Bubbles and the Strong USD Policy

At our Macro retreat last week, there was much interest in the topic of global decoupling. The discussion centred on whether Europe and Japan could step up to take the place of the US in leading the global economy. In this note, I propose an alternative perspective in thinking about this issue. In the last two decades, developed economies dominated through financial bubbles -- Japan in the 1980s and the US in the late-1990s are examples. Thus, in thinking about the prospect of economic decoupling, fixating on relative productivity growth rates between countries and other features of the real sector may be misleading. Rather, whether the rest of the world could decouple from the US economy depends on whether the financial markets can decouple, i.e., can there be an asset bubble independent of the US? A key question this line of thinking raises is whether the strong USD policy is as virtuous as many have thought. The strong USD policy may be guilty of fueling the asset bubble in the US by tilting global capital flows in favour of USD assets and in contributing to the immense misalignments in the global economy.

Financial Markets Drive Real Economies

I see five key issues:

1. Don’t be fixated on relative productivity growth and the conventional drivers of the real economy. Economic growth is not just about productivity and supply of factors of production. The spectacular growth spurts we’ve witnessed in the last two decades were powered by financial bubbles. No longer does the direction of causality run only from economic growth to asset prices, but the feedback effect from financial markets back to the real economies has become very significant. When the US stock markets last crashed in 1987, total equity market capitalisation in the US was equivalent to around 20% of GDP. In 2000, this ratio reached around 130% of GDP. Asset bubbles, now more than ever, drive investment and consumption. Thus, in thinking about whether the global economy will de-couple, the focus should be on the financial markets, not the real economy.

2. What’s wrong with synchronised global growth? In my view, there is nothing inherently bad about synchronised global growth per se. It is natural that the largest economy in the world, riding on the biggest equity bubble the world has ever seen, would dictate the trend of the global economy on both the upswing and the downturn. However, the danger lies in synchronised financial markets. Persistent USD strength and USD-asset dominance discourages cross-border portfolio diversification. This is a particularly acute problem for US-based funds: there is no compelling reason for them to internationalise their portfolios. However, an excessively strong home bias exposes US investors to country and currency risks. Global portfolios being out of balance creates an environment conducive to financial volatility. In sum, the dominance of USD-assets is much more dangerous than the dominance of the US economy.

3. The strong USD policy may not be as virtuous as some may think. We have pointed out that the US opted for a strong USD policy because this encourages capital inflows, as the risks to the USD are perceived to be biased to the strong side. While this policy has kept the cost of financing the US current account deficit low, it has encouraged the current account deficit to expand. In other words, the strong USD policy may not be as virtuous as some may think, and could now be a problem rather than a solution. Further, it should be pointed out that the strong USD policy is not really consistent with the professed view of the US Treasury on currencies -- that they should be determined by the markets, without policy interference. A strong USD policy, in principle, is no different from a weak JPY policy. It is a policy bias aimed to skew the probability distribution of a stochastic variable, even if it does not involve outright intervention.

4. Formulating an exit strategy for the strong USD policy will be difficult. Washingtonians are much better at entry strategies than exit strategies, in my view. For example, the IMF has over the years become expert at helping countries establish currency pegs. However, they had few clues in advising Argentina how to dismantle the currency board arrangement. The strong USD policy suffers from the same problem. The USD is already more over-valued on real, trade-weighted, terms than in the period prior to the Plaza Accord. However, the strong USD policy continues to push the greenback higher. The US Treasury now faces the problem that, if the strong-USD stance is softened, the USD could crash. It is time for the US to formulate an exit strategy for the USD policy, in my opinion.

5. We need to hunt for the next big bubble. Will economies decouple from the US? To me, this is tantamount to asking whether Japan or Europe will experience a bubble. (In this discussion, by ‘bubble,’ I mean a sharp rally in a major asset, regardless of valuation.) The most likely candidate, to me, is a reform-triggered rally in the Nikkei. I see decoupling as more likely in Japan simply because Japan seems more likely to undergo the kind of a dramatic shift in policy that could trigger a rally. With the current conditions of orthodox policy prescriptions and a lack of major market misalignments, I don’t see how a bubble could emerge in Europe.

Bottom Line

The decoupling of economies is about the decoupling of financial markets, and financial markets will have difficulties decoupling as long as the US maintains a strong-USD policy. The strong USD policy has played a critical role in fueling the US asset bubble, which was the key factor behind the dominance of the US economy, and the consequent ‘coupling’ of economies in the last few years. In my view, the strong USD policy may have outlived its usefulness and is more a problem now than a solution. Continued USD strengthening discourages diversification of cross-border investment and exposes investors to country and currency risks. An exit strategy from this currency policy needs to be devised by the US.




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