DR.

KURT RICHEBÄCHER
--0 Muehlegasse 33
CH-8001 Zuerich
CURRENCIES AND CREDIT MARKETS Switzerland

No.195/ July, 1989

Continued large U.S. trade deficits are likely to lead to longer term problems
in large part associated with the financing of the deficits, and to impose
adjustment costs arising from the macroeconomic changes in spending~ exchange
rates, and other variables needed to restore equilibrium.
I!conomic Consequences of Continued U.S. External Deficits
Federal Reserve ,Bank of New York, Quarterly Review
Winter-Spring 1989

HIGHLIGHTS

Inflation can have very different channels of expression. The inflation of the
1980s is fashioned in different clothes. Unprecedented credit excesses have been
largely translated into soaring imports and gaping trade imbalances.
The large capital inflows that then result are grossly counterproductive. Not
only do they checkmate a tight monetary policy~ they also diminish domestic
o savings by boosting consumption while all .the while eroding financial stability.

EffectivelY7 the supply side of the economy is relegated to "runt" status as

consumption crowds out investment from the milk of savings and retards
development of productive capabilities.
One cannot forewarn often enough about wtlat may lie at the root of the chronic
inflationary malaise that threatens the United States economy. Grossly
inadequate savings, grossly inadequate investment, (which in turn contributes
to poor productivity growth) still infests the North American landscape.

At long last, the Fed is now facing the classical late-cycle dilemma where it
has to choose between further curbing an inflation that is running at its fastest
pace in this expansion or trying to revive the economy.

While in our view the soft landing is the one scenario that's almost impossible,
1
the Fed s urgent easing actions in recent weeks prompts review of a third
scenario.

At the moment what we see in the United States is the normal cyclical weakening
at the end of a boom. But this time there are three lurking dangers that could
leap out of the deep should ever a recession ensue.

The high-altitude bombing many currency speculators suffered recently during the
downdraught of the U.S. dollar makes it abundantly clear that the prior surge
was indeed a speculative bubble, just as we had suspected.
o
Very likely, the U.S. dollar is headed sharply lower over the next few months.
The very tightness of recent monetary tightness has also set the stage for a
looser policy as the U.S. economy weakens. As a result~ shrinking interest
differentials should drastically reduce the attractiveness of the U.S dollar.
 :~-=:~..;';~-,~.':~.~'.:;-:'-~_.~";:~.~~.~~~;=:-~.:..
.

-..-
-..

THE DUEL OF THE: ALTER EGOS: ROTATING MANIAS VERSUS MANIC WORRIES
--
The high-altitude bombing many currency speculators
suffered during the recent
downdraught of the u.s. dollar makes it abundantly clear that the
prior surge
was indeed a speculative bubble just as we had suspected. The blow-off of
the
dollar against the hard currencies had all the markings of a speculative mania:
crazy theories, panic, loss of control (by the central banks in this case), high
volume, and mob psychology all fired-up on the mystical strengths of chart
patterns.

There was enormous turnover in the New York currency-exchange

markets, dollar-
volume having shot up to an average of $850 billion per day for the two weeks
ending June 14th. If one were to combine cash, options and futures transactions,
trading may well have reached over $1 trillion each day a new record for the -

financial history books!

No where in any of this can we find solid fundamental justification for this
recent attack on the hard-currencies of Germany and Japan. The fact that the
domestic financial markets of these fundamentally strong economies hardly
suffered at all may prove that persuasion. One can only wonder what would have
happened if an attack of similar psychological dimensions were to be directed
at a more deserving currency. Now that the tornado-like mania has cut
its swath
from stocks to high-yielding currencies to bonds, could it be possible that the
next mania might hit the hard-currencies?

THE CONFIDENCE AND QUESTION OF THE SOFT LANDING

)
What has been the most important occurrence for financial markets recently? As
it again~ it's neither an economic or financial event but rather a
happens~
psychological one. It's the change in the consensus view on the resilience of
the U.S. economy. Exuberance and exaltation has given way to inkling wòrries
over recession.

The previous almost unanimous

~
euphoria was happily consoled in the widely
~

accepted notion that what lies ahead is the best of all possible worlds the -

utopia of the wonderful "soft landing". According to the consensus view, the
U.5. economy would slow just enough to lower inf lation and interest rates
sufficiently enough to get out of harms way...and it should be added, without
any undue economic hardships.

The point to wake up to in all of this misapplied jargon and jingoism is that
most apostles of the "soft-landinglf view are willing to accept 5% inflation rates
as ftnon-inf lationary". Qui te seriously, rathe r than be labour the semantics, we
can only say that mincing words is one thing but mixing numbers is quite another.

THE EFFECTS OF PAST EXCESSES WEAR NEW CLOTHES

As our readers know, we have often expressed our disagreement with the euphoria
that has enervated markets. An old rule of thumb states that the length and
severity of any recession depends largely on the magnitude of the economic and .
financial maladjustments and imbalances which developed during the preceding
boom. The implications of this venerable rule directly counter
current thinking. :,:J
Rather than proving the case for a
suspended sta.te of perpetual economic
_
'~l

j
{~.
:11
 3

o
prosperity, the longer excesses are tolerated and the more protracted imbalances
become, the more wrenching the experience is likely to be when the pendulum again
pulls back to equilibrium.

Every recession has its ultimate or1g1n in the financial excesses that occur in
the preceding boom. The cause can invariably be traced to one thing and one
thing only: credit excesses. As always, credit is allowed to expand out of
proportion to available savings. In the first place, excess credit creation
always means excessive debt accumulation. But, its effect on the economy may
take many different forms. The specific effects depend on where the inflated
money supply is spent in the first
place... whether that may be securities~ real
assets. consumer goods, government largesse ( ie bUdget defici ts), wages,
.

imported goods or whatever else.

THE DIFFERENT FACES OF INFLATION

As a
result, inflation can have very different manifestations and channels. At
the centre of the 1970s inflation was an over-expansion of credit for investment
purposes (mainly real estate). As the economies overheated,
it set in motion
the well-known inflation spiral which culminated in a widespread and highly
visible rise in "general price levels".

The inflation of the 19805 went into a totally different channel. Due to the
fact ,that Japan, Germany and other countries pursued more restrictive monetary
0-:-....."> policies, the credit excesses in the United States and other countries translated
,
"

largely into soaring imports and gaping trade imbalances instead of venting its
forces mainly on domestic "price levels". The release valve of trade deficits
(or the export of excess dollars resulting from high credit growth) funnels
dollars into international hands. These funds then flow back in the form of
foreign stock and bond purchases, takeovers, interbank credits, t1euroll
deposits... etc.
By the way, when one thinks of it, isn't this mechanism a marvellous wealth-
creating devise. Foreigners not only deliver the trade goods but also contribute
to the illusion of wealth through asset price inflation.

Unfortunately, the juicy apple has a few worms and the golden goose is liable
to some fatigue. There are at least three parasites that threaten to hasten the
apple's fall: firstly, excessive debt accumulation; second, overvaluation of
real assets (real' estate, stock, bonds) that also, not co-incidentally,
collateralizes much debt; and third, the invidious effect of capital consumption
as the combination of high interest rates and high exchange rates tends to raise
consumption at the expense of investment.

THE HOST CRITICAL QUESTIONS ARE HARDLY DISCUSSED

Not by accident, all countries with large current-account deficits and high
ínterest rates the same disease eroding the foundations of their long-term
show
economic strength: exceptionally high levels of consumption, sharply lower net
.::"'-' savings and net investment rates. and asset-price inflation all as an outflow
-

'\..
.
of their domestic credit and debt excesses. While asset-price inflation creates
tremendous paper wealth (further stimulating the consumer through the wealth
effects) the productive base of these countries lags.
 4

Most North American economists conclude that the U.S. current-account deficit
')
is 11sustainable" for several years at least because foreign investors would be
only too willing to provide financing indefinitely. But, sustainability is not
necessarily the same as desirability.

In the trample of the eagerness to prove the former theories, forgotten are two
far more important issues: firstly, the ongoing consequences of persistently
large external deficits for monetary policy~ interest rates and financial market
conditions in the longer terms; and secondly, the long-term implications of
overconsumption, under-saving and under-investment for future economic growth
potential, wealth and living standards.

THE FORGOTTEN SUPPLY SIDE

Many economists seem to think that drawing on foreign savings is an acceptable

and fortuitous substitute for deficient domestic savings and one that happily
allows them to eat their cake and have it too. But, contrary to widespread
opinion~ the reinforcement of foreign savings by no means avoids a "crowding
out".

Just as with the inflationary pressures of excessive credit growth., tfcrowding

out11simply finds a different channel of expression. If a country relies heavily
on foreign capital inflows, its overall balance of payments still has to balance,
and that implies that it has to develop a corresponding current-account deficit.
Imports have to exceed exports. Consequently, to the extent that a country uses f)"-.-'
foreign s~vings, it crowds out its own export and import-competing industries. It,~ '..

The Corporate Sector Pays Now......The basic point is that the high interest
rates and high exchange rates squeeze the corporate sector primarily foreign
-

trade and the investment -

while the consumer reaps substantial benefits in the

form of cheap imports and positive wealth effects attributable to large capital
imports.

The Consumer Pays Later. Obviously, however, all these benefits to the consumer
can only be temporary and short-run. Over time, the consumer inevitably has to
pay for these benefits through rising unemployment and.falling living standards
as falling investment ratios undermine future productivity.

The economic damage occurs because the price system more precisely the
-

combination of high interest rates and high exchange rates diverts resources
-

away from investment toward consumption. Lower investment means lo~er growth
of the capital stock which, in turn, is sure to precipitate a shortfall in
productivity growth and with it,
a
deterioration in the relative standard of
living.
Anybody who studied financial history knows that bombastic international
has
borrowing binges (or lending orgies) have always ended in ignominious disaster.
Why? Because they have mostly been the accessory to excess consumption. It
happened to the developing nations (LDC's) during recent decades, also during
the 19205, and it is happening now to the countries of United States, Canada,
Australia, Britain and others. .
 5
'J
A SOBERING ADMONITION FROM THE PAST. ITffS ALL HAPPENED BEFORE.

A famous economist, Joseph Schumpeter, once remarked about one-time huge capital
flows into Germany as follows. His description of that earlier situation is
chillingly familiar and merits careful attention.

"The effects of these capital imports are clear: not only were adjustments
prevented~ but the pulse of German business became dependent on the rate
of flow of foreign funds; with foreign banks financing a considerable part
of investment and current spending in Germany, the policy of the central
bank was checkmated; the consumption-boom was powerfully propelled; and
of course, a financial situation was created that was in constant danger
of collapse on comparatively small provocation. ...Thus, part of the
foreign credits effected precisely what an issue of greenbacks might have
done; in a sense, the foreign credits camouflaged "inflation" by producing
its results under the surface of an apparently very "sound" monetary
system. tl

Quite simply, the shoe fits perfectly. It is clear that large capital inflows
are grossly counterproductive. Not only do they checkmate a
tight monetary
policy, they also diminish domestic savings by boosting consumption while all
the while eroding financial stability.

The whole phenomenon of the cumulative damages, excesses and industrial

:.fO.'.'"..
.

t
maladjustments that are being embedded in the economies of countries as a result
of credit excesses and large external deficits deserves a much closer look.
However, we should first review another important situation: that of worldwide
cyclical and monetary trends.

INTERNATIONAL ECONOMIRS PARTING COMPANY

After a
year of uniformly strong economic growth, the global pattern has begun
to diverge. While buoyant growth continues in Germany and Japan, a significant
slowdown has developed in the United States and Britain. Furthermore, all signs
point to continued (if not progressive) weakening in the United States, just as
in Britain. But, while market opinion has already turned highly critical on both
the British economy and economic policy, the opinion about the u.s. economy
remains remarkably optimistic despite the first sounds of knocking knees in some
quarters.
To be honest, it has
always been our contention that in an environment of a
weakening economy the Federal Reserve would quickly capitulate and loosen the
money spigots. Recent Fed actions have certainly met our expectations. However,
the speed at which the reaction took place in itself is bewildering.

EVIDENCE FOR SLOWING INFLATION IS STILL INCONCLUSIVE

Both Wall Street and the Fed seem to be quick to grab any flimsy evidence that
inflation is moderating. Week after week, rising inflation rates are
''','
1'. .;".
systematically belittled by pointing to the above-average price increases in oil
'\.
"
and farm prices.
~

In reality~ without the optimistic eye-shades, the inflation picture looks much
worse than most people think. Against a
year ago, the consumer price index has
 6

risen 5.4%. But during the three months ended May 1989, the index rose at a
seasonally adjusted annual rate of 7.1%. To say that this is mainly due to a
surge in oil and food prices is a gross overstatement. The truth is that one
large component housing
-

is keeping the index artificially low.

-

42%
of the index and shows a very modest rise of 3.7%
Housing accounts for
against year ago and an annualized 3.3% over the last three months.
a This
measure covers all housing costs including fuel. On the other hand, motor fuel,
which has risen in price by 18% has a weight of 3% in the index.

TRIALS FOR TIlE FED

As for the U.S. no doubt, a great plus was the anti-inflationary

dollar,
credibility of Mr.
Greenspan and the Fed. But we have always stressed that it
is easy to gain credibility when a strong economy demands higher interest rates.
The true test for the resolve of a central bank always comes at the end of a
cyclical upswing ~hen the economy weakens while inflation still rises.
At long last, the Fed is now facing the classical late-cycle dilemma where it
has to choose between further curbing an inflation that is running at its fastest
pace in this expansion or trying to revive the economy. Given the almost panicky
reaction of the Fed to the first signs of an economic weakening even though
employment is still rising by about 200,000 per month, one has to wonder how
long it will take the bank to lose its anti-inflation creditability. As in the
past, and contrary to the well publicized protestations, the Fed obviously
prefers to err on the side of accommodation though the economy is still near full
employment of labour and capital.

After cyclical upswings in its history one should think that

one of the longest
the two or three quarters of zero growth in stride.
Americans could take But,
it isn1t only American politicians that seem to have a
pathological fear of
anything that might be called a recession.

It is true, though, that recent economic data look pretty bad generally. To us
that is little surprise. We had picked up the scent of a slowing economy much
earlier in the year still fretting over the perception of an
even as most were
over-heating economy. housing starts are at their lowest level since 1982.
Now~
Retail sales volume are no higher than a year ago, even less on a real per capita
basis. Auto sales have slumped and last but not least, new orders cast a dismal
pall over future production prospects. Total orders of all manufacturing
industries are up by 7.8% against a year ago. Orders for capital goods, excluding
aircraft, are a mere 4.5% higher. After adjusting for inflatíon~ that speaks
of zero gain for activity.

Judging from these fast fading figures it may appear that the u.s. economy is
headed for a recession as early as the next quarter, let alone next year.
However~ it should be remembered that all these weak data relates to
manufacturing industries which account for no more than 22% of u.s. GNP and only
18%
of total employment. About 75% of GNP and almost 80% of employment is in
services which includes fairly substantial expenditure items that increase C:.-.'.
_.-.

automatically like medical care, housing~ transportation~ etc. .-:

 7

FORECAST A LA CART~. MOST STILL PREFER THEM SOFT AND OVER EASY.

Presently, Wall Street gurus are offering three different scenarios: first, the
Fed will engineer slower growth while avoiding recession (soft landing); second,
there will be slow or no growth but with inflation staying on the high side
(stagflation); and third, a desperate monetary easing and plunging interest rates
produce a new inflationary burst of economic growth followed by a recession in
1990 as the Fed is finally forced to extinguish rampant inflation.

So the soft-landing camp is still dominant, manifesting itself in an ultra-

far,
bullish bond market. In our view, the soft land~ng is the one scenario that's
almost impossible. Although aware of the high risk of recession, we have always
leaned towards the second scenario of stagflation. However~ the quick easing
by the Fed and the overreaction of the markets in pushing long-term bond yields
sharply down to barely 8% has increased our anxiety. There might now be a
greater chance for the third scenario...a "dash-smashu scenario.
DANGERS OF A RECESS ION ARE THREE

At the moment what we see in the United States is the n~rmal cyclical weakening
at the end of a boom. That in itself~ of course, would not normally be cause for
much concern. But this time, it isn't just a few notable thinkers who suspect
that there possibly might be some lurking potential dangers that could leap out
of the deep should ever a recession ensue.
-\
-~ The way we see it, there are at least three serious hazards that compound the
risks of any recession. Firstly, as is well known and feared, a recession is
sure to collide with a tidal wave of debt that spans all three major sectors:
government, corporate and consumer.

The second hazard is the longer-running effects of the I1hollowing-out" of the

U.S. economy on the supply side caused through over-consumption~ under-investment
and under-savings. What that means is seriously impaired productivity which will
ultimately translate into lower income growth and reduced debt quality.

The third element that should not be overlooked is the increasing fragility of
the financial system. Certainly, the Saving and Loans (S&L's) may be the weakest
link but by no means the only fragile link. One might remember Schumpeterts
statement regarding foreign capital inflows we quoted earlier: tt... (that)
a

financial system was created that was in constant danger of collapse on

comparatively small provocation... ". Psychology and confidence plays a very
large ro Ie.

BACK TO THE SUPPLY SIDE. IT HAY COMPOUND THE CYCLICAL.

Apparently, one cannot forewarn often enough about what may lie at the root of
the chronic malaise that threatens the United States economy. The combination
of over-indebtedness, over-consumption, grossly inadequate savings and
investment, (which in turn contributes to poor productivity growth) is a serious
long-term problem of great dimensions. Recognition of those dangerous
I) deficiencies, after all, prompted the heralded goals and remedies of Reaganomics.
Despite good intentions~ but paradoxically because of Reaganomics, U.S. savings
sank to the lowest ebb ever during peacetime as well as the lowest levels in the
industrial world (with the possible exception of Britain).
 8

The point to recognize is that the longer-run may already be rapidly becoming
a
short-run issue. That is why we are forced to reckon with the possibility the
possibility of a long arid severe recession.
DEEP IMPACT ON PRODUCTION ECONOMIES

During the present recovery~ U.S. net investment has averaged barely 5% of GNP,
nearly two percentage points below the postwar average. But what makes this
decline a disaster is the fact that all of the shrinkage occurred in the business
sector and mainly manufacturing at that. In fact, net manufacturing investment
showed no increase from 1982 through 1987 despite the boom. As a result, the
amount of capital per worker in both the whole economy and the manufacturing
sector has been essentially flat. If investment had continued to advance at the
trend rate of the 1968-82 period~ capital per worker in the manufacturing sector
would now be about 25% higher.

Another Rxample of Supply-Side Folly. The other major country where manufacturing
growth and investment proves an unmitigated disaster is Britain. While British
manufacturing is supposed to have achieved a t1productivity miraclell, it has
suffered a calamitous reduction in size. Manufacturing output only recovered
its 1979 level in 1987 and fixed investment in manufacturing has only just
reached its pre-1979 level in real terms. What explains most of the productivity
miracle is that more old plant was scrapped as it wore out or became uneconomic.
So, net investment has been negative for most of the 1980s. Manufacturers stock
of productive assets, factories plant and machinery fell from 48% of GNP in 1979
t

to 38% in 1987. Employment in manufacturing shrank even faster than the capital
stock -

from around 8 million in 1979 to under 5 million in 1988.

THE CONTINUING SUPPLY-SIDß IMPLICATIONS FOR TRADE DRFICITS

Dollar-bulls like to tell us that U.S. labour costs in manufacturing are now well
below those of
major competitor countries. That may be true. But the key
condition for the longer-term improvement of the u.s. trade account is that a
favourable cost position is backed up by sufficient capacity growth to
acconnnodate higher exports and increasing import-substitution. Blatantly
however, that process is not at work.

At any rate, trade adjustment has generally stalled. In most cases, imbalances
are deteriorating again partly due to shifts in net interest income implied by
the widening external asset positions. While the adjustment of the U.S. deficit
has continued as the growth of domestic demand has sharply slowed, even the most
optimistic projections put next year's current account deficit no lower than $115
billion. By contrast, West Germany's current account surplus during the first
five months of the year amounted to DM 45.6 billion versus only DM 32.3 billion
the same period last year, and still German export orders are surging at double-
digit rates. u.s. export orders~ on the other hand according to the nationts
-

purchasing managers are at -

the lowest reading since the index was initiated

in January 1988.

THE DEMAND FOR DOLLAR ASSETS

.
Given the persístence of large trade (even growíng) imbalances the key question
now becomes whether investors and central authorities in surplus countries will

~,;:ir.r;;.. ~

~. .

.*4iø!i~Y
 9

continue to finance these deficits at present exchange rates. Gauging from the
splendid performance~ of all the high-yielding currencies it appears market
opinion reflects little concern.

As usual, many economists eagerly provide kinds all of pandering theories that
support particularly concerning the
and foster an air of sanguine complacency,
U.S. economy and currency.
A
popular postulation is that world investors are so
hungry for dollar-assets that the U.5. currency will rise even in spite of
persistent current account deficits greater than $100 billion over coming years.

Obviously~ many have forgotten that it was as recently as 1987 that the entire
had to be financed by the dollar purchases of foreign
U.S. external deficit
voluntary
private and investors were no where to be seen.
central banks because
Even after the stabilizing Louvre Accord of February 1987 it took more than
a

bank interventions (amounting to more than $100

full year of massive central
billion) and a concurrent sharp rise in u.s. interest rates to restore confidence
in the u.s. dollar and coax back private lenders and investors into dollar
markets.

But triumph gained by central authorities

the in convincing markets of their
a new problem.
ability to successfully defend currencies unintentionally created
With the promise of exchange rate stability~ the high nominal interest rates of
the deficit countries became irresistible. Capital from low-yielding, hard-
currency countries began to flood high-yielding countries with little regard for
inflation and gapping external balances.
We quote from our April letter: "..given the fact that deficit countries have
high interest rates and that surplus countries have low interest rates, this
artificial exchange rate stabilization essentially ends with the perverse effect
that currencies move contrary to their underlying fundamentals. As capital flows
are powerfully lured by the siren call of high interest rates even to the point -

of overwhelming trade deficits the currencies

-
of these countries appreciate.
Meanwhile~ the low-yielding currencies of surplus countries depreciate intf
complete disdain of what would otherwise be considered attractive fundamentals.

THE ROLE AND MECHANISM OF mE CURRENCY BLOCKS

We pointing out, of course, that the U.S. dollar hasntt been the only
keep
beneficiary of this new currency regime. Lenders and investors from hard-
currency countries have bought high-yielding currencies almost indiscriminately.
What is happening has no parallel in history: that countries with ever increasing
external deficits attract ever increasing foreign capital and experience ever
increasing currencies.
the
The rise of these currencies reveals that capital inflows greatly exceed
some
financing requirements of their current-account deficits. As consequence,
a

banks did intervene by selling their own currency mainly against

-
the
central
to restrain the rise of their own currencies. In other words, they
U.S. dollar
-

too bought and accumulated large amounts of dollars.

) This brings us to an important point of distinction between the high-yielding

currencies: that is to which currency bloc they are linked to the dollar-bloc
-

or the D-Mark bloc. For bond investors that will be the most important question
since the currencies of each bloc will tend to rise and fall together.
 10
"

}
Let us first take
look at the dollar bloc. For international bond investors
a

the big play has been in three markets: the United States, Canada~ and
Australia.
In 1988~ net foreign private purchases of u.s. bonds totalled about $72 billion.
In addition~ foreign central banks increased their holdings of U.S. Treasury
paper by $39 billion. In the case of Canada~ net foreign purchases of fixed
income instruments amounted to approximately $19 billion~ proportionately
probably even higher that U.S. levels. Flows of similar magnitude went into
Australian bonds yielding 13 to 14%.

If one wishes to stay ahead of the next major movement in the currency and
financial markets it is essential that one becomes familiar with the mechanism
that ties the dollar-bloc currencies. That's because if they fall they will tend
to fall in a domino-like fashion. This link is caused by the two functions of
the U.S. dollar (as we've one explained before in an earlier letter):
firstly,
its intermediary role in cross-trading between other currencies (especially
between the two major blocs), and secondly~ from its employ as the predominant
international reserve currency.

The intermediary role arises from the" fact that all trading between different
currencies outside of the European Monetary System (EMS) is carried out through
the intermediary conduit of the U.S. dollar. For example~ when a German investor
buys Canadian bonds, his bank will first turn his D-Mark funds into U4S. dollars,
which it then uses to buy Canadian dollars.

Though the U.S. the dollar base is not affected directly by this transaction,
the result is that the u.s. dollar tends to weaken against Canadian dollars and )
at the same time strengthen against the D-mark. The offset is that the Canadian
central bank has~ in turn~ bought U.S. dollars. This same process applies to a
number of other central banks~ among them the Bank of England, who all have been
heavy buyers of U.S. dollars adding to its strength.

The point to see is that this mechanism is liable to cut both ways. If anyone
of the dollar-bloc countries faces an attack on its currency its central bank
will be sure to dump dollars and may very likely cause" dollars to be dumped
against hard-currencies.

SUMMARY CONCLUSIONS

For now, financial markets are buoyed by the hope for a further Fed easing. There
is just one problem with this euphoria. Financial markets seem to have forgotten
that they exist within an interlinked global economy and that everythíng- will
depend on the willingness of voluntary foreign investors.

The consensus view that

softening of the U.S. economy with attendant falling
a

interest rates will capital inflows untouched is incredibly naive.

leave
Experience says that foreign investors will take flight because they have always
associated falling interest rates with a falling currency.
The dollar-DM relationship has always been influenced by two reciprocating
cycles: that of the capital account and the trade account. The pro-cyclical U:i' "

influences of the capital account tend to dwarf the counter-cyclical trend of "~-
,"

the trade accounts and thus tends to be the dominating influence on exchange rate "'~

movements. Thus to conclude that a slowing economy with attendant lower import
 11

levels will not negatively influence the u.s. dollar is patently ridiculous.

One last point regarding the plight of monetary policy that deficit-countries
face during a recession. Here history serves up a host of lessons and examples.
The dilemma begins when capital inflows weaken and bring down high-flying
exchange rates thus triggering a
"vicious eye leu of higher inf lation, lower
confidence and sagging currencies. Central banks then become prisoners of their
currencies and are forced to place a high priority on exch~nge rate
stabilization. Invariably what that means is high interest rates even as the
economy slows.

As a
rule, banks of countries with large current account deficits have
central
to raise their interest rates to hold and attract foreign capital. Presently,
now that the speculative euphoria stages have receded, we see that relationship
at work in at least three countries: Britain, Australia and New Zealand. The
trouble is that interest rate increases (as we discussed at length in the last
letter) tend to have little impact from a
position of weakness. All three
countries now face ~ky-high interest rates primarily to prevent further weakening
currencies.
Of these, New Zealand is the most advanced. The country has been in a deep
recession since 1987 and yet inflation is still at 6%. And just to maintain a
stable currency, the country faces interest rates in the 12-13% range.
As as the U.S. dollar is concerned,
far market sentiment has not yet really
turned bearish because most people still cling to the hope of a "soft landing1t.
The critical phase for the U.S. dollar will begin when the alarms bells of an
economy sliding into recession begin tolling and confidence in the Fed and the
fundamental health of the economy begins to wane. It is then that we shall see
new lows against the D-Mark bloc currencies.

We find it most interesting to note that the Itsoft landing" ideology is gal.n1ng
its greatest amount of converts on the strength of evidence pointing to an
economy that is generally weaker than is expected.

Let us state one point, explicitly and categorically: the soft landing scenario
is virtually impossible. Large external deficits that reflect overconsumption
and over-borrowing are the surest recipe, not only for recession, but for the
long-term economic decline of a
country.

Analyzing cyclical forces as well as economic and financial fundamentals for the
major countries~ we have come to the conclusion that 1990 will very likely be
the year for the whole D-Mark bloc. Continental Europe is booming, pulled by
the locomotive of the German economy. The crucial point of difference to
remember in any comparison to the notorious deficit countries is that the
European boom is fed primarily by investment and takes place against a backdrop
of low inflation. Continental Europe has achieved an economic composition of
stability and low inflation unequalled since the 1960s.
1990
Among markets, our choice for the second half of 1989 and
international bond
) would be the D-Mark-bloc markets. As ever, the policies of the Bundesbank remains
the key to all the European markets. There is no danger of a major monetary
tightening. The last raise in the discount rate actually buoyed the German bond
 12
.<~)
market. At same time, we would also expect that the Bundesbank will not match
any easing by the Fed.

Within the D-Mark bloc, we suggest that the prudent investor would choose between
German, Dutch, and French bonds. Dutch government bonds yield a more than little
German government bonds while French bonds- appear-as the safest high-yield within
the group, now effectively yielding 8.7% against 6.8% on German bonds and 7.2%
on Dutch bonds.

We have to admit that the timing of future events is more difficult to predict
than ever. Excesses as large as they may be
-

can persist as long as there

-

are oblivious and compliant players. The fact that credit excesses have taken
on the image of trade deficits rather than the more familiar effect of domestic
price .inf lation fosters false optimism and camp lacency. Mas t
certainl y., an
accident of some kind will be required to jolt people back to a
sense of reality.
All the same, we must stress that there are enormous risks building up -

certainly more than most perceive. The world economy is out of balance as never
before.

\.
)

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