Emerging Markets – Caught in the Crossfire

US monetary policy has missed its mark and it is a handful of emerging markets that look set to pay the price

The big guns of monetary policy used to combat sluggish economic growth are about to be put away but the real damage may be just about to kick in.  The Federal Reserve adopted loose monetary policy to get the US economy moving again but it is elsewhere where the effects have been felt the most.  Having benefited more from the loose monetary policy than the intended target, some emerging markets look set to suffer as a policy reversal prompts US investors to stage a destructive retreat back home.

Danger zone

The proverbial printing presses at central banks are like the heavy artillery of monetary policy.  Central banks such as the Federal Reserve had been pumping out cash to buy bonds as part of quantitative easing.  Yet, the US economy had failed to fire up with companies unwilling to invest while spending remains weak.  Investors with cash in hand turned their sights overseas and targeted emerging markets where economic growth was still perky. 

The surplus US dollars helped to lower interest rates for borrowers in many countries which had not gotten caught up in the global financial crisis.  The reduced borrowing costs pushed up lending elsewhere despite not having the same effects in the US economy.  The muted effects of monetary policy in the domestic economy prompted the Federal Reserve to unleash even more firepower.  Money, like some things, is fine in moderation but the bombardment of US dollars inadvertently created its own minefield. 

Borrowers in emerging market were only given access to cheap cash by borrowing in US dollars for a short period of time.  This was fine as long as the prospects for the US economy were poor and US dollars were readily available.  But any significant improvement in the US economy would see investors shift their money back.  A stronger US economy would also push up the value of the US dollar and make it tougher for overseas borrowers to pay off any debts in US dollars. 

Collateral damage

Like solider stationed in a hostile region, investors were set up to bail when the opportunity arose.  Just the mere mention by the Federal Reserve in May 2013 that quantitative easing might be coming to an end was enough to trigger a rush by investors to get their money out.  Six months of market volatility followed even though quantitative easing did not actually end until October 2014.  With the Federal Reserve now mulling lifting interest rates up from their low levels, more upheaval seems likely.

This is because money often does more damage on the way out compared to the gains when it is initially welcomed.  Yet, the lure of cheap cash is too much to ignore.  Even the financial sectors in richer countries have shown themselves to be unable to cope when too much money is on offer.  Less developed banking systems in emerging markets are often even worse at putting any cash to good use.  This increases the likelihood that many borrowers will struggle when US dollars are harder to come by. 

As the aftermath of the global financial crisis has made painfully clear, a swift end to a lending boom is not something easy to get over.  In its attempts to deal with an US economy sagging under the weight of excess debt, the Federal Reserve has inflicted the same woes on others who are less able to deal with the consequences.  Like any form of warfare, it is the innocent victims that suffer the most.

Inflation – Hard to ignore again

Low inflation is a nuisance for central banks looking to increase interest rates but they would be wrong to dismiss it

Family get-togethers over Christmas often involve naughty children but it is inflation that is making trouble for central banks.  Inflation unexpectedly shot up in the aftermath of the global financial crisis but is now surprisingly falling despite a burgeoning economic recovery.  Central banks ignored the jump in inflation in 2011 and are now stuck figuring out how to deal with persistently low inflation.  The antics of inflation will be difficult to disregard a second time around considering that the causes for static prices are not all external.

Inflation acting up

The level of inflation is used as a measure to check whether all is well with the economy.  There should neither be too much inflation (suggesting an overheating economy) nor too little (which is a sign of weak overall demand).  With countries increasing sourcing goods from overseas, prices levels in any country can be influenced by prices of commodities on global markets.  This can push inflation in a different direction to the particular circumstances of any economy.

The best recent example of this was a plague of high inflation in 2011 when the economies of many countries were still in the doldrums.  The Chinese economy was still humming along despite financial turmoil elsewhere and China continued to buy up commodities on the global markets.  The result higher prices were most prominent in the UK where inflation topped five percent in 2011.  This bout of inflation was not just a brief spike with prices rising by more than four percent for over a year.  Despite inflation being well above its target of two percent, the Bank of England maintained its loose monetary policy to support the weak economy.  The argument behind this was that the inflation was temporary and not related to the underlying economy. 

Behaving badly again

Inflation is currently misbehaving in a different way and is causing concern due to being too low.  Prices are not rising by much due to lower commodity prices with the spurt of growth in emerging countries having run its course.  While this is a positive for consumers who benefit from a boost in spending power, low inflation is a source of anxiety for central banks.  The Federal Reserve and the Bank of England are getting set to increase interest rates to more normal levels.  Even the prospect of the economic recovery gaining further momentum would not provide central banks with enough of a reason for higher interest rates when inflation is around one percent. 

This irritation is not likely to go away anytime soon if the high inflation in 2011 is any guide.  Inflation is likely to slip even lower in 2015 as the effects of the plunging price for oil feeds through into the economy.  On top of this, swings in commodity prices tend to last for a few years so that inflation is unlikely to pick up for the next couple of years.  This would suggest that inflation will be below target for 2015 and 2016 which is the two-year time frame that central banks look at when deciding interest rates. 

Ignoring inflation would be naughty

Low inflation should imply low interest rates but central banks could choose to ignore this and raise interest rates away.  This is because the same argument as in 2011 could be applied – disregarding trends in inflation that are attributed to outside sources.  It is a convenient strategy for central banks worried about the economic recovery triggering a jump in inflation due to the potential for wages to rise as unemployment falls.  Such an outcome does seem optimistic considering that wages are not budging by much even as the economy picks up steam.

A further problem with turning a blind eye to inflation is that it is tough to gauge what the inflation level would be without the fall in commodity prices.  It is not as if consumers have money to spurge having been stuck with stagnating wages and considerable debts from the pre-financial crisis spend-up.  Sluggish prices are harder to dismiss considering that low inflation is also caused by weak domestic demand.  With inflation likely to continue to play up for a while yet, central banks will need to be patient and bide their time before raising interest rates or else it will be the central banks that may be the ones getting into trouble.

Bargain Low Interest Rates to Continue in 2015

Borrowing is likely to stay cheap in 2015 as a drop in inflation puts pay to talk of higher interest rates

Christmas is usually followed by a rush off to the sales but borrowers need not hurry as cut-price loans are likely to remain for most, if not all, of 2015.  Acting like retailers with surplus stock to sell after Christmas, central banks slashed interest rates after the global financial crisis.  Six years later, there are growing calls for this to be reversed in countries such as the US and the UK due to as a strengthening economic recovery backed by more people finding jobs.  Yet, plans for higher interest rates have been way laid with falling inflation suggesting that all is not well with the economy.  With unemployment and inflation likely to fall further in 2015, there seems to be few reasons for any changes to be made to interest rates over the next 12 months.

Shopping around

The Federal Reserve and the Bank of England are in the midst of a dilemma – like a shopper not sure of where to head first to snap up some bargains after Christmas.  Unemployment data suggests that the economic recovery is becoming more entrenched with the proportion of Americans and Brits without jobs now below 6%.  Yet, despite more workers being hired, companies are still holding back from investing to expand output.  Aggregate demand is also suffering due to cuts to government spending resulting in an economic recovery that is still patchy.

If the stuttering economy is giving central banks reason to worry, it is inflation that is the real sticking point getting in the way of higher interest rates.  The extent at which prices are rising (or falling) has been adopted by central banks as a gauge for the health of the economy.  It is thus a point of frustration that inflation is heading downward as other signs, such as lower unemployment, suggest that the economy is picking up.  These mixed signals from the economy mean that Federal Reserve and the Bank of England are caught in two minds in terms of what do to with interest rates.

Best to stay put

Things are not likely to get any easier for central banks considering that the trends in unemployment and inflation are not likely to change any time soon.  With companies not yet willing to spend big on new equipment, it makes sense to employ more workers (who are relatively cheap) to get things done.  Lower commodity prices is the main cause behind falling inflation and a rebound in commodity markets is not likely as shifts in demand and supply of commodities taking years to change.  Neither are consumers in any mood for higher prices considering that wages have not kept up with inflation over the past few years. 

All this suggests that 2015 will be more of the same and interest rates are also unlikely to change.  Some will argue that interest rates need to rise to give central banks leeway to act in case of other threats to the economy.  Others will claim that the economic recovery means that inflation will be just around the corner and central banks need to pre-empt any jumps in prices.  But these are risky strategies considering that a bit of inflation in the future will do less damage to the economy than a premature hike in interest rates. 

A still fragile recovery means that, like any shopper out after Christmas, the economy could also do with a bargain (in the form of low interest rates).

US Monetary Policy – Investors face stormy future

US investors have been blessed with calm seas of late but their good luck is unlikely to last

Monetary Policy has entered a period of calm after enduring something of a turbulent passage through the global financial crisis.  The unprecedented tempest which buffeted the banking sector led central banks to trial a number of measures never seen before.  Yet, since tapering of quantitative easing was launched at the end of 2013, it has been relatively smooth sailing.  Tapering has been implemented in steady waves so as to not shake the delicate stomachs of investors.  However, rather than signalling the end of the choppy weather in the financial markets, the current lull could just be the eye of the storm.

Skies clear following predictable monetary policy

Investors prefer favourable conditions in the same way as sailors.  A view far ahead to the horizon is prized in the financial markets as well as by mariners.  One element that helps investors to better plan a course for the future is having a predictable monetary policy as a guide.  Investors had come to rely too much on the Federal Reserve as a steady hand at the helm using quantitative easing to put some wind back in the sails of the US economy.  Problems thus arose when the Federal Reserve first floated the idea of trimming back its expansive monetary policy in the middle of 2013.

What was a stiff breeze for the US hit many emerging markets like a financial hurricane.  This is because a considerable portion of the money printed in the US had travelled the globe in search of more bountiful returns.  Some developing countries had become a haven for the extra cash but the money left in a whirlwind once the prospects for returns in the US picked up.  The resulting market turbulence pushed some countries to the brink of going under, but investors eventually settled down again after adjusting to the new forecasts.

The outlook for US monetary policy has brightened considerably with the steady progression of tapering.  The Federal Reserve has cut back its purchasing of bonds by US$10 billion at each of its meetings, which happen almost every month.  As a result, bond purchases have been reduced a few times already in 2014 and fell from US$85 billion in late 2013 to US$45 billion at the most recent meeting at the end of April.  The predictability of US monetary policy also survived the potential shipwreck that was the change in skipper from Ben Bernanke to Janet Yellen at the beginning of the year.

Forecast for storms ahead

All is well for now.  However, there may be trouble on the horizon as tapering is just the start of the Federal Reserve relinquishing its role of propping up the economy.  A bigger storm may be coming next year as interest rates have to be raised from their current record low levels.  The Federal Reserve has pledged not to change interest rates for a while as it monitors the economic recovery.  Interest rate hikes must happen sometime in the next year or so especially in light of the surprising improvements in the US job market.

The end of quantitative easing and higher interest rates are all part of a voyage back to normality.  It has been a strange new world in terms of both the financial markets and monetary policy following the waves of financial havoc over the past several years.  The recent squalls that hit emerging markets can be seen as a necessary part of this journey.  Nevertheless, other rough patches may still lie ahead considering that it is far from normal for US stocks to be pushing on record highs despite slow economic growth. 

While it is tough to gauge what normal should look like in terms of the financial markets, the signs indicate that rough seas lie ahead.  Emerging markets have already taken a beating which makes it likely that the next storm may strike US investors closer to home.  

Free Trade – Missed by Many

Free trade is a route to greater prosperity and better government but its biggest advocate has retreated from its crucial role

US foreign policy was something that people loved to hate.  America was portrayed as a global bully who pushed everyone else into playing by its rules.  The Iraq War is perhaps the most obvious example of this but the conflict also marked a turning point when the US started to withdraw from its dealings with other countries.  While this might appear to be cause for rejoicing, the retreat of the US from international affairs has left a gap that has yet to be filled.  A lack of impetus in the promotion of free trade is one key area where the world is missing the US in a way that is not yet widely understood.

More than just buying and selling across borders

Free trade is something that many people would be glad to see the end of.  It allows for greater globalization which has been vilified as costing jobs and hurting our economy.  Although a source of pain for some in the West, globalization has been a boon for most of us, providing a range of cheaper goods for everything from bananas to iPhones.  At the same time, export industries in less developed countries have pulled millions out of poverty.

Openness to free trade with the rest of the world involves more than just exporting and importing.  It is part of a bigger package that includes less overall regulation and more economic freedom.  This may not seem like much to those in countries that already have this in place, but to places under the rule of an autocratic government, it is something worth fighting for.  Such a battle has dominated the news so far this year as it plays out in Ukraine.

The protests that overthrew the oppressive regime in Ukraine were triggered by the government stepping back from an EU trade agreement and instead opting for a closer relationship with Russia.  This was taken to have the broader meaning that the Ukrainian government was choosing the autocratic style of government characterised by Russia rather than the democratic freedoms of the EU.  Yet, the unrest in Ukraine shows the preference of its citizens and how opening up to trade (and expansion of the EU) can spur on hearts and minds when seen as part of a bigger picture. 

Free trade can have a positive influence in other ways as in Japan.  Political lobbyists such as farmers have tended to block greater access for imports into Japan.  Japanese politicians are apt to side with such vested interests instead of with voters in general who would benefit from cheaper imports.  In the past, it has only been pressure from outside the country - typically from its main ally, the US – that has helped open Japan up to free trade.  Delayed but critical reforms needed to fire up the Japanese economy could be pushed through if a deal were to be done on the Trans-Pacific Partnership which is a free trade zone encompassing countries on the Pacific Rim.

China can only offer so much

The fight for free trade typically needs a champion.  This is because the negative impact of greater trade is concentrated in a few sectors which are proactive in their opposition.  The gains from more open borders are, on the other hand, spread out amongst us all, resulting in only weak support.  Thus, despite the substantial advantages of free trade, progress has been halting.  The problem is exacerbated by each country having its own boisterous domestic forces against free trade so that getting a large number of governments to sign up is a tricky proposition. 

The US government had been the driving force behind free trade, using access to its own lucrative domestic economy as a bargaining piece.  Rather than being a bully, the US spread economic freedoms through trade like a benevolent power.  But, the US no longer has the ability or willingness to play this role.  A rebalancing of the global economy means that the lure of the US economy pales in comparison with other countries such as China.  The weakening of its relative economic strength also means that the US is less generous in its bargaining with other countries.  This is reflected in the stalling of what was supposed to be the next big round of global trade talks which started in Doha in 2001.

The lure of Western ideals as embodied in free trade still remains.  Countries clamber to join the European Union despite its recent troubles.  Economic power may be shifting away from the US and Europe but their democratic style of government is still sought after by many (although politicians have not been showing themselves in a good light).  Free trade in itself is not the answer but it will help push many countries in the right direction. 

Dysfunctional Politics Needs Economic Reforms

Politics typically operates like a badly run economy with unappetising choices between limited options

Current politics could be compared with the old Soviet economy – consumers frustrated due to few choices between ill-conceived products designed to fit what most people want but ultimately satisfying very few.  Replace “consumers” and “products” with “voters” and “parties” and this is an apt description of many Western democracies.  The analogy is even more appropriate in that the solution in both cases is the same – reforms to make participation easier for newcomers so as to create more competition.

How have things gone wrong?

Public perception of politicians seems worse than ever.  The aftermath of the global financial crisis has further exacerbated this.  Governments showed themselves to be inept in managing their finances before the crisis and misguided in their response to the ensuing economic slump.  Though elected to serve for the good of the country, governments often prove themselves unable or unwilling to do so.

A number of examples spring to mind.  The United States came to the brink of defaulting over its debt and almost triggered another global financial crisis due to a reluctance on the part of its politicians to compromise.  The nation states of Europe almost destroyed more than half a century of integration and spreading democracy across the continent by refusing to band together to help out the weaker EU members until the central bank stepped in.  The economic recoveries in many countries have also struggled to gain traction as government policies have been more of a hindrance than a help.

The argument could be made that this is not the Soviet Union and democracy gives us a choice of government.  But this choice is often an illusion and often times boils down to selecting the least worst option.  To take a more pessimistic view, the most common political strategy appears to be to make voters dislike the other party more than your own.  This only works when the electorate is faced with limited options as is typically the case in countries where two parties dominate.

Outflank the other party on a few key issues and the voters have no other choice but to tolerate your policies.  The UK Labour Party lost the public trust by overspending in the lead-up to the global financial crisis, thus giving the current Tory-led government a freer rein on its economic policy.  As a result, the British have been lumped with austerity despite the need for measures to boost aggregate demand.  In the US, the Tea Party has infiltrated the Republican Party making it unpalatable for most voters resulting in a second term for an Obama administration which has been slow to act and disappointing in delivering on its promises of change.  The results of the European elections in May 2014 are yet another example of how mainstream parties are failing voters.

Change is possible

An economy with such poor products on offer would collapse but our political system continues to stumble on with voters choosing to tune out instead.  Reforms more typical in economics provide an option for changing this – more competition.

One key area would be changes to the voting system.  Elections using the first-past-the-post format hamper change by ensuring a large number of safe seats for each party while preventing smaller parties from getting into power.  New political parties would shake up politics by bringing in ideas in contrast to the stale left and right divide that still dominates politics.  Coalition governments do not always work (such as in Italy), but are not a recipe for sclerosis in politics as the experiences of the UK government have shown over the past few years.

Such changes may not bring about anything as profound as the fall of the Berlin Wall, but any change from the status quo is likely to be an improvement.

Uncertainty is still the only certainty

Sometimes you come across data that seems to capture the current mood.  This was the case with a survey by an investment firm showing that 32% of wealthy investors plan to increase their holdings of cash over the next 12 months.  This change in asset allocation toward cash is strange considering some investments such as stocks are having a stellar year while returns from leaving money in the bank have been dismal.  This high level of caution shown by investors, who typically have advisers telling them where to put their money, highlights the level of uncertainty faced by those trying to invest their money.  Yet with a number of possible hiccups on the horizon, cash seems to be the least bad of a poor range of options. 

The key concern for many investors is the upcoming reduction (so-called tapering) of bond purchases by the Federal Reserve.  Improvements in the US job market are expected to see the Federal Reserve cut back its monthly purchases of US$85 billion worth of bonds in the next few months.  One of the side-effects of this monetary policy has been to push investors away from bonds and into riskier assets such as stocks which has helped to lift the S&P 500 up 26% so far this year to record highs.  The actions of the Federal Reserve have grown to be the dominant factor in the direction of share prices with investors placing more stock in announcements from the central bank than data on the strength of the underlying economy. 

There has been a debate raging over the extent of the influence of the Federal Reserve with some degree of distortion inevitable considering the scale of the bond buying operations.  Share prices could be overinflated and a sharp fall might be necessary to find their correct value.  Alternatively, any changes from the bond buying end may be minimal and it may just be worries about what might happen that is scaring off investors.  Some experts argue that it is good news that investors are holding a lot of cash as it suggests that shares are not yet overpriced and this cash may still flow into the stock market over the next year.  However, in this scenario, the smart money would already be invested in stocks. 

The uncertainty is such that investors are shunning higher returns from stocks for much lower pay-outs from leaving money in their bank (the best efforts of Your Neighbourhood Economist resulted in yours truly being locked into cash for two years to eke out a miserly interest rate of 2.0% through a UK savings account).  Among the few certainties for investments over the next year or so is that a considerable amount of volatility is likely as investors try to figure out what the Federal Reserve will do next and how other investors will react.  Great if you like investing to be like a roller coaster ride, but the rest of us may be better off settling for meagre returns from our banks.  

Federal Reserve – preparing to taper

With crunch time coming up, the Federal Reserve puts in the groundwork for a key change in policy

In the long march of dealing with the aftermath of the global financial crisis, the recent baby steps taken by the Federal Reserve may be one of the most crucial parts of the journey.  The Federal Reserve is considering lowering the interest rate on reserves it holds for banks as part of a move to offset upcoming reductions (tapering) in its bond purchases which currently amount to US$85 billion each month.  This tapering is perhaps the most important policy change in the past 12 months with the health of the global economy in the balance, so the Federal Reserve is anxious to ensure all goes well.

The actions of the Federal Reserve have been keenly felt across the globe with stock markets everywhere buoyed by the extra cash sloshing around the international financial system.  This abnormal state of affairs where central bank policy dictates the movement of stock prices is increasingly creating distortions through excessive gains in stock prices.  A pickup in the US economy would mean that the extra stimulus is no longer needed, but a smooth transition as the Federal Reserve changes tack will be key to sustaining any economic recovery in the United States and elsewhere.

As such, the Federal Reserve has been keen to soften the blow to the stock markets with policies that act as a stimulus as it cuts back on the bond buying which has been the main focus of its expansionary policy.  The mere rumour that the Federal Reserve would buy fewer bonds resulted in the interest rates on 10-year US government bonds jumping from around 1.7% in May to almost 3.0% in September.  Forward guidance, with future hikes in interest rates linked to unemployment, was tried as a means to signal the intent to help the economy but investors did not buy it (see prior blog for more).  

Changes to interest rates on banks’ reserves which are under consideration will only probably have a minimal effect but it is the signalling by the Federal Reserve that may be more important.  By showing a willingness to continue to support the economy, the Federal Reserve eases concerns that its actions will trample over the nascent economic recovery.  Some of the best successes of monetary policy have taken effect through nothing more than the suggestion of future action, such as the promise by the European Central Bank to do “whatever it takes” to save the euro.  This convinced enough people that it put paid to the Eurozone crisis without a single bond being purchased or interest rate being changed.  

Your Neighbourhood Economist was previously critical of the Federal Reserve for not taking the opportunity to begin tapering in October but the extra couple of months have been put to good use in ensuring that the change in policy goes smoothly.  All eyes will now look to the next meeting of the Federal Reserve (17th to 18th December) when tapering may be announced especially if US job data released on the first Friday in December is seen as positive.  The Federal Reserve is taking a cautious line but it is worth ensuring that there are no stumbles in the finishing stretch.

Debt Ceiling: Once more unto the breach

Politics in the United States is starting to cause more problems than it solves as compromise still seems far off.

Politicians are not usually seen in the best light.  Even in that context, the partial shutdown of the federal government in the United States is exasperating, so much so that Your Neighbourhood Economist was not even going to bother to comment.  The situation leading to the shutdown brings to mind kids in a playground fighting over a toy with everyone losing out after all of the toys are put away.  However, behind all the antics and posturing, there are bigger themes at play which is even more depressing.

October is marked with a number of dates which gradually ramp up the economic stakes.  The month began with the US government having failed to pass legislation for its spending budget for the 2014 fiscal year which starts on 1^st October.  While the bulk of spending by the government, such as benefits for the elderly or unemployed, is not affected, a significant portion of money doled out by the government must first be ratified by Congress before being spent.  As a result, not passing the budget resulted in a partial shutdown of the federal government with around 800,000 out of 2.8 million public employees being sent home without pay.  The parts of government affected include bodies such as the Environmental Protection Agency and the Food and Drug Administration, meaning that many procedures such as permits for certain business activities will not be processed.  NASA will also mostly shutdown as will many of the tourist sites overseen by Federal government employees.

But the partial government shutdown is just a precursor to something more threatening – the government running out of money to pay its bills.  While such an outcome may sound preposterous, it stems from the current budget deficit (with the government spending more than it receives) and the need to borrow to make up the shortfall.  The total amount of debt that the US government can take on is also something that requires approval from Congress.  With the government having racked up a string of budget deficits in the aftermath of the global financial crisis, the amount of borrowing has been steadily rising.  More debt is needed but the government has reached the debt ceiling which was raised in 2011 and is expected to run out of money by around 17^th October.

The stakes are higher if no deal can be done with regard to the debt ceiling.  While the partial shutdown of government can be seen as a bit of a nuisance, a government cash shortage could have global ramifications if it means that the government misses an interest payment on its bonds and thereby triggers a default.  Given that US government bonds are akin to another form of currency in the financial system, a default has the potential to bring the global financial system to its knees. 

In spite of this, the financial markets, while on edge, have not panicked - negotiations regarding the raising of the debt ceiling are still on-going, and even if a deal cannot be brokered, the effects are still unclear.  There are other sources of income such as money from taxes so the government will be able to keep up with some outgoing payments.  But that in itself creates another dilemma – which, if any, payments to forgo.  Investors would hope that debt payment would take priority over, for example, the payment of pensions.  Despite the potential consequences to the international financial system, it would take a brave politician to cut off pensions for old people.

Considering what is at stake, the consensus view is that the politicians will sort themselves out before the government is forced into making such choices.  Your Neighbourhood Economist would like to assume that this will be the case.  But the two main political parties have been squabbling for number of years with the situation getting worse rather than showing any signs of improvement.  Over the past few years, there have been skirmishes over a previous increase of the debt ceiling in 2011 as well as the negotiations regarding the fiscal cliff less than 12 months ago (for more on this, see Winning the election was the easy part) and one of the key obstacles to compromise is growing in strength – that being the so-called Tea Party portion of the Republican Party.

The Tea Party is the radical anti-government element of the Republican Party which is not afraid to be aggressive in pushing for a reduction in the size of government among other policies.  Its members in Congress are targeting large concessions from Obama to raise the debt ceiling – a position which is further fortified by Obama having conceded little in previous showdowns.  Perhaps the biggest concern is that the anti-government fervour of the Tea Party will translate into a view that the debt ceiling is an effective way of slashing government spending irrespective of the costs involved.

The Tea Party has found growing support among Americans disillusioned with the role of the government.  It is part of the rise of populist movements that can also be seen in Europe which rail against mainstream policies, such as an opposition to immigration.  The multi-party political systems in Europe can include such movements as separate parties which often struggle to get the necessary level of support to make it into government.  The political system in the United States only has two political parties and the Tea Party essentially controls a large portion of the Republican Party.  With voting districts in the United States having been shaped over the years to produce safe seats for either the Republicans or the Democrats, Tea Party candidates in Republican seats are typically better at whipping up support enabling them to win out over more moderate candidates. 

The Republican Party as a whole has increasingly felt the need to pander to this radical fringe which has brought a heightened level of conflict to US politics, within the Republican Party itself as well as between the two major parties.  Its unique system of democracy has been a key element behind the successful rise of the United States to global dominance.  But with the country’s place at the top of the global pecking order no longer assured (as described in A New Inconvenient Truth), it would be ironic if its political system was central to its downfall.

Quantitative Easing - Harder to End than to Start

The Federal Reserve changes tack on its change of tack in monetary policy which will make it less credible in the future.

It is still a month away from Halloween but something seems to be scared Ben Bernanke, the chairman of the Federal Reserve.  Bernanke was expected to announce that the Federal Reserve would be buying fewer bonds in September but surprised most pundits (including Your Neighbourhood Economist) by deciding not to make any changes with the status quo.  The unexpected bonus of a delay to the start of “tapering” helped push stocks in the United States to record highs but gains were limited by worries about the future direction of monetary policy.  By backing down from a change in policy, the Federal Reserve has made its job of finding an exit from quantitative easing more difficult while also making it trickier for investors to understand the big question that still remains – how far off is the beginning of the end for quantitative easing?

The Federal Reserve began to signal a change in direction in May and June using its own version of forward guidance where central banks outline future policy through using economic data as markers.  The current policy of the Federal Reserves has entailed buying US$85 billion in bonds each month with interest rates set at close to zero – its forward guidance in July put forward an end to bond buying by the time unemployment reached 7% with interest rates to rise once unemployment had fallen to 6.5%.  With unemployment expected to reach its first target by the middle of 2014, there was an anticipation that the Federal Reserve would move to reduce its bond purchases before the end of 2013, so as to ensure a more gradual decline in quantitative easing which would be less painful for the economy. 

Yet, investors drew their own conclusions from the forward guidance and took it as an excuse to sell bonds whose prices had climbed to record highs (for more, see Managing Expectations).  As lower bond prices translates to higher interest rates for bonds, the bond sell-off resulted in interest rates on benchmark US government bonds increasing from around 2% to close to 3%.  This ran contrary to the gradual adjustment which the Federal Reserve was attempting to facilitate to ensure that the nascent economic recovery would not be choked off by higher interest rates. 

The jumpy market reaction along with slower improvements in the US job market were enough to spook the Federal Reserve into keeping the quantitative easing going.  Only time will tell whether the cautious approach was the right call but Your Neighbourhood Economist fears that Ben Bernanke may have been too timid for his own good.  While there is always the possibility of gremlins lurking in the economy somewhere, the timing did seem as good as it will ever be for starting the drawn-out process of tightening monetary policy.

Unemployment in the United States has fallen to 7.3% in August compared to 7.9% in January (even though part of the fall is due to some people not bothering to look for work any more).  And, while the size of the market reaction was a tad overdone, investors always factor in events ahead of time – as such, the bond sell-off was just the normal response to an end to actions by the Federal Reserve which have propped up both the markets for bonds and stocks.  So, any further movements in the financial markets were likely to have been muted.  But as it happens, prices for bonds and stock perked up as investors looked forward to continued efforts by the central bank to prop up the markets.

With the Federal Reserve forgoing an opportunity to pare back its bond purchases in September, market participants are trying to figure out the possible timing for the inevitable change in policy.  The Federal Reserve meets again in October but will have few new bits of economic data to sooth its concerns over the strength of the economy.  The subsequent meeting of the Federal Reserve is in December with this seen by many as the next chance for action. 

The cautious approach by the Federal Reserve does have its costs.  It is a fad among central banks these days to signal in advance of changes to policy, but by choosing not to follow through with the expected change of policy in September, investors will be less likely to believe the Federal Reserve in future.  In the short-term, it is unclear what will be sufficient to trigger the beginning of the end of quantitative easing – weak economic data for the rest of 2013 may see the “to taper or not to taper” saga drag on for a while yet.  The resulting uncertainty and likely volatility in the financial markets may be even more harmful than the expected tightening of monetary policy. 

A central bank is only as good as its word and the Federal Reserve has cheapened its own words.  That is a scary prospect considering the current hands-on management of the economy by the Federal Reserve and how much it will have to do to talk its way out of this management role.

Managing expectations as part of monetary policy

In trying to ease concerns about higher interest rates through forward guidance, central banks have ended up doing the opposite.

Managing expectations when you work with people in an office environment can be tough but imagine dealing with the multitude of global investors as well as the international press.  This is what central banks have to cope with.  Central banks have tried to provide greater clarity regarding the direction of monetary policy using forward guidance – linking changes in policy to improvements in economic data.  The plan was to ease concerns that monetary policy would be tightened too soon through fewer bond purchases and eventually higher interest rates.  But forward guidance instead triggered the selling of government bonds with investors now expecting tightening of monetary policy sooner than central banks are suggesting.  Why have investors reacted in this way and what might central banks do in return?

A change in monetary policy was always going to be a tricky proposition considering the influence that the central banks have built up over the markets due to their purchases of billions in bonds as part of quantitative easing (refer to Caution - Windy Road Ahead).  It all started with a statement by the Federal Reserve in the US in June that it was considering tapering off its bond purchases which currently amount to US$85 billion.  Any new policy initiatives in the US are predicated on the pledge by the Federal Reserve that interest rates will remain at their current low levels until there is substantial improvement in the labour market.  This is one version of forward guidance that has also been adapted by Mark Carney, the new governor of the Bank of England, who also linked future decisions on monetary policy to the unemployment rate in the UK (for more, see Same low interest rates but for longer).  The reasoning behind forward guidance is twofold – to assure potential borrowers that interest rates will stay low for a few years yet and to placate fears that tightening of monetary policy will hurt the nascent economic recovery.

Not much of a market reaction was expected from these announcements as central banks were signalling that changes to the status quo would be gradual depending on the state of the economy.  However, investors have reacted in a way that seems to suggest that tightening of monetary policy is imminent, that is, by selling off government bonds.  The interest rates on government bonds have risen from record lows and 10-year bonds issued by the US and UK governments have both reached close to 3% (lower bond prices due to selling results in higher interest rates on bonds).  Why did the markets respond in this way to seemingly innocuous comments?

Cautious investors had been big buyers of safe assets such as UK and US government bonds due to the weak state of the global economy coupled with the sovereign debt problems in Europe.  This had capped off a period where bond prices had followed an upward trend for a few decades, which is a long time in investment markets.  Higher bond prices had pushed interest rates to painfully low levels so the timing was ripe for investors to move their money somewhere else.  All that was needed was a trigger and this ended up being the statements on forward guidance.  It is as if the mere mention of the end of the current loose monetary policy got investors thinking that a bond sell-off was coming and that it would be better to beat the rush.

For holders of UK government bonds, data on the economy has added to the reasons to sell.  The OECD released economic forecasts in early September which predicted that the recovery in the UK would pick up pace faster than in other countries.  A potential housing bubble in the UK adds to concerns that the Bank of England will have to increase interest rates earlier than planned.  Mark Carney also left plenty of escape clauses in the forward guidance pledges which allows the central bank the freedom to act but gives rise to worries that interest rates will not stay low for as long as has been suggested.

The rebellion of the markets against the careful planning of the central banks does throw up a few issues.  Considering that both the US and UK have mountains of government debt, higher interest rates will translate through to greater limitations on government spending which, in turn, will hurt the economy.  The fortunes of the global economy have also taken a hit with higher returns on bonds prompting investors to repatriate money invested in emerging markets over the past few years when there were few other investment options.  But the rush of money leaving places such as India and Turkey has brought howls of protest as well as fears about the ramifications of the end of quantitative easing on international finance.

It is central banks that now have to make the next move.  Yet this could involve doing nothing.  The tightening of monetary policy was never going to be easy and the recent jumpiness of investors could be just seen as collateral damage.  This would be a prudent option if central banks believe that there is nothing else that they could do to dictate the directions of the market.  But, on the other hand, central banks may decide to wrest back control of the expectations of investors.  Such a course of action could be prompted by fears that interest rates on government bonds, which act as a benchmark for interest rates throughout the whole economy, are too high at a time when the economic recovery is just starting in earnest.  Since forward guidance has shown that mere words are not enough, central banks may have to act, possibly with more bond buying.  Such a shock would bring investors back into line and serve as a reminder not to second-guess central banks.  However, with central banks likely to be keener to step out of the limelight (for What's the rush?), investors are likely to be left to their own devices.

Time to reform the Microsoft Monopoly

Windows software is used by many of us every day but is it right that we have to pay the price for Microsoft’s follies?

One reason why economist are always plugging reforms is that they often enable greater competition which is good as it pushes firms to offer better products for lower prices.  The opposite of this is monopolies who dominate a sector of a market resulting in higher prices and lacklustre products.  There is one monopoly in particular that Your Neighbourhood Economist loves to hate – Microsoft. 

Over 90% of the world’s computers run a version of Windows (including the one that this blog is being written on) which provides Microsoft with a captive audience and allows it to charge high prices for its products generating bucket loads of profits.  However, the failure of Windows 8 and a host of other products shows that Microsoft does not have a great track record in terms of customer satisfaction – it seems to prioritise extending its empire above anything else.  But the influence of Microsoft is even worse than that and here is why.

The dominance of Microsoft comes through a phenomenon known as a network effect.  This is where a product becomes more useful (and valuable) to each user as more people use the product.  The software products from Microsoft have become the global standard for exchanging documents between computers and this has locked everyone into Microsoft’s software with few other options outside the mainstream.  The same phenomenon can be seen elsewhere with Twitter and Facebook but the ease of switching does not result in user being beholden to one provider of a service such as has been shown with the rise and fall of MySpace. 

Economic theory shows that it is optimal for firms operating as monopolies to charge higher prices than normal to extract maximum profits from its consumers.  Microsoft seems to be doing a good job of this and generated US$23 billion in surplus cash in the past fiscal year from revenue of US$78 billion.  Some of this cash would go towards making improvements to its software products but a substantial portion is also spent on extending its influence to other areas.  Its first big foray was bundling of its own web browser with its other software in the late 1990s to shut out a rival in the shape of Netscape.  But this proved to be the first of many costly strategic errors as Microsoft ended up with a hefty legal bill after being found to have abused its dominant market position.

Microsoft has struggled to get its foot in the door in a range of burgeoning Internet markets such as online searches and social networking but it has lacked the market nous of rivals such as Google and Facebook.  It has also been left trailing in the wake of Apple and Google in terms of software on tablets and smart phones with electronic manufacturers cautious about dealing with Microsoft.  This is because Microsoft’s profits on its computer software have come at the expense of the firms that make the hardware and the market for computers as a whole with sales of PCs expected to decline by around 10% in 2013.

Microsoft comes across as a company from a different era, lacking a consumer focus and being unable to innovate fast enough.  It seems to have more of an engineering mind-set with new product development as not one of its strong points – its only one popular offering has been its Office software over twenty years ago which was first pioneered by Apple.  This is perhaps best personified by its Windows 8 software, which was an attempt to use its free reign in PC software to rescue its fortune with tablets and phone by imposing the same touch-screen format on PCs as well but instead further alienated consumers due to its being ill-suited for use on computers.  Such a slip-up with its main product would be the death of most other firms but Microsoft lives on.

One of the basic notions behind capitalism is that a prospering company is good for the whole economy as it’s presumed to be providing a product which is in demand.  But Your Neighbourhood Economist would argue that Microsoft fails this test.  Its position in the PC market means it’s more like a tax which many PC buyers have no choice but to pay hurting both consumer and computer makers with few benefits – Microsoft uses its market ascendancy for a series of failed attempts to gain footholds elsewhere.  This will be the likely conclusion of its purchase of Nokia’s mobile phone business with Microsoft’s previous venture into hardware, its Surface tablet, resulting in a US$900 loss in the previous fiscal year.  Its rivals could not be more different – Apple generates almost religious fervour in its products while Google invests money in such far-fetched schemes as driverless cars and glasses doubling as wearable computers which could benefit society well beyond its mainstay business of online searches.

Having made the case that Microsoft has monopoly control and that this is resulting in higher prices with scant benefits for consumers, the only thing that remains is deciding what should be done.  One line of thought could be to strip Microsoft of its ownership of its Window software due to its market abuse and allow other firms to provide their own versions.  But there is a notion in economic theory that innovation deserves financial reward to ensure that firms will take risks in developing new products in the hope for a pay-out in the future.  So even though many who invested in Microsoft have already been richly rewarded, the company does deserve some financial compensation. 

With this in mind, Your Neighbourhood Economist would argue for a licensing agreement whereby other firms would get access to the technology behind Windows software and are able to add improvements to attract their own customers.  This is because the software from Microsoft is so widespread that it is part of digital infrastructure needed to do business and allowing such key infrastructure to be managed by one firm has been problematic.  This possible solution is similar to the way in which other monopolies have been dealt with in the past – phone companies who have gone to the trouble of laying down cables are no longer allowed to monopolise the market and must offer up the use of the cable to other firms but at a fee.  Microsoft’s time has come and gone but we should not all have to suffer because of it.

Detroit – Just the beginning?

A city is driven into bankruptcy by the same problems that plague the United States as a whole but will the outcome be any different?

We have become all too accustomed to firms going bust recently amid the economic doom and gloom but a city going bankrupt seems a little strange.  But that is what happened to Detroit last month as years of decline culminated in the city admitting that it was no longer able to pay its bills.  Having thrived along with the auto industry, Detroit was always doomed to struggle as American car makers lost out to foreign rivals but its problems are not that different from those facing the country as a whole – overgenerous spending commitments from politicians focusing on the short term.  Can the politicians in Washington do any better in dodging a budgeting accident?

Detroit’s demise has come after it lost the industrial base that was the foundation of the city – the manufacturing industry around Detroit was decimated as overseas firms took a large chunk of the US auto market.  The population of Detroit was close to two million in 1950 but has since plunged to around a third of its peak as the deteriorating job market prompted people to move elsewhere to find work.  The exodus created a downward spiral with a growing number of boarded up houses and deteriorating public services as tax payers fled to more prosperous locations. 

The sharp decline still left Detroit with a large number of bills to pay, and along with having to maintain the infrastructure of a shrinking city, there was also the pensions for its public sector workers.  Its debts are estimated at $18.2 billion but around half of this money is owed to its present and past workers in the form of promises of retirement pay-outs.  It is common for government workers to be paid pensions which are a percentage of their salary (referred to as defined benefit plans) which is different to the private sector where workers must pay into their own pension pot from which pensions are paid out (referred to as defined contribution plans). 

Promises made by politicians have come back to haunt their successors – offering up bigger pensions rather than higher wages as a means to placate government workers with lower pay rates.  Pledges made when times are good are difficult to uphold when things turn bad especially since officials fail to put away sufficient funds to cover future pension payments.  The fixed sums offered to public sector employees after retirement have become more of a burden with people living longer and investments yielding a lower return after the global financial crisis (which means that the initial level of funding of pension pots is higher).  It is like a massive scheme of offering up IOUs with big pay-outs in a few decades but not bothering to put away much money to settle up in the future.

Detroit was not the first city to go bankrupt (Stockton, Mammoth Lakes and San Bernardino in California did in 2012) and it will not be the last (even some of the largest firms in the United States such as General Motors and most of the airline companies have been laid low by lavish pension schemes), but more crucial are the similar problems faced by the federal government in the United States.  The US government has committed to paying pensions and medical bills for the old and poor which will gradually ramp up the pressure on the government budget as the baby boomer generation heads into retirement and the number of workers per pensioner falls (i.e. costs will rise as revenues fall but more slowly than in the case of Detroit).  Social spending on these and other entitlements accounted for 56% of government spending or almost 14% of GDP in 2012 and increasing spending is threating to overwhelm the government spending plans.

The approach of a fiscal disaster comes at a bad time - the US government is already struggling to sort out a considerable budget deficit equal to 7.0% of GDP in 2012.  The timing is made even worse when considering that the dominant global position of the United States is under fire due to the rise of new powers such as China (for more on this, see A New Inconvenient Truth).  Instead, politicians would rather squabble than deal with the raft of problems facing the country with numerous other areas such as taxation and immigration also crying out for reform.  Even sensible adjustments to policy, such as increasing the retirement age to account for people living longer, get vilified with both the Democratic and Republican parties at each other’s throats.  Elections do little to resolve the issues with politicians happy to just target their own supporters (refer to Election with no winners for more detail).  The country as a whole is being driven toward the same destination as Detroit and politicians would rather play a game of chicken amongst themselves than steer clear of trouble – watch out for accidents in the road ahead.

How Monetary Policy plays out in the Real World

The past week or so has shown hints of what is in store as the Federal Reserve hands back the reigns to the US economy.

The theory about the ramifications of the inevitable changes in monetary policy have been spelled out in this blog over the past couple of weeks (Caution - Windy Road Ahead) but market movements at the end of last week show how it will play out in practice.  Heavy selling last week was triggered by the rosy outlook painted by the chairman of the US Federal Reserve, Ben Bernanke, which was more upbeat than had been expected and is likely to signal that the end to bond buying by the Federal Reserve is nearer than many had thought.  It is worth taking a closer look at the reactions of the markets to get an idea of how future actions by central banks may impact on us all.

Bernanke’s statements around a week ago made the case that the economic recovery in the US was sufficient enough for the Federal Reserve to move forward with its plans to reduce its buying of bonds later in the year with a target of stopping completely in the middle of 2014. Pains were taken to get across the notion that the change in tact was not a tightening of monetary policy but just loosening at a slower pace and that any changes in monetary would depend on a continued recovery in the economy. Yet, because the bond buying by the Federal Reserve has become a crucial support holding up the prices of bonds and stocks, its imminent demise has rattled investors who were caught out by the bullish comments by Bernanke.  

The degree of surprise was spelled out in the sharp movements in the investment markets with prices of bonds plunging and the interest rate on 10 year US government debt jumping from around 1.5% to 2.5% (lower bond prices equate to higher interest rates). This will feed through into the real economy as government debt is typically the benchmark for which all other interest rates in the economy are set. The result will be higher interest payments for mortgage holders which will act as a damper on the promising recovery in the housing market in the US. The higher costs for borrowing will also be a point of concern for companies who are thinking of making new investments.

There are further negatives for the US economy from the changes in monetary policy – the ensuing volatility in the stock market will make households worry about their pensions and other investments making them less likely to spend. A slower pace of bond buying will result in a fall in the amount of new currency getting into circulation which will raise the value of the US currency.  A stronger dollar will make life more difficult for exporters, many of whom are already struggling in the global marketplace. 

This all puts the Federal Reserve in an awkward position of its own actions creating a headwind blowing in the opposite direction of where it is trying to get to – an end to its role of propping up the economy. Bernanke is trying to lessen negative effects of its bond buying plans by outlining in advance a clear schedule for its changes in policy. But the Federal Reserve also needs to ease concerns that it will act too fast and has allowed itself flexibility to modify its plans if the economic recovery weakens. The overall effect is the level of certainty which is craved by many investors will remain out of reach, and the twists and turns of monetary policy will be played out in jumpy markets that will keep everyone on their toes.

Where to next for central banks?

Saving the global economy might have been the easy bit – now central banks have to find a way to get out of the limelight.

The outlook for the world economy is far from sunny but talk of impending doom regarding the fiscal cliff in the US or the collapse of the Eurozone seems to have passed.  Central banks have been called on like never before to save us from economic catastrophe and have developed new strategies to deal with the unique problems thrown up by the global financial crisis.  But the deeper the central banks get involved, the more difficult it will be for them to extract themselves from their new dominant roles in propping up the global economy.  Signs of economic recovery mean that this tricky task is at hand but the way out will not be easy.

The first to have to come up with an exit strategy is the Federal Reserve in the US due to a relatively robust economy with the US economy expected to expand by 1.9% in 2013 and growth of 3.0% forecast for 2014.  The third round of quantitative easing means that the Federal Reserve is currently purchasing bonds worth US$85 billion each month with a promise to continue this until there is substantial improvement in the labour market.  With the unemployment rate having edged downward from 8.1% in August to 7.6% in June, the chairman of the Federal Reserve, Ben Bernanke has begun to talk of tapering off its bond buying which will be the beginning of the a long process of winding up the aggressive loosening of monetary policy.

The loose monetary policy has not only involved central banks becoming considerable buyers in the bond market but also interest rates being set at record lows.  It is fair to assume that these policies have helped ease the pain stemming from the global financial crisis, if not having staved off economic meltdown.  Yet, the flipside of the dominant role taken by the central banks is that the reversing of these policies brings its own problems.  Central banks have typically been supported for their actions in the face of possible disaster especially considering the squabbling of politicians.  While policies that boost the economy during slowdowns will always be welcomed, measures that add headwinds to an economic recovery (tightening of monetary policy) are unlikely to make central banks popular.  Yet, the bond buying and record low interest rates distort the economy and may create problems in the future. 

So a return to normality in terms of monetary policy is inevitable but it will be a protracted process with purchases of bonds by central banks being pared back followed by interest rates being nudged upwards all depending on the state of the economic recovery.  This chain of events may start this year in the US, maybe in the summer but probably later in the year or in early 2014, and will take at least a few years.  The decision making of the Federal Reserve will face even more intense scrutiny in the media considering the influence that its actions have over the markets for bonds and stocks (see Caution - windy road ahead for explanation).  The glare of the media will make it difficult to keep the majority onside as even the much-revered former chairman of the Federal Reserve, Alan Greenspan, discovered after falling from grace due to having been seen in hindsight to have left interest rates too low for too long.

The other major central banks will have the luxury of following behind the Federal Reserve.  The European Central Bank cut interest rates in May 2013 in a mainly symbolic sign of its continued intentions to bolster the Eurozone where the economy is expected to weaken by 0.3% in 2013 according to the IMF.  The real possibility of a breakup of the Eurozone was almost single-handily put to rest by the European Central Bank’s willingness to do “whatever it takes” to save the euro (for more, refer to "Whatever it takes"). Yet, the lack of a recovery has left the European Central Bank on red alert – everything is on hold in case another crisis breaks out.  The central bank in Japan is heading in the opposite direction to its US counterpart and is ramping up its monetary policy in the hope of kick-starting an economy which has been stagnating for the past two decades (for the details, see All bets are ON).

So trying times lay ahead for central banks and the rest of us left trailing in the wake of their actions.  Not only will the direction of prices for stocks and bonds depend on developments in monetary policy but gauging the suitable tempo of change by central banks will be crucial in encouraging the nascent recovery in the global economy.  It may be the beginning of the end in terms of central banks saving the world but there is still a long way to go to get to safety.

Disappearance of the “Strong Dollar”

The demise of this phrase from the lexicon of politicians in the United States says a lot about the changing landscape of the global economy.

It is easy to notice when a new term pops up but harder to spot when a phrase falls out of use.  Adherence to the principle of a “strong dollar” was a cornerstone of government policy in the United States for generations but it is not something that is referred to by politicians anymore.  Your Neighbourhood Economist would argue that this change in thinking by politicians about the US dollar that has mostly gone unnoticed is part of a wider picture of the changing global position of the United States.

It may seem strange at a time when countries are vying with each other to weaken their currencies (for more, see Currency Wars), but not so long ago, politicians in the United States would pledge their support for the notion of a strong dollar.  But the origin of the strong dollar was from a previous era when the United States was the dominant global trading power.  Trade flows in the thirty years following the Second World War typically followed a certain pattern – rich, developed countries such as the United States would import agricultural products and raw materials for manufacturing while importing manufactured goods back to the poorer, less developed countries. 

Manufacturing at this time was limited to a small group of privileged countries that benefitted from economies of scale stemming from their large and wealthy domestic markets.  Most other countries were limited to importing materials which ended up being plentiful and cheap due to the large number of other countries having nothing else to offer in terms of trading.  So the United States was in an advantageous position of being one of a few that supplied crucial manufacturing products but having a wide choice of trading partners in other goods.  Its dominance was extenuated with many other manufacturing countries being decimated following the War. 

This central role of the United States in the global economy also extended to its currency and the US dollar was used in trading between different countries and as a means for any country to store its wealth.  The widespread popularity of the US dollar increased its value which put the United States in an even better position.  A strong currency helped businesses in the United States by making imports cheaper but was only helpful in so far that there was minimal competition regarding exports.  

While the United States remained on top for a few decades after World War II, it inevitably faced numerous challenges.  The oil embargos in the 1970s were a shock to the system but it was the rise of Japan as a manufacturing rival that signalled that the good times were coming to an end.  Companies in the United States had grown flabby and slow due to a lack of competition.  Focused and ambitious Japanese firms easily outperformed their US rivals in areas such as cars and consumer electronics.  The revival of business in the United States was facilitated in part due to an agreement in 1985 to revalue the Japanese yen at a higher value. 

However, the new competition from Japan was just a sign of things to come as other countries in Asia such as South Korea and Taiwan followed in the footsteps of Japan culminating in the re-emergence of the sleeping dragon, China.  The global economy was in the process of becoming increasingly interlinked due to lower costs for transport and communication and the resulting surge in imports into the United States devastated some local manufacturing industries.  Surviving businesses in the United States lobbied for support from the government through protectionist measures.  Yet, politicians maintained their belief in the benefits of a strong dollar with reiterations of this policy being repeated as recently as during the Bush Junior administration.

The United States government policy regarding its currency eventually caught up with the realities of the repositioning of the United States in the global pecking order.  Nowadays, the only mention relating to the US dollar by politicians is belligerent moaning about the perceived injustices stemming from a belief that China is manipulating its currency.  This is part of an increasing vocal backlash looking to stem the flood of goods from overseas and reflects the difficulties that businesses in the United States are having as globalization increases the number of rivals.  Slower economic growth and an increasingly high debt burden means that exporting is becoming more important as the United States economy has to work harder to generate growth.  This is one of the many challenges that are likely to lie ahead as the United States scrambles to hold onto its global crown.