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A small belated Christmas present for you folks....

 

When Prophecy Fails

Paul Krugman

December 23, 2012

New York Times

http://www.nytimes.com/2012/12/24/opinion/krugman-when-prophecy-fails.html

 

Back in the 1950s three social psychologists joined a cult that was predicting the imminent end of the world. Their purpose was to observe the cultists’ response when the world did not, in fact, end on schedule. What they discovered, and described in their classic book, “When Prophecy Fails,†is that the irrefutable failure of a prophecy does not cause true believers — people who have committed themselves to a belief both emotionally and by their life choices — to reconsider. On the contrary, they become even more fervent, and proselytize even harder.

 

This insight seems highly relevant as 2012 draws to a close. After all, a lot of people came to believe that we were on the brink of catastrophe — and these views were given extraordinary reach by the mass media. As it turned out, of course, the predicted catastrophe failed to materialize. But we can be sure that the cultists won’t admit to having been wrong. No, the people who told us that a fiscal crisis was imminent will just keep at it, more convinced than ever.

 

Oh, wait a second — did you think I was talking about the Mayan calendar thing?

 

Seriously, at every stage of our ongoing economic crisis — and in particular, every time anyone has suggested actually trying to do something about mass unemployment — a chorus of voices has warned that unless we bring down budget deficits now now now, financial markets will turn on America, driving interest rates sky-high. And these prophecies of doom have had a powerful effect on our economic discourse.

 

Thus, back in May 2009 the Wall Street Journal editorial page seized on an uptick in long-term interest rates to declare that the “bond vigilantes,†the “disciplinarians of U.S. policy makers,†had arrived, and would push rates inexorably higher if big budget deficits continued. As it happened, rates soon went back down. But that didn’t stop The Journal’s news section from rolling out the same story the next time rates rose: “Debt fears send rates up,†blared a headline in March 2010; the debt continued to grow, but the rates went down again.

At this point the yield on the benchmark 10-year bond is less than half what it was when that 2009 editorial was published. But don’t expect any rethinking on The Journal’s part.

 

Now, you could say that The Journal’s editors didn’t give a specific date for the fiscal apocalypse, although I doubt that any of their readers imagined that they were talking about an event at least three years and seven months in the future.

 

In any case, some of the most prominent deficit scolds have indeed been willing to talk about dates, or at least time horizons. In early 2011 Erskine Bowles confidently declared that we would face a fiscal crisis within around two years unless something like the Bowles-Simpson deficit plan was enacted, and Alan Simpson chimed in to say that it would be less than two years. I guess he has about 10 weeks left. But again, don’t expect either Mr. Simpson or Mr. Bowles to admit that there might have been something fundamentally wrong with their analysis.

No, very few of the prophets of fiscal doom have acknowledged the failure of their prophecies to come true so far. And those who have admitted surprise seem more annoyed than chastened. For example, back in 2010 Alan Greenspan — who is, for some reason, still treated as an authority figure — conceded that despite large budget deficits, “inflation and long-term interest rates, the typical symptoms of fiscal excess, have remained remarkably subdued.†But he went on to declare, “This is regrettable, because it is fostering a sense of complacency.†How dare reality not validate my fears!

 

Regular readers know that I and other economists argued from the beginning that these dire warnings of fiscal catastrophe were all wrong, that budget deficits won’t cause soaring interest rates as long as the economy is depressed — and that the biggest risk to the economy is that we might try to slash the deficit too soon. And surely that point of view has been strongly validated by events.

 

The key thing we need to understand, however, is that the prophets of fiscal disaster, no matter how respectable they may seem, are at this point effectively members of a doomsday cult. They are emotionally and professionally committed to the belief that fiscal crisis lurks just around the corner, and they will hold to their belief no matter how many corners we turn without encountering that crisis.

 

So we cannot and will not persuade these people to reconsider their views in the light of the evidence. All we can do is stop paying attention. It’s going to be difficult, because many members of the deficit cult seem highly respectable. But they’ve been hugely, absurdly wrong for years on end, and it’s time to stop taking them seriously.

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No one thought to remind me that its been almost a year since I posted anything useful in this thread?!

 

Given the current political game of chicken that Congress and Obama are playing with the debt ceiling and budget, this is quite appropriate.  The conventional wisdom is that default is uniquely bad because it will raise the costs of borrowing for everyone as the faith in the credit of the United States will fall.  The ability to borrow is an indirect measure of economic health.  So here is a piece of evidence which highlights a credit default scenario with the specific link of a hard default [A hard default means that a country has missed or delayed the disbursement of a contractual interest or principal due past the contractual grace period (if any).].  It even leverages the idea that the tendency of economic adversaries to work towards mutual interests could be overcome by the precise economic shock of a default.

 

Richard J Herring "Default and the International Role of the Dollar" Is US Government Debt Different?  Penn Law and Wharton Financial Institutions Center.  FIC Press, Philadelphia.  p58-59  2012

* Richard J. Herring is Jacob Safra Professor of International Banking and Professor of Finance at The Wharton School, University of Pennsylvania, where he is also founding director of the Wharton Financial Institutions Center. From 2000 to 2006, he served as the Director of the Lauder Institute of International Management Studies and from 1995 to 2000, he served as Vice Dean and Director of Wharton’s Undergraduate Division. During 2006, he as a Professorial Fellow at the Reserve Bank of New Zealand and Victoria University and during 2008 he was the Metzler Fellow at Johann Goethe University in Frankfurt. He is the author of more than 100 articles, monographs and books on various topics in financial regulation, international banking, and international finance. His most recent book, The Known, the Unknown & the Unknowable in Financial Risk Management (with F. Diebold and N. Doherty) has just been recognized as the most influential book published on the economics or risk management and insurance by the American Risk and Insurance Association. (the qualifications go on and on for another 20 lines...)


The size and persistence of the imbalances between the U.S. and China, the two largest economies in the world, has led to mutual suspicion and discomfort. On the one hand, the Chinese are deeply ambivalent about their holdings of dollars. They are very concerned with maintaining the purchasing power of their huge stock of dollar assets and resent the pressure that dollar inflows put on their monetary policy, requiring increasingly aggressive measures to sterilize inflows to avoid a higher rate of inflation than they prefer. On the other hand, they are reluctant to let the yuan float because control over the exchange rate has been an important tool of stimulating growth and maintaining high levels of employment. In contrast, factions in the U.S. hold two distinctly inconsistent views. One faction fears the potential leverage that might be inherent in such a heavy concentration of claims on the U.S. government held by one foreign government. They fear that a threat to disrupt financial markets might be used by the Chinese to gain political advantage. The other faction is concerned that the Chinese might suddenly decide to diversify their foreign exchange holdings for economic reasons, with the result that the U.S. might face much higher costs to finance its debt and deficits that it appears politically unable to manage fiscally – at least in the short run. 

In my view, both the Chinese and U.S. views are misplaced. Interdependence on this scale tends to align incentives rather than exacerbate differences. Even with the depth, breadth, and resilience of U.S. financial markets, the Chinese would drive rates sharply against themselves if they tried to reallocate a large portion of their portfolio. And the question remains: reallocate to what? At the moment there is no credible alternative foreign currency market to place their funds. Countries with attractive currencies such as Switzerland or Singapore could not possibly absorb the magnitude of inflows, nor would they tolerate the consequent appreciation of their exchange rates. The euro area surely looks less promising as a refuge than the U.S. at present and the Chinese are likely to rule out the Japanese yen on a number of grounds.

The history of the pound sterling suggests that reserve currency status need not last forever. Nonetheless, it would take a dramatic shock to the system – much larger than the recent financial crisis – to eliminate the enormous network advantages the U.S. currently enjoys.  Of course, a hard dollar default that is not cured immediately could be precisely that sort of shock. Although the benefits of issuing the predominant international reserve currency may not be overwhelmingly large, the costs of suddenly abandoning that role would have systemic consequences not only for the U.S., but equally for the rest of the world.

 

 

And for those thinking that China has aspirations to be the head honcho... here is some evidence to deflate your bubble. It would probably cost China's leadership their status and power, and since when did you know those nationalists over in Beijing be willing to step aside and willingly take a backseat to anyone?

 

Richard J Herring "Default and the International Role of the Dollar" Is US Government Debt Different?  Penn Law and Wharton Financial Institutions Center.  FIC Press, Philadelphia.  p58-59  2012

* Richard J. Herring is Jacob Safra Professor of International Banking and Professor of Finance at The Wharton School, University of Pennsylvania, where he is also founding director of the Wharton Financial Institutions Center. From 2000 to 2006, he served as the Director of the Lauder Institute of International Management Studies and from 1995 to 2000, he served as Vice Dean and Director of Wharton’s Undergraduate Division. During 2006, he as a Professorial Fellow at the Reserve Bank of New Zealand and Victoria University and during 2008 he was the Metzler Fellow at Johann Goethe University in Frankfurt. He is the author of more than 100 articles, monographs and books on various topics in financial regulation, international banking, and international finance. His most recent book, The Known, the Unknown & the Unknowable in Financial Risk Management (with F. Diebold and N. Doherty) has just been recognized as the most influential book published on the economics or risk management and insurance by the American Risk and Insurance Association. (the qualifications go on and on for another 20 lines...)

 

What other currency might ultimately challenge the dollar in its reserve currency role? The Chinese government is taking the first steps toward enhancing the international role of yuan. China has the natural advantage of an enormous, well-diversified economy, but, to date, the development of their financial markets has substantially lagged behind the development of their economy. In June 2011, however, the Chinese allowed most corporations to pay for imports in yuan. Then 365 Chinese companies were allowed to sell exports for yuan.  During August 2011, this privilege was extended to 67,359 companies. Not surprisingly, foreigners prefer to sell goods and services for yuan rather than to purchase Chinese exports with yuan. (Their presumption is that the yuan will inevitably appreciate relative to most other currencies.) The result is that there is an increasing offshore pool of yuan (‘redbacks’) held mainly in Hong Kong. A nascent offshore market in yuan-denominated bonds has emerged (the dimsum market) based mainly in Hong Kong, but with recent issues in London.  Nonetheless, all of this activity is far short of what would be required to launch the yuan as a major reserve currency. To do so, China would need to end its policies of financial repression and capital account controls – which have been important tools to sterilize reserve inflows and manage the economy. China would also need to give up setting its exchange rate, which has been a key policy tool, and permit itself to run sizeable current account deficits to accommodate the reserve currency demand for the yuan. This agenda is not impossible. Indeed, it would probably be in the best interests of China’s citizens. But the difficulty in moving from China’s current financial system to the open financial system necessary to sustain a reserve currency should not be underestimated. The measures necessary to open domestic capital markets might, indeed, undermine the current political structure.

 

 

As I read more of the book, I'll post anything else I think could be useful....

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The dollar's slide is about way more than Trump, and everyone should take notice

 

Yahoo Finance

Myles Udland

Yahoo Finance

September 18, 2017

2:152:22

 

 

The drop in the U.S. dollar has been one of the defining trades in financial markets this year.

 

After rallying following the election of Donald Trump in November 2016 and hitting a 13-year high that same month, the dollar has been slammed this year, logging its worst year since 1986 against major currencies as of September 5, according to Bespoke Investment Group.

 

The most popular explanations for this year’s dollar decline revolve around two key players in Washington, D.C. — Donald Trump and Federal Reserve.

 

As Yahoo Finance’s Nicole Sinclair outlined last week, Trump’s failure to deliver on his major policy initiatives has in part led to a softening of the dollar. Hopes for fiscal stimulus (and in turn faster economic growth), and fears of more restrictive trade policies, both boosted the dollar’s outlook earlier in the year. Neither have materialized.

 

Then there is the Federal Reserve, which is no longer alone among major central banks in tightening — or preparing to tighten — monetary policy. The Bank of Canada has raised rates twice, the European Central Bank is jawboning towards the end of its asset purchase program, and the Bank of England has suggested rate hikes could take place later this year.

 

The transition from dollar to yuan has begun

 

But in a note to clients out Monday, Carl Weinberg, chief economist at High Frequency Economics, cast doubt on the veracity of arguments that a re-synchronization of global monetary policy is to blame for the dollar’s bad year.

 

Instead, Weinberg points east to China, citing the growing role of the world’s second largest economy on the global stage, and in particular the oil markets. And the most basic tenant of the global economy Weinberg sees being undermined is the dollar’s primacy as the currency used to facilitate international trade.

 

Weinberg notes that as of June, Russia accepts yuan — rather than dollars — as payment for oil sales to China. Russia now has 25% of China’s oil import market, up from 15% earlier this year. The significance here is that Russia has been rewarded by China, the world’s largest oil importer, for using its local currency rather than dollars to complete these transactions.

 

Saudi Arabia, the world’s largest oil exporter, has also been courted by China to break an arrangement under which Aramco, its state-run oil producer, prices oil only in U.S. dollars, Weinberg notes.

 

“The prospect of the world’s largest importers and exporters of oil pricing and trading crude in yuan is a big dollar-negative,” Weinberg writes.

 

“If oil trade moves to yuan, it will mean a potential loss of $800 billion per year in U.S. dollar transactions, and a similar reduction of $800 billion in re-cycling of petro-surpluses into U.S. dollar assets. That is not a pretty picture for either the dollar or U.S. securities in the longer term.”

 

To parse some of this language, most international trade is currently facilitated using U.S. dollars. Which means that it behooves big players in trade — like, for example Aramco — to hold lots of dollar-denominated assets, like Treasury securities. Aramco can then sell Treasuries for cash if it needs the liquidity or can use the proceeds of a deal to buy Treasuries in case it needs the liquidity down the line. This is a simple outline of what is meant when the dollar is spoken of as the world’s reserve currency.

 

And it is this move away from the dollar as the main facilitator of international commerce that Weinberg sees as driving the value of the greenback lower this year.

 

“[The dollar’s decline] is not about interest rates,” Weinberg writes.

 

“It is, instead, anticipation of the dollar being dethroned as the world’s reserve and transactions currency. To our eye, this transition has already begun.”

 

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I saw this and found it very intriguing as building towards a dollar crash argument.

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