By Axel Merk
President and Chief Investment Officer, Merk Investments
Manager of the Merk Funds, www.merkfunds.com
Which political party will do a better job at preserving the purchasing power of the U.S. Dollar? A common tenet amongst Treasury Secretaries, irrespective of their political affiliation, has been a claim that the U.S. pursues a strong dollar policy. To find out, let’s look at what type of tax and regulatory policies foster a strong dollar.
Tax Policies may lead to weaker dollar
Supply and demand determine the value of anything tradable, including a currency. Noteworthy with regard to the value of a currency is a country’s current account deficit, which can be thought of as the amount foreigners need to buy in a year – the required demand -, just to keep the currency from falling. To cover a $470 billion current account deficit, U.S. policy makers generally favor policies that promote growth: after all, foreigners may be more inclined to invest in the U.S. when the economy is expected to grow. However, the notion that growth is always good for a currency may be a myth. Consider Japan: even as Japan is expected to report its first trade deficit in decades for 2011, it continues to have a current account surplus. When the earthquake hit in Japan, putting the breaks on economic growth, the yen rose; in contrast, when an earthquake hit New Zealand, a country with a current account deficit, its currency fell. Interestingly, the Eurozone’s current account is roughly in balance, suggesting that – all else equal - the euro may be able to muddle through in the absence of economic growth.
While the current breed of Republican presidential candidates have distanced themselves from growth through stimulus spending, Democrats and Republicans alike have “put money into the pockets of consumers” or deployed “shovel ready projects”. It’s not an American invention, either: many politicians worldwide like to argue that the “other” party engages in wasteful spending, but if only they were elected, they would direct spending towards “worthy” projects. Presidential candidate Newt Gingrich’s plans to build a permanently manned lunar base may be a classic example of someone decrying deficit spending of the past, yet proposing to deploy resources for more worthy causes.
In our assessment, a strong dollar policy requires policies that support sustainable growth, pursuing policies that limit the supply of dollars relative to their demand. While the Federal Reserve (Fed) controls the printing press with an unlimited checkbook, debt creation in general – be that by the Fed, the Treasury, corporations or consumers – all contribute to a supply of dollars (creating Federal Reserve Notes or quantitative easing all create obligations by the Fed, even if they are mere accounting entries for a central bank; the Fed’s debt is special in that the monetary base created is a platform nurturing a multiple of debt creation in the banking system).
Improving the balance of trade would help the current account balance and, with it, might make the U.S. dollar more robust. Importantly, any country with a serious trade deficit tends to shoot itself in the foot when imposing measures that hinder trade. Historically, the U.S. dollar has often sold off when trade tensions flare up. That’s because the flexible workforce in the U.S. has adjusted to a trade based world. Imposing trade barriers then punishes those that have adjusted, rewarding those that have not. We phrase it in this fashion, suggesting that those that have not adjusted are more likely to be in uncompetitive industries, but stay in business because of government intervention.
U.S. corporations have been in the limelight because they keep cash earned abroad outside of the U.S., not paying “their fair share of U.S. taxes.” Indeed, companies like Microsoft are issuing debt in the U.S. because they don’t want to repatriate their foreign cash. Talk flares up from time to time to grant a temporary tax break to allow companies to repatriate their earnings. Such a strategy may give a temporary boost to the U.S. dollar as money is moved back to the U.S., but in turn, it encourages corporations to repatriate even less thereafter, in anticipation of additional future tax breaks. Opponents tend to argue that the money won’t be used to hire more workers, but typically paid out to shareholders. We don’t have a problem with that aspect: by returning money to shareholders, they can re-deploy it. U.S. policy makers must ensure that investors have incentives to deploy it domestically.
The problem with these temporary policies is that they are temporary. If businesses had a permanent incentive to repatriate earnings from abroad, it would go a far way to encourage investment in the U.S, allowing executives to devise long-term strategies rather than reacting in an ad-hoc fashion to the latest policy move. One reason why the U.S. dollar had become the world’s reserve currency is because of the free flow of capital: being able to move money in and out of a country is a great incentive to invest in the country. President Obama’s recent proposal to tax businesses that take jobs overseas opens a can of worms, as it enters a slippery slope that may lead to capital controls, which could be rather bad news for the U.S. dollar. Even without fearing the worst, the President’s State of the Union address appeared to suggest differentiated tax treatment for different types of activities. Tax policy has every right to channel money to specific sectors of an economy. However, we would like to caution that it is exactly those rules that are put in place with the best of intentions that create the “loopholes” criticized by later generations. Micro-managing an economy may lead to more bureaucracy, but not strengthen the U.S. dollar.
Instead of promoting consumer spending at just about any cost, a pro-dollar policy fosters savings and investment.
Working hard on being an equal opportunity offender, let’s turn to some pro-active policies to support the U.S. dollar. Instead of promoting consumer spending at just about any cost, a pro-dollar policy fosters savings and investment. Given that much of what we consume has been manufactured abroad, tax spending to reduce the trade deficit. Indeed, to generate sufficient tax revenue to cover promises made in various entitlement programs, there aren’t enough rich people around to tax. Increasing the capital gains tax rate as is currently under discussion would, in our assessment, create further headwinds to the U.S. dollar. The only policies that generate substantial amounts of revenue are those taxing consumption, either broadly as a national sales (or value added) tax or a tax on energy consumption. If one looks at financially sound Scandinavian countries, note that they all have very high value added taxes (VAT) and low corporate tax rates. That’s because corporate capital knows no boundaries: tax corporations and they shall move their earnings or headquarters. But consumers are less mobile, more reluctant to move across national boundaries. Scandinavian (and some other) countries have learned this lesson, while U.S. corporate tax rates are amongst the highest in the developed world. While the “fair tax” movement to replace the current tax system with a national sales tax might be one of the most effective ways to provide long-term support to the U.S. dollar, our assessment is that, should the movement gather momentum, we would end up with both national income and national sales taxes. In practice, we don’t think either a national sales tax, nor a national energy tax has a high probability of passing Congress and being signed into law. Thus, there may be no reprieve for the dollar.
Replacing the current tax system with a national sales tax (as advocated by the Fair Tax movement) might be one of the most effective ways to provide long-term support to the U.S. dollar
Talking about bureaucracy, regulatory limbo is a great concern for economic growth and has held the U.S. dollar back. Many industries are complaining that investments are currently not being made because of regulatory uncertainty. The current environment goes beyond the bickering seen every election cycle. Today, one has to look to Singapore as a place that’s trying to attract, rather than scare away, business. While we don’t foresee a major exodus, bureaucratic roadblocks are a serious impediment to job creation, economic growth and ultimately dollar strength. These trends are exacerbated by policy makers obsessed with turning banks into utility companies. While we must not tolerate that banks are “too big to fail”, rather than working with market forces (e.g. using market levers such as requiring mark-to-market accounting and collateral for levered transactions), policy makers have taken both the “risk” and the “friendliness” out of risk friendly capital; you are left with capital – fine, except that an economy can’t grow on financial stability alone. And the U.S. needs growth to support the U.S. dollar given its current account deficit.
The U.S. needs growth to support the U.S. dollar given its current account deficit
Both taxes and regulations can make a country an attractive place to invest in. While low taxes and low regulatory hurdles would be helpful in this regard, take California that has historically attracted a lot of capital, despite high taxes and high regulations. In our assessment, clarity of regulations is at least as important as regulations themselves. That’s because regulations for the most part increase the barrier to entry; while that makes it more difficult for newcomers to enter a field – and as such is not ideal -, experienced venture capital firms - in the case of California - know how to navigate the regulatory environment. In contrast, other countries that have promoted startups have often had great difficulty duplicating the Silicon Valley’s success, partially because every new venture is structured differently, investors and entrepreneurs alike don’t know what to expect. Like the federal government, California spent too lavishly during good times, also creating more regulations stifling future growth. Business and government alike should not forget that success has to be earned all the time; one cannot rest on the laurels of past achievements.
Fiscal policy is about deciding on the right balance of revenue versus expenses, about steering money into the economy according to what elected officials have legislated given the framework of the constitution (hint to policy makers: the “right balance” is not trillion dollar deficits that might scare away foreign investors). Legislators often have priorities other than preserving the purchasing power of the U.S. dollar. But if the U.S. dollar were a top priority, savings and investment should be fostered. Policy makers will state that they agree to this idea, but usually want those admirable goals to be implemented later, or when they have left office; the top priority tends to be to boost the economy by incentivizing consumer spending. In our view, such an approach is a recipe for a weaker U.S. dollar.
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Manager of the Merk Hard, Asian and Absolute Currency Funds, www.merkfunds.com