Friday, October 09, 2009

The Third-World way of asset allocation

David Malpass posits some interesting comments about the relation between a weak currency, particularly in this case the US dollar, and the prosperity of a nation in a WSJ column today.

Malpass was formerly the Chief Global Economist for Bear Stearns, who has done stints in both Reagan's and Bush I's administrations. In short, he's someone with much greater knowledge and experience in these matters than Guambat by lightyears.

Says he,
The Weak-Dollar Threat to Prosperity.

On the surface, the weak dollar may not look so bad, especially for Wall Street. Gold, oil, the euro and equities are all rising as much as the dollar declines. They stay even in value terms and create lots of trading volume. And high unemployment keeps the Fed on hold, so anyone with extra dollars or the connections to borrow dollars wins by buying nondollar assets.

Investors have been playing this weak-dollar trade for years, diverting more and more dollars into commodities, foreign currencies and foreign stock markets. This is the Third-World way of asset allocation.

Corporations play this game for bigger stakes, borrowing billions in dollars to expand their foreign businesses. As the pound slid in the 1950s and '60s and the British Empire crumbled, the corporations that prospered were the ones that borrowed pounds aggressively in order to expand abroad.

If stocks double but the dollar loses half its value, who beyond Wall Street are the winners and losers? There's been a clear demonstration this decade. The S&P nearly doubled from 2003 through 2007. Those who borrowed to buy won big-time. Rich people got richer, seeing their equity bottom line double. At the same time, the dollar's value was cut nearly in half versus the euro and other stable measures. Capital fled, undercutting job growth. Rent, gasoline and food prices rose more than wages.

Equity gains provide cold comfort when currencies crash.

A better approach would start with President Barack Obama rejecting the Bush administration's weak-dollar policy.

Guambat was intrigued by the analysis, mainly because Guambat is easily impressed, but more so because it had escaped Guambat's attention that Bush even had a weak dollar policy. All Guambat recalled was Hank Paulson's insistence on a strong dollar policy.

But, then, sure enough, right back there in the start of that 2003 through 2007 period Malpass mentioned, there is Bruce Bartlett in the National Review warning of just such a calamity:
Bush and the Buck, December 8, 2003

One of the reasons why presidential administrations fail is that they often fall victim to the law of unintended consequences.

Unfortunately, the Bush administration is in danger of making the same mistake with respect to the dollar. Having become obsessed with the trade deficit, it is looking for other ways to reduce imports and raise exports. One way of doing this is to reduce the value of the dollar on foreign exchange markets. A lower dollar makes imports more expensive and exports cheaper in terms of foreign currencies.

The problem is that this process is not taking place on its own, nor is it cost-free. The Treasury Department has been signaling for some time that it would not be displeased if the dollar fell. This sort of "benign neglect" can be as effective as direct action in foreign currency markets, such as having the Treasury sell dollars. When currency traders know that we won't defend our currency, they take advantage of it by selling dollars against other currencies. That is a key reason why the dollar has fallen sharply against the euro and is now at a record low.

Another effect of this weak-dollar policy became evident in recent days when the OPEC oil cartel indicated that it might raise prices to compensate for the falling dollar.

Although the signs are nascent, they indicate that inflation is starting to show its ugly head again, the result of an extremely easy Fed policy over the last three years. Sensitive commodity prices like gold are up, the dollar is down, and OPEC is again complaining about lost purchasing power. It's like déjà vu all over again.
All interesting, but Guambat's hind leg is furiously scratching his head trying to remember any rampant inflation since 2003. Apart from stocks and real estate and commodities, there was no particular inflation, leastwise, of the sort the CPI measures.

Was there something else, then, that led to the rich getting richer and wages not keeping pace with goods, as Malpass pointed out? Is a weak dollar the cause or coincidence of that condition, or nothing more than a furhpy?

Maybe; just maybe. This is what Malpass had to say (also in the National Review) back at the start of that period, 2003, when things just started going out of control according to his current write.
Tax-Cut Scorecard, It’s not all Bush asked for, but it will add materially to economic growth, May 23, 2003

President Bush met with House and Senate leaders on Monday and urged them to finish the tax cut this week. Final negotiations took place Wednesday with Vice President Cheney. The tax-cut bill should be signed into law by the president around Memorial Day.

So how does it stack up? The final bill is not all that Bush asked for, but it will add materially to economic growth and equity values.

Important growth provisions include the acceleration of the already-scheduled income-tax cuts, a cut in the long-term capital gains tax rate to 15 percent, a cut in the dividend tax rate to 15 percent, and an expansion of the expensing of business-equipment purchases.

Unlike the president's original proposal, the final deal reduces dividend taxes to 15 percent rather than zero percent and does not include the "deemed dividend" concept or basis step-up. As a result, it won't be as beneficial to share values or the U.S. corporate capital structure as the president's original proposal.

A rough estimate is that the tax cut will add at least $600 billion (or 5%) to U.S. equity market capitalization.
Guambat notes the DJIA peaked in November 2007 at just over 14,000 from a low in March 2003 (coincidentally anticipating the tax cuts in May mentioned by Malpass?) of just under 7500. A bit more than a mere 5% addition to the equity market capitalization, shall we say? Either that estimate was made by someone purposefully low-balling for political purposes, or incompetent.

Malpass, today, blames it all on a weak dollar policy. The Third World way of asset allocation, he says.

Guambat sort of suspects it is all the result of a First World way of asset allocation, by way of wealth distribution through taxation of ordinary incomes while alleviating taxation of gains from capital assets. Asset allocation is one thing, but the prosperity of a nation is another.

FOLLOW-UP: Reading some of the past blog comments about Malpass, Guambat noticed that he has regularly been pilloried for his views, such as this from Barry Ritholtz a few years back, as well as this : "I really don't like to single out any one firm or strategist for excessive criticism -- hey, we're all wrong on quite a regular basis. But, goddamn, if Bear Stearn's David Malpass hasn't been on the wrong side of more than a few major issues facing the economy over the past few years."

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