EclectEcon

Last week I pondered the extent to which the Canadian dollar (aka the "Loonie") is a petro-currency and wondered why the US price of a Canuck buck wasn't rising along with the US price of oil.

By the end of the week, the US price of oil had dropped considerably, and the US price of a Cdn$ had dropped by approximately the same percentage, suggesting that perhaps the linkage between the value of a Canadian dollar and the price of oil was stronger than it had seemed for several months. And last Friday I received this from RGE Monitor in its daily report:

Canada: Recoupling?

With 75% of its exports bound for the U.S. (whose economic outlook was revised downward by the OECD), Canada seems hard pressed to avoid the effects of the likely U.S. recession. So far, though, terms of trade gains from a strong loonie have boosted domestic demand and offset rising credit costs, and the export and manufacturing slump. But its vulnerabilities have led the Bank of Canada to cut aggressively (100bps since December), even if less so than the Fed. With Canada one of few countries where inflation – even of food – is slowing, it may continue to ease policy rates in the hopes of cushioning the economy. Take a look at: “Canada Decoupled or Not? External Weakness To Infect Domestic Demand” and “Canadian Credit Market Infected By Global Crunch”

For the past several years, the Canadian dollar had been appreciating in value relative to the US dollar --- until last September (2007). Since then, the US dollar price of a Loonie has been fluctuating around $1.00 or so.

Meanwhile the prices of gold, oil, and other commodities have continued their rise, and these are things which Canada has a comparative advantage in producing. One might expect that as the prices of these resources rise, people wanting to buy them would also bid up the price of the Canadian Loonie. That doesn't seem to have happened, though, for the past 6 months or so, at least not noticeably (There are movements, sometimes large, each day in exchange rates; I am referring here to the lack of a general trend upward — See this site for Bank of Canada data, especially Tables I1 and I2.) In fact, the Euro price of a Cdn $ has fallen, not risen, on average over the past six months, the opposite of what one might expect if, in fact, the Canuck Buck is a petro currency.

So what is happening with the Canadian dollar? Why has its value not been rising relative to the Greenback or the Euro?

My first guess was that the Bank of Canada is stockpiling US dollars, but if they are, the accumulation does not show up in their US dollar reserve numbers which have remained roughly constant since last September. I looked at these numbers because I had wondered whether, in an attempt to cushion the blow of a rising Loonie, the Bank of Canada was engaging in a seriously dirty float, buying US dollars to help hold down the US price of a Canadian dollar. But the data do not seem to bear that out.

Another possibility is that the US Fed is selling Cdn dollars to help support the US dollar to cushion its fall. I haven't checked to see if that is what is happening.

So here is the question:

1. If the value of a US dollar is plummeting on the world markets, and
2. If the demand for the Canadian dollar is rising due to rising commodity prices, then
3. Why hasn't the Canadian dollar risen more against the US dollar (especially during the last six months; also, why has it fallen against the Euro?

Do these trends mean the rest of the world has high inflationary expectations for Canada?

Or do these trends mean that the rest of the world expects interest rate differentials (with respect to Canada) to narrow in the future?

What is going on?

Addendum #1: Earlier this month, Stephen Gordon suggested that the halt in the rise of the Cdn $ is possibly due to the negative balance in Canada's current account, that the drop in exports and rise in imports more than offset the tendency for the Canuck Buck to be a petro currency.

Addendum #2: It also appears that the US current account has moved to a much smaller deficit than it had had earlier. These two addenda combined suggest that the premise of this entire posting is less strong than I expected: maybe the Canadian dollar is less of petro currency than I had originally thought it to be.

Backpatting Digression: For a fun look at some forecasts about what would happen to the US dollar check out this earlier piece, written over two years ago, in which I disagreed with some highly paid analysts.

From CurrencyTrading.Net:

1. Afghanistan
2. Argentina
3. Belarus
4. Canada
5. China
6. India
7. Mexico
8. New Eurozone Countries
9. Switzerland
10. United States

Who does that leave to be hurt? Korea, Japan, all the SE Asian newly emerging economies, Australia, everyone in Africa, the remaining countries in Central and South America, Russia, Pakistan, the Baltic Republics and other non-Euro former soviet countries, and the older European countries.

But remember that in each of these countries there will be gainers and losers. People exporting to the US will face reduced demand for their goods and services, while people importing from the US will find the effective prices have dropped.

Gresham's Law is often stated colloquially as "Bad money drives good money out of circulation." More generally, it means that if there are two different currencies circulating at the same face value but with different intrinsic values, the one with the higher intrinsic value will be kept by people, and they will spend the one with the lower intrinsic value.

The latest example of Gresham's Law has become apparent with the circulation of coins in Canada. Back when the US price of a Canadian Loonie was only 67 cents or even 80 or 90 cents US, we rarely if ever received US coins mixed in with our change in Canada. But during the past couple of months as the Canuck buck has appreciated in value to be worth $1.03, $1.07, or more in US currency, I have begun to receive US coins in my change now and then. On average, I would guess I have received about 1% of my change as US coins during the past two months.

In bulk, US coins have a lower intrinsic value than Canadian coins right now. Nevertheless, for minor purchases Canadian and US coins are used interchangeably in Canada — the transaction costs of converting just a couple of US coins into Canadian coins are too high to make the conversion worthwhile.

The result is that rather than get stuck with US coins now, Canadians spend them. Given a choice, they would rather not hold onto the US coins, which (according to the exchange rate, at least) have a lower purchasing power than the Canadian coins. They spend the US coins and hold onto the Canadian coins. In direct confirmation of Gresham's Law, bad money (US coins) is driving good money (Canadian coins) out of circulation.

As the Canadian dollar has appreciated in value relative to the US dollar (nearly 20% since June this year, largely due to the run-up in the price of oil), US goods have become considerably cheaper for Canadians to buy (see here and here for my earlier postings on this topic).

One area of concern for many consumers has been books and magazines, which have US prices and Canadian prices printed on them. The US prices have typically been much lower than the Canadian prices, reflecting exchange rates from perhaps a year ago and certainly not reflecting current exchange rates.

To address this concern, Wal-Mart in Canada has recently announced that it will now charge the US price, not the Canadian price that is printed on all books and magazines. When I heard this, I thought, "Leave it to Wal-Mart to address changing costs long before other retailers do." After all, Wal-Mart is my very favourite store.

Sure enough, when I was at Wal-Mart recently there were displays of books and magazines, all proudly announcing that because Wal-Mart cares about providing lower prices for its customers, they were charging the printed US prices, not the printed Canadian prices.

And then it hit me: Wal-Mart used to sell its books (I don't know about magazines) at anywhere from 25% to 40% off the suggested retail prices, and these discounts were no longer available. In effect, Wal-Mart hadn't lowered their prices much, if at all!

Digression #1: Here is further evidence that economists are failing in our attempts to educate people. While looking at the Wal-Mart book display I overheard one person say to another, "Look, Wal-Mart is selling their books at US instead of Canadian prices. That's nice," to which the other person responded, "I think Wal-Mart makes enough money they can afford to give us a price break".

Both statements strike me as typical perceptions about how economies work and both belie serious misapprehensions about economics.

There were two problems here. First, as I noted above, Wal-Mart probably wasn't really providing much, if any, of a price break to its customers. Second, Wal-Mart doesn't cut prices because they can afford to. They cut prices to induce us to buy things from them. They wouldn't do it unless they thought doing so would add to their overall profits.

Digression #2: I note that for every single book I have considered buying, the prices at Amazon.ca are still higher than the prices at Amazon.com. Of course one effect is overload at the post office as more Canadians buy things from US sources.

Our Cuisinart finally gave out on us. It had been a wedding present and had served us well for the past 25 years.

Since we live some distance from most major shopping areas, Ms. Eclectic and I began shopping for a new one on-line. Here are the best prices we could find for a 14-cup capacity Cuisinart:

Future Shop: $349 Cdn, on sale for $299 Cdn.
Amazon.com: $199US

Does that make any sense, given that one Canuck buck is worth more than one US dollar? Why is there such a huge difference in prices? And why does it take so long for prices to adjust to movements of the exchange rate?

Former student, Scott, tells me that Chapters bookstore has a sign up saying that they are not making any extra profits because of the movement of the exchange rate but that the massive price differentials between Canadian and US prices (still) stamped on books is due to higher publishing and distribution costs in Canada.

I don't believe them. If we had free trade in books, Ontario would be a big market, well-served from Detroit and Buffalo.

Instead, I think it just takes time for people and prices to adjust to the new and changing exchange rates. People may have rational expectations, but that does not mean we have instantaneous adjustments when things change.

Nevertheless, I'm eagrely waiting for international competition to put downward pressure on Canadian prices.

Referring to jaw-boning/grand-standing by Finance Minister John Flaherty, Catherine Swift was quoted in the Trono Globe and Mail:

Some businesses, such as Wal-Mart Canada Corp. and Zellers Inc., have already cut prices but a Canadian business leader said it will take some time for the majority of the country's firms – small businesses – to move through older inventory.

Catherine Swift, president of the Canadian Federation of Independent Business, said Mr. Flaherty should “know better” when it comes to lecturing entrepreneurs.

“It's simplistic to say, ‘Cut your prices.' It'll happen. It's a very competitive market. Our members have to stay current in terms of pricing. The market does work and the market will work – but to think it'll turn on a dime, that's pretty unrealistic. Some people are carrying older merchandise,” Ms. Swift said in an interview yesterday.

Of course from an economics perspective, it doesn't matter what businesses paid for their old inventory. What matters is what the businesses can sell it for in the current marketplace under current competitive conditions (and that is why economists strongly favour using LIFO instead of FIFO for valuing inventories). The fact that prices in Canada are slow to adjust mostly reflects the degree to which competitive forces take time (a month? a few months?) to react to changed conditions.

Stephen Gordon, writing at Worthwhile Canadian Initiative, has a very revealing graph (reproduced here):



The upper, dashed blue line represents Canada's trade surplus with the US from 2002 until the present; the lower, solid blue line represents Canada's trade surplus with the rest of the world. From 2002 until about two years ago, Canada's trade surpluses remained roughly constant and positive. Put bluntly, we were sending more of our goods and services to foreigners than they were sending to us.

Two years ago, the surpluses started to decline a bit, but they are still surpluses! Canada is still sending more goods and services to foreigners than they are sending to us.

And this high demand for Canadian stuff just keeps putting upward pressure on the Canuck buck, as shown by the red line in the graph. There's a tendency to think that because the Loonie is appreciating, our trade surpluses will decline, but that phenomenon (analogous to a movement along a demand curve) is more than offset by the continued growth in demand (shift of the demand curve) caused by rising oil and commodities prices.

Digression: Stephen also has some poignant insights about The Bank of Canada in his recent postings -- well worth reading.

Last week, Sadistics Canada reported that the unemployment rate in Canada dropped below six percent for the first time in a zillion years (at 5.9%, it "reached its lowest point since 1974").

Canada's jobless rate unexpectedly fell to its lowest level since November, 1974, as the economy created triple the jobs that economists expected last month.

Employers added 51,100 jobs September, sending the rate to 5.9 per cent, Statistics Canada said Friday. ...

Economists had forecast 17,500 new jobs and an unchanged unemployment rate of 6 per cent.

Why is the unemployment rate so low now, and why has it not been this low for 33 years?

• Beginning in the early 1970s, Canada dramatically raised the height of its social safety net. As a result, people searched longer for jobs and the unemployment rate rose to new, nearly permanent higher levels.
• Over the past decade, though, the height of Canada's social safety has drifted downward slowly, inducing unemployed persons to take jobs more quickly, thus lowering the unemployment rate.
• Also over the past decade or so, the echo from the post-war baby boom has matured in age a bit... the demographics of the labour market are such that as more people have more education and work experience, couple with more family responsibilities than they did before, they tend to be unemployed less and to remain unemployed for shorter durations.

In other words, although the natural unemployment rate might very well have been up over 7% back in the late 1980s, it is probably much lower now.

But do long-term forces provide the entire explanation for the 5.9% unemployment rate? Probably not [see here for what I wrote last March about Canada's natural unemployment rate; I seem to adjust with a lag...]. The Canadian economy is booming even though the rising US price of the Canadian dollar is reducing the demand for manufactured goods. Elsewhere in the economy, the resource sector, the oil patch, and personal services are all booming.

Construction, utilities, professional and accommodation and food services have created the most jobs this year while factories have cut the most, shedding 71,300 jobs.

If the natural unemployment rate is still greater than 6%, then the current unemployment rate is further evidence that the Canadian economy is experiencing excess aggregate demand. This possibility causes expectations in the financial markets that the Bank of Canada will maintain a sizable interest-rate spread vis-a-vis the US (see this), and that expectation has sparked an even greater demand for the Canuck Buck:

The report sent the Canadian dollar soaring against its U.S. counterpart, trading at $1.0135 (U.S.) from [its previous] close of $1.0026.

Digression: We can tell when the jobless rate has dropped and labour markets have tightened: a concurrent indicator is that service at Tim Horton's and other fast-food outlets tends, on average, to get slower as the labour turnover with such employers quickens and as they dig deeper into the unskilled labour pool for employees, coming up with increasing numbers of employees who are less skilled and/or less motivated to provide quick, efficient, and friendly service.

I'm sure I am missing something, but why is it that strong economies cause the value of their country's currency to rise on the foreign exchange markets?

Doesn't a strong economy mean higher domestic incomes and hence more imports, thus putting downward pressure on the currency? Or is that being too Keynesian?

Or is it that the strength of the economy signals reduced risk for investors and hence attracts more inflows of foreign capital, driving up the price of the domestic currency?

Or is it that the [comparative] strength of the economy signals that the central bank will likely raise or keep interest rates above those in other countries? If so, why not wait until that actually happens?

At any rate, "strong economy" does not strike me as a very significant explanation for the recent run-up in the US price of a Loonie. Instead, to understand why the US price of Cdn dollar has risen, just look at the world price of oil. Like it or not, the Canuck buck is a petro-currency.

Many years ago, while I was talking with an esteemed colleague, I said something about some market's being out of equilibrium. He reacted pretty strongly, saying that if a market appears to be out of equilibrium then I hadn't taken into account all the relevant variables. Good advice.

So what is happening with prices in Canada and the U.S. now that the U.S. price of a Canadian Loonie has risen to about 94cents? Back when the U.S. price of the Canuck Buck was 84 cents, prices of goods seemed to pretty much reflect purchasing power parity, and there wasn't a tonne of cross-border shopping. But now goods from the U.S. are so much cheaper. Manufacturers in Canada are finding it harder to sell their products in the U.S., and many more Canadians are engaging in cross-border shopping. I find it much more attractive, myself, to order things from the U.S. than from Canada.

As an example, consider any item listed at both Amazon.com and Amazon.ca. A year ago, the price spread was off-putting, but not so much as to keep me from ordering things now and then from Amazon.ca, especially since the Amazon.com free shipping offer for large orders does not apply to shipments to Canada. But now, even without free shipping on larger orders, most things are much cheaper when ordered from Amazon.com instead of Amazon.ca. Prices in Canada and the U.S. simply are not adjusting to the shifts in supply and demand that follow from the recent, sizable jump in the U.S. price of the Canadian Loonie.

In a model of purchasing power parity in a flexible exchange rate regime, one would expect that the prices of goods and the prices of currencies would adjust so that the same book would cost the same for me to buy in either Canada or the U.S. But prices and exchange rates simply are not adjusting that quickly. Books still have Canadian prices stamped on them that are maybe 30 - 50 percent higher (nominally) than the U.S. prices.

Of course many other things determine prices and exchange rates (try oil and other resource price swings, inflationary expectations, political uncertainties, etc.), but if the prices stay the way they are, also look for Amazon.ca to have to lower its prices eventually. Also look for Chapters-Indigo to have to lower its prices, too. If they don't, watch for some outlets to close.

But these changes do not happen overnight or instantaneously. Rather, it takes time for customers to adjust to purchasing things from different sources. And it takes time for many merchants to adjust their prices to new market realities.

It is easy for us to draw the graphs and shift the curves, but we are not price searchers in an uncertain world; these movements do not happen automagically and immediately without decision-makers contemplating them and trying to reformulate their own expectations. Retail merchants, though, should be seeing these changes on the horizon and making plans now to deal with them.

I'm generally pretty ignorant when it comes to international finance and exchange rate determination, so can someone please tell me why this is an equilibrium (from Steve Poloz):

The yen carry trade can take on a variety of forms, but at the heart of each is a loan taken out in Japanese yen, the proceeds of which are used to invest in financial assets elsewhere in the world. It takes advantage of the fact that Japanese interest rates are extraordinarily low, while other countries' interest rates are much higher. For example, an investor can borrow yen from a Japanese bank, convert the funds into Canadian dollars, buy a Canadian government bond, and earn an interest rate spread of around 4%.

The best part of this investment strategy is that the investor makes a 4% spread return on the entire structure, most of which is not his money. He may be required to put up 5% or 10% collateral with the bank - essentially investing $5 of his own money to buy $100 in Canadian bonds, thereby earning a $4 return on just $5 invested, or effectively 80%. Layered on top of the structure is an expectation that the Japanese yen will continue to drift down while the Canadian dollar may continue to appreciate - another positive return.

Why haven't speculators/arbitragers been doing this to the nth degree, driving up Japanese interest rates and driving down Canadian interest rates? And why hasn't this caused expectations of future apprectiation or depreciation of the relevant currencies? How can this be an equilibrium that lasts longer than a few nano-seconds, much less months or even years? Why aren't fund managers and investors doing this with even bigger chunks of their portfolios? Is the risk of future foreign exchange movement so high? Really????

Steve's answer, which doesn't completely persuade me, is that, yes, exchange rate risk is at work here.

The problem with these structures is the potential for an abrupt unwinding of positions. An investor who decides to take his $5 out of the market sells $100 in Canadian bonds, sells $100 of Canadian dollars, and buys yen to close his position. Accordingly, a shift in expectations about monetary policies or currencies can lead to a very rapid evaporation of positions and huge moves in exchange rates.

The bottom line? The yen carry trade is a legitimate tool for many financial institutions. But, like many synthetic financial structures, its over-use as a wagering tool runs big risks, both for the investors and for the global financial system at large.

In a recent speech, David Dodge (Governor of the Bank of Canada) worried that because the world is awash with liquidity, it is becoming increasingly difficult to manage Canadian monetary policy.

There seems to be a lot more global liquidity out there than one might have anticipated," Mr. Dodge said. Spreads of high-risk investments are "pretty narrow" and don't properly reflect risk, he warned. In other words, issuers of high-risk debt can get away with paying historically low prices to get investors to carry their debt.

Because of the phenomenal growth in communication and technology, the supply of lendable funds to any one country, especially a small one, is highly elastic. A slight change in the interest rate, ceteris paribus, can cause massive tides of funds to leave or enter the country until interest rates and exchange rates adjust. These changes, including the rate adjustments, happen quickly, with the tendency for the supply of lendable funds to be horizontal, not vertical as we were all taught in our good old Keynesian models of the 1960s.

If the Capital-Asset Pricing Model has any validity (I think it's pretty good for most situations), it looks as if Dodge is concerned that the Security Market Line is shifting downward and becoming flatter. What he seems to be saying is that when returns drop as a whole, some people are willing to accept a bit more risk, which implicitly assumes "normal" shaped indifference curves in the risk-return trade-off, I guess.

...there is so much money chasing a limited number of investment opportunities, driving down aversion to risk - especially for high-risk debt issuers such as companies with junk bond status or emerging market economies. As a result, spreads (a proxy for the price that bond issuers pay investors to carry their debt) have eroded steadily and steeply over the past five years, leading many economists to warn that they are too narrow, and that investors have become complacent. "That is a real issue ... a very, very real problem and potentially a real concern," Mr. Dodge said...

He is worrying too much. Even if growing global liquidity might pose some problems, what's he gonna do about it? slap on exchange controls? I sure hope not!

In his latest newletter, Stephen Polos predicts that the rapid growth of the Chinese economy will more likely than not continue to slow a bit over the next year or so. He adds that as this happens, the demand for commodities will ease off, and their prices will likely fall somewhat.

It is too early to declare that China is slowing, but the early signs are there. Once a consensus emerges on this, global commodity prices are likely to see another down leg.

Down leg? This imagery of this metaphor is beyond consideration.

As I watch the NFL playoffs on US television stations, I see that McDonald's is advertising my very favourite restaurant food, double cheeseburgers, for only one dollar.

In Canada, this same delicious entree is priced at $1.39 (Cdn). Ignoring transportation costs, I could take $1.15 Cdn to the bank, get $1U.S. and buy a double cheeseburger in the U.S. for a lot less than I would have to pay in Canada. That's a huge difference, crying for an explanation.

I really doubt there is less competition in Canada, and I really doubt that McDonalds is trying to stick it to Canadians, and so the differences in the price (compared with the exchange rate) must have some other explanation.

My explanation is that the Canuck buck is a petro currency, and even though oil prices have been declining, they are still quite high historically. The result is that people want to buy Loonies in order to buy our oil (and other resource-based products), driving up the price of Loonies even though it also drives up the effective prices Canadians pay for manufactured goods.

[Of course this sounds a lot like the Big Mac Index because it's the same idea.]

Menzie Chinn at Econbrowser seems pessimistic about the outlook for the US economy:

Yesterday's dollar plunge unnerved markets. What's the likelihood of a sustained, drastic decline?

... The presumption that there is investor myopia means that median measures of exchange rate expectations might provide very inaccurate indicators of what will happen in the future. Right now, typical forecasts are for gradual dollar depreciation — 8 percent over the next twelve months (in log terms) from November 17th, according to DeutscheBank. The USD/EUR rate is forecasted to depreciate by 5.3 percent. In contrast, the Economist reports JP Morgan forecast of zero USD/EUR depreciation over the next year from November 23rd.

... [T]he extent to which the rate of return on USD denominated assets is less than those on other assets is too large to be rationalized by standard portfolio balance models.

... a little less optimistic about avoiding a slump if the current strength of the dollar is due to investor myopia, and housing prices exceed those consistent with rationality and the transversality condition (for instance, if there is a bubble). A downward revision in both the relative market-to-book price (i.e., "q") of housing as well as the value of the dollar might induce a slump if the lags in adjustment to the exchange rate are longer than those to housing prices. My own view is that is likely to be the case.

Indeed, the lags to exchange rate changes are more likely to be longer, the harder it is to move capital and labor to the export sector. After the battering taken by the tradable sector over the past decade, I worry. [emphasis added]

I have a strong suspicion that Ed Lazear would have agreed had he not adopted a political stance as Chair of the Council of Economic Advisors.

Addendum: Also see this from Greg Mankiw who presents additional evidence that the probability of a downturn next year is rising.

Commenting on a speech by Olivier Blanchard, Menzie Chinn writes at Econbrowser,

...[S]ensible policies aimed at reducing the current account imbalance should focus on the sources of the deficit. Hence, like Blanchard, [I believe] trade restrictions are almost assuredly counterproductive. Unlike Blanchard, I think the budget deficit is a major source of the current account deficit.

As Chinn said in the linked item, referring to some empirical work he summarizes here,

This shouldn't deny the fact that international factors may have an impact on our current account imbalance. But those who hold blameless U.S. fiscal policy should reconsider the empirical evidence.

As I noted yesterday at the end of my posting about the worries, fears, or concerns of three former central bankers, not everyone agrees with them. In particular, The Skeptical Optimist posts this [h/t to Craig Newmark]:

According to the fear-peddlers’ innuendo, we’re supposed to be preparing for foreign T-bond owners—especially the Chinese—to conspiratorially dump all their holdings at once, sending everyone (including themselves) into the poorhouse. (Sounds a lot like the global-finance version of a suicide bomber, doesn't it?)

This point is a good one. Foreign owners are not likely to dump their holdings of US T-bills or T-bonds all at once unless they think there is likely to be a massive failure and run on US economy; and even then, a holder of billions of dollars of US T-bills would find it very difficult to liquidate their position quickly. The Skeptical Optimist continues,

The official numbers say that, if we are to trust the Blue Dog Democrats' rhetoric, we should now be deathly afraid of the British, who have bought three times as much new debt than the Chinese have in the last twelve months.

This probably won’t surprise you: I don’t take the same stance as the Blue Dog Democrats. I do think the British, the Chinese, the Canadians, and many other foreigners know a good, safe, secure investment when they see one.

This is another good point, one to which most economists have referred at one point or another over the past two years or so. If foreigners are gladly buying up US debt at relatively low interest rates, they must not be as afraid of future risks as one might think. He concludes,

So my response to the Blue Dog Democrats fear-mongering about “foreign creditors” investing in United States Treasury securities is this:

“Mr. Blue Dog, you don’t even need a high school diploma to appreciate that the British are buying up our debt because they think it’s a safe, secure investment—and not because they’re planning to become T-bond suicide bombers.”

Cute. He certainly has a way with words. But as one reader so forcefully pointed out in a comment to yesterday's posting, many of the British purchases are just a reflection of the fact that many people in other countries do their purchasing through financial intermediaries in London. Furthermore, it is not just "blue dog democrats" who are concerned about the risk of recession in the near future. For just two notable examples, see the blog writings of Nouriel Roubini and Brad Setser.

And even if his points are correct, try out a slightly different scenario — one in which foreign holders of US debt don't try to dump it all at once but begin to "rebalance" their portfolios, even slightly, away from US gubmnt paper and toward other assets. They do not have to dump US paper to do this; all they have to do is roll over less and less US debt as it comes due, as it appears has been happening in Japan, where holdings of US gubmnt debt have declined by more than $32b over the past 12 months. A little more rebalancing in the rest of the world, and watch for one of the two following reactions:

1. US interest rates will be driven skyward by the near insatiable demand for lendable funds by the US gubmnt combined with a declining supply of lendable funds from the rest of the world. The international supply of liquidity to the US is not infinitely interest-rate elastic; nor is it infinitely risk-inelastic. Or
2. The US Fed will monetize the debt by buying up more and more of the debt itself. Were this to happen, the concerns that inflation might take off again in the near future, mentioned by Volcker and Corrigan in yesterday's posting, could materialize.

Perhaps there are small (but growing!?) risks that this scenario will play out, but either way, the US Fed and the US economy face more risk than the Skeptical Optimist acknowedges in his posting.

The NYTimes reports [reg req'd] that the RMB has been appreciating against the US dollar (but, then, what currency hasn't been?).

[T]he Chinese government has sharply stepped up the appreciation of its currency, allowing it to push through an important level against the dollar on Thursday for the first time.

The recent climb — less than a full percentage point since the beginning of September — is still modest and perhaps will not last. ...

The strengthening of the currency in September, at an annualized rate of 10 percent, compares with an annual appreciation of less than 2.5 percent for most of the year after China’s small revaluation in July 2005.

“The reality is they’re moving at a faster pace,” said Jonathan Anderson, the chief Asia economist at UBS. Others said the pace was likely to be temporary.

This is potentially important news. It provides further evidence that even more foreign central banks are losing confidence in the US dollar at its previous value and expect, eventually, that the US may have to monetize more of its massive debt. This expectation leads them to expect that the US is in for another bout of stagnation, inflation, or both — stagflation. And with these expectations, they simply do not want to hold as many US-dollar denominated financial assets.

One way for foreign gubmnts to shed some of these assets, without causing too much of a stir, is for their central banks to stop buying so many of these assets (and letting others lapse) to keep the US dollar price of their currencies, such as the RMB, artificially low.

These central banks can say nice things, and economists can put a nice spin on what is happening, (from the same NYTimes article) like this:

“The Chinese are doing this as a gesture of good will,” said Tao Dong, the chief Asia economist at Credit Suisse, while adding that he expected the pace of appreciation to settle down soon to about 5 percent a year.

I really doubt it is just a gesture of goodwill. Certainly the managed appreciation of the RMB is, in part, a response to the Smoot-Hawley-type tariff sabre rattling in the US Congress. But just as likely, another, more subtle, explanation is that China simply wants to divest itself, slowly, of ownership of so much US paper that will have reduced purchasing power in the future. I don't really blame them.

Watch for additional flight from the US dollar. And that will have serious ramifications for the US economy.

For more along these lines [h/t to MA], see Brad Setser who, just a few days ago, wrote that the most important price in the world today is not the price of oil or sugar or soybeans: it's the RMB/US$ price. For his latest on the yuan, see here.

Update: Bill Polley has a posting about this news, too. He has a comment here about it, but here is more:

[W]hile the politicians may spin the recent trend in yuan appreciation as a result of our tough talk by certain senators, I think that would be arrogant and naïve. The discussions between Secretary Paulson and the Chinese leaders [are] likely to have been a lot more nuanced--getting to the nuts and bolts of how to pull off the biggest feat of prestidigitation in currency history. That is, getting to the question of how to proceed with a substantial revaluation of the yuan without letting anyone see how you're doing it. At least I hope that is the case.

And David Altig's analysis of a couple of days ago is also relevant here, where he discusses the implications for the US if all its borrowing is not for capital-deepening but is used either for gubmnt, consumption or residential real estate.

The European Central Bank must conduct its open market operations using the debt of any or all of its member countries without discrimination. So guess which ones are sold most often to others on the open market: Greek and Italian. So, given the opportunity, people have an incentive to unload the ones that, if nothing else, are perceived as riskier. They would much rather hold the treasury debt of the financially stronger other member nations. Sounds like Gresham's Law at work.

At the David Laidler Festschrift, John Crow, former Governor of the Bank of Canada, pointed out how the rising price of oil has put upward pressure on the Canadian dollar. He further pointed out that while the oil patch is primarily in the western provinces, the rising international price of the Canuck buck has reduced world demand for other Canadian goods and services, which has particularly inflicted some economic pain on firms in the eastern provinces.

What if there were two different currencies, one for eastern Canada and a different currency for western Canada? The western currency would certainly appreciate relative to the eastern currency, and this led Clark Leith (who was presenting a paper about currency unions) to reply to John Crow's comment,

Canada is not an optimal currency union.

At that point David Laidler interjected that labour mobility is important. Within a given country, differential shifts in demand induce considerable labour mobility, which tends to attenuate the shifts that would otherwise occur; if there were two different countries with two different currencies and with barriers to labour mobility, a currency union would have much more difficulty.

In that sense, it is easy to understand how crucial it was/is that barriers to labour mobility be reduced within the Euro community in order for the Euro to survive as a common currency across different countries.

Related: David Laidler also pointed out that the US treatment of Canadian softwood lumber producers indicated that when a small country signs an agreement with a very large neighbour, it has little recourse if the very large neighbour abrogates the agreement. He used this example to argue against forming a currency union between Canada and the United States.

At the David Laidler Festschrift, Charles Goodhart (former independent member of the British Monetary Policy Committee) said,

We don't know what is happening to exchange rates, and we cannot explain why they are what they are.

If that guy says that, I guess it helps explain my own discomfort (and feelings of ignorance) with the area.

Is the South Korean economy a leading indicator of what will happen in the rest of the world? From Steve Poloz:

Korea’s unique position as a major exporter to both the U.S. and China and a major importer of oil mean that all of the big forces acting on the world economy are hitting it head-on. This has been true for past fluctuations in the world economy, too. During the global slowdown of 1997-99, Korea was naturally one of the leaders, since the Asian crisis was a key ingredient of the downshift. Similarly, Korea’s recovery in 1999-2000 preceded global recovery by a couple of quarters. But Korea’s slowdown in 2000-01 also preceded the global moderation, and its recovery in 2002-03 was also a leading indicator for the world. Accordingly, its new slowdown is very likely a harbinger of slower growth at the global level, once again.

I'm not so ready to accept South Korea as a leading indicator. Rather, it seems pretty clear that Steve has identified the true indicators: forces that affect the major economies seem to have a big impact on Korea.

A few days ago, Nouriel Roubini wrote:

In these conditions it usually takes little to rattle markets and trigger a meltdown. Hopefully Paulson will be smarter and more discrete than Baker in avoiding bullying China and the countries that are financing the US current account deficit; it is both bad manner to bite the hand that feeds you (or, as Italians say, to spit into the plate from which you are happily eating) and also reckless financial behavior as the US badly needs this cheap foreign financing. Markets are already hedgy on their own and international investors are increasingly risk averse. The US needs to borrow every year almost another trillion US dollars – on top of all the previous stock of past borrowing - to finance its still increasing external deficit. Thus, the risks that things will get out of hand and trigger a financial meltdown of the scale that was experienced in 1987 are serious.

Today you have trade protectionism and asset protectionism; hedgy and trigger-happy investors and rising geopolitical risks; the risk of a disorderly fall in the US dollar; a slush of financial derivatives that are a black box that no one truly understands (the operational risk in credit derivatives is only the tip of much larger systemic risk iceberg in these instruments, as the pricing of these instruments has not been tested in a real cycle of increasing corporate bankruptcies); increasing VARs and growing levels of leverage; frothy markets where years of too easy money have created bubbles galore - the latest in housing - that are ready to burst; a bubble of thousands of new hedge funds with inexperienced managers that have no supervision or regulation of their activities; risk management techniques in financial institutions that miserably fail to truly stress test for fat tail events; hedging strategies that – like in 1987 – can hedge nothing once everyone is rushing to the doors and dumping assets at the same time; and a housing markets whose rout may trigger systemic effects through the mortgage backed securities market and the non-transparent hedging activities of the GSEs.

This is a toxic and combustive mix of volatile elements that can lead to a financial explosion and meltdown. And it may take any small match to trigger it: a trade war scare mongering, scorning the foreigners that finance you with restrictions to inward FDI, talking down the dollar to bully China and the US trade partners, a flip-flopping monetary policy, a further spike in oil prices, an event of terrorism or a wider Mid East conflict, a housing market rout rattling the MBS market, the collapse of a large and systemically- relevant hedge fund or of another highly-leveraged financial institution, a Chapter 11 event for a major US corporation such as Ford or GM leading to systemic effects in the credit derivatives market. There is indeed an embarrassment of riches in terms of factors that can trigger a financial meltdown. A single factor among those discussed above may be enough to trigger it; and the risk that a variety of such factors may simultaneously emerge is increasing.

So, to paraphrase Bette Davis in "All About Eve": Fasten your seat belts; it’s gonna be a bumpy ride ahead for financial markets and the global economy…

Last year I was not convinced the doomsayers were correct. This year I would guess that they have a better-than-50% chance of being correct about a serious downturn sometime during the next two or three years. I recently suggested to a friend in England that now might be a good time to sell his residential properties.

According to the Big Mac Index, the Danish Krone is substantially over-valued and has been for many years. It sure looked that way to me while I was there. Hotels and B&Bs were very expensive, relative to other places I had visited. So were food, meals, clothing, souvenirs, etc. It didn't make sense to me that everything could be so much more expensive in Denmark than it is everywhere else. I wondered what other people are buying that is keeping the Krone over-valued relative to purchasing power parity [PPP]?

Oh, sure, Denmark producers export some beer, some cheese, some furniture designs, some architectural services, but what else is keeping the foreign price of the Krone up there? Why does the Danish Krone seem even more over-valued than the Euro, to which its value is pegged?

Energy, according the CIA Factbook. But that source, too, notes that the nominal exchange rate differs noticeably from the PPP exchange rate.

Even though the changes in the U.S. price of a Canadian Loon have reflected the swings in oil prices over the past several decades, Steve Poloz argues that the "natural" level of the Canuck Buck is around 80 cents U.S. because Canadian productivity is roughly only 80 percent of the productivity in the U.S., having drifted downward over that same span of time.

The reason why models of the Canada/U.S. exchange rate point to a natural value somewhere between 75-80 cents is that Canadian business productivity levels are on the order of 80% of U.S. productivity levels. This reflects a steady erosion in Canada’s relative productivity performance during the past 20-25 years. That means that a level of the dollar in the 75-80 cent range levels the playing field for manufacturing in the two countries, making costs of production about equal.

Narrowing that productivity gap would lead naturally to a higher Canadian dollar over time. This began in 2005, when manufacturing productivity rose 5.4% in Canada and 5% in the U.S. We expect Canada’s outperformance to continue, but it will take many years to close a 20% gap and move the natural level of the Canadian dollar up to parity. The good news is that such a gradual move would be sustainable, because improved fundamentals would be driving the dollar’s rise.

This is a strange argument, on the face of it. I am far from being an expert in the field, but I cannot easily see a direct connection between productivity ratios and exchange rates. Surely different monetary growth rates, expectations, and prices play a more important role.

Steve Poloz doesn't think so. He says:

The U.S. dollar is not weak. It is well within its normal historical range given the condition of the world economy. Furthermore, emerging global conditions point to a stronger U.S. dollar, not a weaker one – not to mention a softer Canadian dollar, too.

His reasoning is a little off. Basically it's that the US dollar is well within its historical range.

But that means nothing. What are the fundamentals like? From where I sit, they don't look too good.

Steve Polos has this forecast for the Canuck Buck:

The U.S. dollar will be firm; the Canadian dollar should ease to 83-84 cents by year-end, and to 80-81 cents by late 2007.

This forecast is wildly inconsistent with rising prices of oil and, in that respect, diverges significantly from his argument last year that the Loonie is a petro-currency. I am especially doubtful about his short-term prediction. I can readily imagine the Canadian Loonie will still be in the 90-cent range or higher by year's end. After that, who knows. But it is clear that Steve Polos does not think the Canuck Buck is as closely tied to the price of oil as I think it is or as he used to think it is. Or maybe he is indirectly predicting a major drop in the world price of oil...

For more of my assessments of the Canuck buck (including some decent forecasts back in January), see this.

With the U.S. price of the Canadian dollar bouncing around in the range of $.86 to $.88, some speculative writers are wondering if the loonie will top $.90 US soon.

Steve Poloz of the EDC doesn't think it will happen (or, if it does, it won't last) because of fundamentals:

All this adds up to a forecast for the Canadian dollar in the later months of 2006 of 83-84 cents. If the price of oil were to fall by another $10 then the forecast value of the dollar would drift down to 80-81 cents. Of course, speculative forces are quite capable of taking the currency higher, even above 90 cents, before it heads lower in line with its fundamentals, but this analysis suggests that such a speculative episode would probably be short-lived.

Be sure to read his entire piece to learn what "All this" means.

My own guess is that the U.S. price of the loonie will be in the 85-cent range by the end of 2006, just a shade higher than Steve's estimate, but close.

Steve Poloz, former UWO graduate student and now Chief Economist of Export Development Canada, is a bit more optimistic about the global economic outlook than I am:

The world economy grew by 5.1% in 2004, an unsustainably rapid pace. Some moderation in growth in 2005 was both inevitable and desirable. And, although not all countries have published their numbers yet, a moderation clearly did occur in 2005: we estimate that world economic growth was 4.4% last year, a clear moderation from 2004.

... the OECD leading economic indicator has been edging higher in recent months, after its big decline in 2004. Meanwhile, there is not much slowing going on in the developing world, either. China's growth has remained steady at just below 10%, and growth has picked up in India, Russia and Mexico. Brazil has slowed, but even that looks like [sic] it could prove temporary.

... The bottom line? The world economy still seems more likely to slow than to speed up. But with global production firing on all cylinders the world’s central banks are on high alert, and are more likely than not to take out some additional anti-inflation insurance by nudging interest rates higher.

My own expectation is that central banks will tighten a bit more than others expect. Look for lower global growth rates than most economists are predicting, if not in 2006 then in early 2007.

In an interview that was podcasted back in December, Tim Harford mentions his work with a World Bank programme called "Doing Business" [I think the interview can be found here.].

The Doing Business programme at the World Bank

provides objective measures of business regulations and their enforcement. The Doing Business indicators are comparable across 155 economies. They indicate the regulatory costs of business and can be used to analyze specific regulations that enhance or constrain investment, productivity and growth.

One of the neatest things at this site is they provide their results in easy-to-use tabular form. Click on a column heading and the data are re-sorted according to how the 155 countries in the study ranked on that particular topic. In the list below, I have copied their overall summary, in alphabetical order, of the ease of doing business in each of these countries; but check out their site because they have a mass of hyperlinks that will yield a great deal of information about each country.

[update: Adrian thought the table was more informative if presented by rank order rather than alphabetically and graciously sent me the revision, which I have posted to replace the alphabetical listing. His note:

Certain things jump out, such as the Anglo-Saxon (common law) countries and the Nordics at one end, and much of Africa at the other.

For alternative arrangements of the data, visit their website and click on the head of any column.

New Zealand 1
Singapore 2
United States 3
Canada 4
Norway 5
Australia 6
Hong Kong, China 7
Denmark 8
United Kingdom 9
Japan 10
Ireland 11
Iceland 12
Finland 13
Sweden 14
Lithuania 15
Estonia 16
Switzerland 17
Belgium 18
Germany 19
Thailand 20
Malaysia 21
Puerto Rico 22
Mauritius 23
Netherlands 24
Chile 25
Latvia 26
Korea 27
South Africa 28
Israel 29
Spain 30
Maldives 31
Austria 32
Namibia 33
Fiji 34
Taiwan, China 35
Tonga 36
Slovak Republic 37
Saudi Arabia 38
Samoa 39
Botswana 40
Czech Republic 41
Portugal 42
Jamaica 43
France 44
Kiribati 45
Armenia 46
Kuwait 47
Marshall Islands 48
Vanuatu 49
Palau 50
Oman 51
Hungary 52
Solomon Islands 53
Poland 54
Nepal 55
Micronesia 56
Panama 57
Tunisia 58
Nicaragua 59
Pakistan 60
Mongolia 61
Bulgaria 62
Slovenia 63
Papua New Guinea 64
Bangladesh 65
Colombia 66
Zambia 67
Kenya 68
United Arab Emirates 69
Italy 70
Peru 71
Uganda 72
Mexico 73
Jordan 74
Sri Lanka 75
El Salvador 76
Argentina 77
Romania 78
Russian Federation 79
Greece 80
Macedonia, FYR 81
Ghana 82
Moldova 83
Kyrgyz Republic 84
Uruguay 85
Kazakhstan 86
Bosnia and Herzegovina 87
Paraguay 88
Costa Rica 89
Yemen 90
China 91
Serbia and Montenegro 92
Turkey 93
Nigeria 94
Lebanon 95
Malawi 96
Lesotho 97
Azerbaijan 98
Vietnam 99
Georgia 100
Ethiopia 101
Morocco 102
Dominican Republic 103
Bhutan 104
Guyana 105
Belarus 106
Ecuador 107
Iran 108
Guatemala 109
Mozambique 110
Bolivia 111
Honduras 112
Philippines 113
Iraq 114
Indonesia 115
India 116
Albania 117
Croatia 118
Brazil 119
Venezuela 120
Syria 121
Afghanistan 122
São Tomé and Principe 123
Ukraine 124
West Bank and Gaza 125
Zimbabwe 126
Mauritania 127
Algeria 128
Benin 129
Cameroon 130
Madagascar 131
Senegal 132
Cambodia 133
Haiti 134
Angola 135
Sierra Leone 136
Eritrea 137
Uzbekistan 138
Rwanda 139
Tanzania 140
Egypt 141
Timor-Leste 142
Burundi 143
Guinea 144
Cote d'Ivoire 145
Mali 146
Lao PDR 147
Congo, Rep. 148
Togo 149
Niger 150
Sudan 151
Chad 152
Central African Republic 153
Burkina Faso 154
Congo, Dem.Rep. 155

Update: for more on the bureaucratic costs of doing biznezz in many countries, see the latest from Ben Muse.

If you look at the growing deficit in the U.S. current account, you might be tempted to say "They're doomed!" [a la Roubini and Setser, work I have enjoyed considerably.]

A fairly recent piece by Hausmann and Sturzenegger challenges this view.

Their approach is not unlike that of astrophysicists trying to explain the stability of galactical systems; the physicists have had to rely on the gravitational pull of something called "dark matter" for their explanations. Hausmann and Sturzenegger argue, analogously, that the international exchange market is much more stable than one might think, based on looking at only current account deficits. They posit that there must be something else, call it dark matter, holding the system together and imparting considerable stability to the system of international exchange.

The nature of this dark matter, according to them, is trade in know-how and specific information. When goods and services are sold (and especially licensed) to foreigners by US firms, there is almost always a part of the agreement specifying that the licensee will also purchase technical know-how and implementation consulting services. These are long-term contracts, and they are assets for the firms selling them, but they don't show up in the current account as sales of assets. Including them in the data provides a different picture of the U.S. dollar situation. My reproduction of their graph below is far from clear, but the two lines show a dramatic difference over the years from 1980 - 2004 (the teal-coloured line is the cumulative current account, as measured; the brown line is the cumulative current account, including a measure of "dark matter" and showing a stable balance over the past two and a half decades).


It is enough to make me hesitate, that's for sure. To the extent this is true, foreigners are importing a lot of know-how from the U.S. and exporting a lot of promises to pay in the future, and neither of these items is showing up on the books.

Brad Setser has a lengthy analysis of their argument; summary: it's the result of corporate tax arbitrage.

I don't think it is wise to downplay the role of licensing know-how in technology transfer. Numerous folks at UWO's Ivey Bizskool have done research on this topic and, as I recall, thought it was pretty important.

I'm afraid it may be too late to submit a paper on this topic to this conference.

What would be the effect if people no longer needed to use U.S. dollars to buy and sell oil on world markets? Here is one perspective.

[h/t to Aaron Braaten, but read the comments there as well]

China has announced that it will diversify its reserve holdings even more than it has. [see this by Brad Setser]. To the extent they do, their actions will reduce the demand (and possibly increase the supply) for U.S. dollar-denominated financial assets, putting downward pressure on the U.S. dollar relative to other currencies, ceteris paribus.

This possibility is in line with what I wrote just a few days ago and last month, too.

As I write this, the Candian dollar seems to be worth about 85 cents (US). This is near the highest US price of a loonie that we've seen for many, many years. One reason the US price of a loonie has been so high lately is that the price of oil has been high, and, like it or not, the Canuck buck borders on being a petro-currency. [digression: my colleague, David Laidler, has argued for decades that the value of Canadian currency has been determined, in large measure, by world prices for raw materials and resources, which Canada has a comparative advantage in producing and exporting].

Hahn Investments thinks the Canadian dollar value is about to fall relative to the US dollar. Their argument is seven-fold, but one of their main points is that it is unusual for Canadian interest rates to be below the U.S. interest rates; when this happens, one might expect short-term capital to flow to the U.S. and out of Canada, thus pushing down the U.S. price of a Canadian dollar.

I think their position ignores two important additional, related considerations (which may explain why, according them, most economists do not agree with their forecast):

1. Expected Inflation. If people expect that the twin deficits in the U.S. will lead to more inflation there than in Canada, then it makes sense that they might send their short-term capital to Canada despite Canada's lower interest rates. Interest-rate parity is important, but it embodies inflationary expectations, too. To see this, just compare Spanish, Italian, Swiss, and Japanese interest rates.
   
   
2. And this raises the second point. Despite its recent growth, many reasonable people think the U.S. economy is headed for trouble. The large gubmnt deficits and the large current-account deficits lead, at the very least, to growing uncertainty about the strength of the U.S. dollar in the near future. And this uncertainty induces people to hold more Canadian currency than they might otherwise.
   

In other words, it is possible that Hahn has placed too much emphasis on short-term interest rates as indicators of what might happen in the future and not enough emphasis on short-term interest rates as indicators that have already discounted people's expectations about the future. The former view says the interest-rate differentials will lead to downward pressure on the Loonie; the latter view says the interest-rate differentials will persist because of changes in the underlying strengths of the Canadian and U.S. economies.

I am fairly pessimistic about the short-term future for the U.S. dollar, and that is one of the reasons I'm more optimistic about the Loonie than Hahn is. At the same time, though, you might wish to consider Bill Polley's forecast that the U.S. dollar will gain a bit of strength over the next year.

Well, he also predicts that Canada will defeat the U.S. in curling at the Olympics, so at least he got that one right.

Update: For more reasons to be skeptical about the future strength of the U.S. dollar, see Kip Esquire and Econbrowser. At the same time, as a commenter notes, other currencies do not look terribly strong, either.