accept a cheaper dollar thus restoring US export competitiveness and a way out of recession without raising workers wages. (The Fed's approach is grounded in class warfare.)

Tim Duy sums it up in a brilliant post that shines a light on the Fed's real objectives. The article should be read in its entirety, but here's a brief clip:

"The time may finally be at hand when the imbalances created by Bretton Woods 2 now tear the system asunder. The collapse is coming via an unexpected channel; rather than originating from abroad, the shock that sets it in motion comes from the inside, a blast of stimulus from the US Federal Reserve. And at the moment, the collapse looks likely to turn disorderly quickly. If the Federal Reserve is committed to quantitative easing, there is no way for the rest of the world to stop to flow of dollars that is already emanating from the US. Yet much of the world does not want to accept the inevitable, and there appears to be no agreement on what comes next. Call me pessimistic, but right now I don't see how this situation gets anything but more ugly." (The Final End of Bretton Woods 2?, Tim Duy, Fed Watch)

By Mike Whitney

Email: fergiewhitney@msn.com

Mike is a well respected freelance writer living in Washington state, interested in politics and economics from a libertarian perspective.

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