Key News
- Investors outside the U.S. are purchasing companies in the Standard & Poor's 500 Index at the cheapest valuations on record, their buying power boosted by a seven-month decline in the dollar. (Bloomberg)
- The British government is holding a fire sale of public assets including the undersea Channel rail link to raise 16 billion pounds ($25 billion) as Prime Minister Gordon Brown warned on Monday that the country is only halfway there in overcoming the recession. (AP)

We have updated our favourite metric of excess liquidity for the five-biggest industrialised economies and the four-largest EM economies to include 2Q09 data. Unsurprisingly, with the growth rate of the monetary aggregate M1 (cash and sight deposits held by non-banks) outpacing nominal GDP growth, excess liquidity has risen to yet another record-high both in the G5 and in the BRICs. As we have argued repeatedly, this has been the main driver behind the impressive rally in risky assets over the past six months, in our view.
Spyros Andreopoulos, Joachim Fels & Manoj Pradhan, Morgan Stanley

Economics is a wonderfully confusing field of study. The debate on the US dollar proves once again the words economics and science should never be used in the same sentence. There is the prevailing wisdom side of the fence that says the US dollar must depreciate if its trade blance is to improve. Proof positive economists rarely let real world facts get in the way of a good story. Below is a chart of the Balance on Merchandise Trade for the United States. The worsening trade deficit began its next sharp leg down around 2002, the beginning of a massive bear market in the US dollar. The point: A weak dollar and massive deficit in trade were correlated; one discerns from this chart.

The dollar bottomed in value (for now) near 70 on the US dollar index in March 2008, it is up about 9% in value since then. Yet the balance on trade has improved almost 50% since then! Kid you not, the chart doesn’t lie. So, to summarize, the trade deficit got worse when the dollar was weakening. And the trade deficit improved while the dollar strengthened. But according to the tenets of the economist-cum-dollar-depreciation-trade deficit-improvement-crowd it can’t be possible. It shouldn’t happen that way. They say the dollar must fall for the trade deficit to improve. Hello! Is anybody home? [Has any member of the E-C-D-D-T-I-C noticed Germany’s trade balance improving while the relative value of the euro was going up? Why should it be so different here?]

Could it be the dollar is following the trade deficit—not leading? Well, yes it could be.
US consumers have stopped buying as many imports as usual, that is why the trade balance has improved—it had ZIP/SQUAT/NADA to do with a weakening dollar. So, the idea that global rebalancing must be accomplished primarily through a weaker dollar is total hogwash—we surmise. The conundrum for the global economy is summarized quite well by Michael Pettis, Professor of Peking University:

“Everyone seems to agree that as part of the necessary global rebalancing the US will have to reduce its net imports, and this will be achieved in part by a depreciation in the value of the dollar, but everyone also seems to agree just as fervently that any reduction of the US trade deficit should not come at their expense, but rather at the expense of the rest of the world. Europe says it is Asian that must appreciate, Asians implicitly insist that it is Europe that must appreciate. It doesn’t take a PhD to see the mathematical difficulty.
“Like in the 1930s, every country wants to devalue its currency relative to the currencies of its trading partners in order to boost domestic employment and take a larger share of foreign demand. But as we learned in the 1930s, it is by definition impossible for everyone to improve export competitiveness by devaluing.”

Should it be a surprise trade tensions are on the rise? Maybe global rebalancing goes a lot deeper than currency values. Stick that into your econometrics model and smoke it.