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April 9, 2006 in Face of Inflation: Does the U.S. Have a "Peso Problem" we laid out a worst case scenario for the U.S. economy and dollar when the markets are finally allowed to devalue dollar. It explained that the U.S. may have what has been termed by economists a "Peso Problem."
"No one knows the precise origin of the term peso problem, but it is often attributed to Nobel laureate Milton Friedman in comments he made about the Mexican peso market of the early 1970s. At that time, the exchange rate between the U.S. dollar and Mexican peso was fixed, as it had been since 1954. At the same time, the interest rate on Mexican bank deposits exceeded the interest rate on comparable U.S. bank deposits. This situation might seem like a flaw in the financial markets, since investors could borrow at the low interest rate in the United States, convert dollars into pesos, deposit the money in Mexico and earn a higher interest rate, then convert the proceeds back into dollars at the same exchange rate and pay off their borrowings, making a tidy profit.
Friedman noted that the interest rate differential between Mexico and the United States must have reflected financial market concerns that the peso would be devalued. Otherwise, the interest-rate differential would soon disappear as investors increasingly took advantage of it. In August 1976, those concerns were justified when the peso was allowed to float against the dollar and its value fell 46 percent."
- FEDERAL RESERVE BANK OF PHILADELPHIA BUSINESS REVIEW SEPTEMBER/OCTOBER 2000: Understanding Asset Values: Stock Prices, Exchange Rates, And the "Peso Problem" (PDF)
The article proposed that the relationship that existed between the Mexican peso and the U.S. dollar in the early 1970s had developed between the U.S. dollar and the currencies of several of its trade partners. The exchange rate between the U.S. dollar has been effectively fixed by China and oil producing countries, although not fixed with respect to the British pound, euro, or Canadian dollar. As a result, the dollar has been steadily losing ground to those currencies while the exchange rate remains relatively level with respect to the currencies of trade partners that manage currency exchange rate values via a currency peg or, as in the case of China, a virtual peg. The interest rate differential between the U.S. and its trade partners, especially Japan and China, likely reflects financial market concerns that the dollar will be devalued. Friedman noted that the interest rate differential between Mexico and the United States must have reflected financial market concerns that the peso would be devalued. Otherwise, the interest-rate differential would soon disappear as investors increasingly took advantage of it. In August 1976, those concerns were justified when the peso was allowed to float against the dollar and its value fell 46 percent."
- FEDERAL RESERVE BANK OF PHILADELPHIA BUSINESS REVIEW SEPTEMBER/OCTOBER 2000: Understanding Asset Values: Stock Prices, Exchange Rates, And the "Peso Problem" (PDF)
With this week's emergency .5% rate cut by the Fed, the US$'s "Peso Problem" has been pushed to a crisis, starting with the announcement today by the Saudi central bank that it will not lower interest rates to import more U.S. inflation in order to help bail out the U.S. economy as it heads into a post housing bubble recession. Soon the dollar may float against the currencies of all oil producers, yuan, and others.
How far might the dollar fall and what kind of the economic impact can we expect? Unfortunately, the worst case scenario that we formulated to shock our readers into action April last year is beginning to play out.
Although the U.S. economy maintained its rapid growth during most of the 1990s and 2000s, it was progressively undermined by fiscal mismanagement and a resulting sharp deterioration of the investment climate. The GDP grew about 4 percent annually during the administrations of President Bill Clinton (1993-2001) and during that of his successor, President George W. Bush (2001-2009), except for a brief recession following the collapse of the stock market bubble in 2000. But asset prices fluctuated wildly during the decade, with booms and busts in the stock, bond and real estate markets.
Fiscal profligacy combined with the 2008 oil shock exacerbated inflation and upset the balance of payments. The balance of payments disequilibrium became unmanageable as capital flight intensified, forcing the government in 2008 to devalue the dollar by 30 percent.
Although a bubble in bond and real estate prices from 2001 to 2006 allowed a temporary recovery, the windfall from sales of financial assets to foreign central banks also allowed continuation of the Bush administration's destructive fiscal policies. In the mid-1980s, the U.S. went from being a net exporter of goods and to a significant importer. Sales of financial assets became the economy's most dynamic growth sector. Net foreign purchases of U.S. financial assets grew from 50% of issuance in 1996 to nearly 80% in 2005. Rising foreign borrowing allowed the government to continue its expansionary fiscal policy. Between 2001 and 2006, the economy grew more than 4 percent annually, as the government spent heavily on the military and the real estate and financial sectors provided more than 50% of private sector employment.
This renewed growth rested on shaky foundations. The United States' external indebtedness mounted, and the dollar became increasingly overvalued, hurting exports in the late 2000s and forcing a second dollar devaluation in 2010. The action effectively ended the U.S. dollar's status as a reserve currency. The portion of import categories subject to controls rose from 10 percent of the total in 2008 to 24 percent in 2010. The government raised tariffs concurrently to shield domestic producers from foreign competition, further hampering the modernization and competitiveness of U.S. industry. As unemployment rose to more than 20%, government policies to limit immigration fueled further increases in wage rates and inflation.
The macroeconomic policies of the 2000s left the U.S. economy highly vulnerable to external conditions. These turned sharply against the U.S. in the late 2000s, and caused the worst recession since the 1930s. By mid-2010, the U.S. was beset by rising oil prices, higher world interest rates, rising inflation, a chronically overvalued dollar, and a deteriorating balance of payments that spurred massive capital flight. This disequilibrium, along with the virtual disappearance of the U.S. international reserves--by the end of 2010 they were insufficient to cover three weeks' imports--forced the government to devalue the dollar three times during 2012. The devaluation further fueled inflation and prevented short-term recovery. The devaluations depressed real wages and increased the private sector's burden in servicing its dollar-denominated debt. Interest payments on long-term debt alone were equal to 28 percent of export revenue. Cut off from additional credit, the government declared an involuntary moratorium on debt payments in August 2013, and the following month it announced the nationalization of the U.S. private banking system.
The entire projection is speculation based on our understanding of historical determinism from the starting point we chose in mid-2006. It is meant to give a sense of how these kinds of imbalances tend to play out, although the likelihood is very low that events will unfold precisely in this way.Fiscal profligacy combined with the 2008 oil shock exacerbated inflation and upset the balance of payments. The balance of payments disequilibrium became unmanageable as capital flight intensified, forcing the government in 2008 to devalue the dollar by 30 percent.
Although a bubble in bond and real estate prices from 2001 to 2006 allowed a temporary recovery, the windfall from sales of financial assets to foreign central banks also allowed continuation of the Bush administration's destructive fiscal policies. In the mid-1980s, the U.S. went from being a net exporter of goods and to a significant importer. Sales of financial assets became the economy's most dynamic growth sector. Net foreign purchases of U.S. financial assets grew from 50% of issuance in 1996 to nearly 80% in 2005. Rising foreign borrowing allowed the government to continue its expansionary fiscal policy. Between 2001 and 2006, the economy grew more than 4 percent annually, as the government spent heavily on the military and the real estate and financial sectors provided more than 50% of private sector employment.
This renewed growth rested on shaky foundations. The United States' external indebtedness mounted, and the dollar became increasingly overvalued, hurting exports in the late 2000s and forcing a second dollar devaluation in 2010. The action effectively ended the U.S. dollar's status as a reserve currency. The portion of import categories subject to controls rose from 10 percent of the total in 2008 to 24 percent in 2010. The government raised tariffs concurrently to shield domestic producers from foreign competition, further hampering the modernization and competitiveness of U.S. industry. As unemployment rose to more than 20%, government policies to limit immigration fueled further increases in wage rates and inflation.
The macroeconomic policies of the 2000s left the U.S. economy highly vulnerable to external conditions. These turned sharply against the U.S. in the late 2000s, and caused the worst recession since the 1930s. By mid-2010, the U.S. was beset by rising oil prices, higher world interest rates, rising inflation, a chronically overvalued dollar, and a deteriorating balance of payments that spurred massive capital flight. This disequilibrium, along with the virtual disappearance of the U.S. international reserves--by the end of 2010 they were insufficient to cover three weeks' imports--forced the government to devalue the dollar three times during 2012. The devaluation further fueled inflation and prevented short-term recovery. The devaluations depressed real wages and increased the private sector's burden in servicing its dollar-denominated debt. Interest payments on long-term debt alone were equal to 28 percent of export revenue. Cut off from additional credit, the government declared an involuntary moratorium on debt payments in August 2013, and the following month it announced the nationalization of the U.S. private banking system.
Even with a year of hindsight, our only major revision is to note that the process is happening sooner than we expected, and rather than being triggered by an oil shock in 2008 was triggered by a crisis in U.S. credit markets in mid 2007. In any case, we believe it's safe to say that indeed the dollar did have a "Peso Problem" and the markets are now correcting it.
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