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Press Release

    Rubin Where Art Thou?

    08/14/2002

    Yesterday, President Bush hosted a forum in Waco, Texas to defend the administration’s economic policies and those responsible for their formulation. Recent data suggest the economy faces significant hurdles: unemployment continues to rise, productivity growth has slowed, and unease continues to grip the financial markets. With Democrats eager to make the economy the centerpiece of this fall’s midterm elections, it is politically imperative for the Administration to find its voice on economic policy.

    With the economy sputtering and presidential proclamations about the economy’s fundamentals unable to soothe investor concerns, many analysts have suggested that President Bush needs a “Republican Robert Rubin” to replace the flippant Paul O’Neill as Treasury Secretary. As Clinton’s economic point man at the White House and then Treasury, Rubin was lauded for his astute financial management and rapport with Wall Street. Rubin’s cool demeanor and investment banking experience enabled him to calm markets during the Asian financial crisis and collapse of the Ruble in 1998.

    By contrast, O’Neill has had some desultory moments since taking the helm. In the first few months he expressed some reservations about specific provisions of the Bush tax cut. Then he questioned the intelligence of those conservatives who questioned the need for federal terrorism reinsurance legislation. Recently he scoffed at the notion that foreign aid helped developing nations – or, more precisely, that it produced the dividends to justify its expansion – and then suggested that international funds to stabilize Brazilian’s public accounts would probably end up in a Swiss bank account.

    But while O’Neill could learn much from Rubin from a public relations perspective, a replication of Rubin’s policies is untenable. With the stock market overvalued by trillions of dollars, trade deficits at record highs, and inflation – as measured by the Consumer Price Index (CPI) – at record lows relative to economic growth, the U.S. economy reflected a pyramid scheme more than a sustainable model for growth.

    The extent to which Rubin was responsible for the formation of the stock market bubble is not yet clear, but the origins can be traced to Rubin’s oft-quoted statement, “a strong dollar is very much in this nation’s interests, both now and for the long term.” This policy contrasted with that pursued by Secretary James Baker III, who sought to devalue the dollar to increase American competitiveness during the 1980s. But while domestic manufacturing and export suffers when a rising dollar tightens margins, demand for securities denominated in US dollars increases.

    In Rubin’s first year at Treasury, the “strong dollar” policy faced its first test as the dollar was at an all-time low against the Japanese yen (one US dollar equaled 80 Japanese yen). By 1998, the dollar had risen by 45 percent to 146 yen and the trade balance between the two countries exploded.

    Between 1997 and 2000, the dollar appreciated by an estimated 40 percent against gold and a bundle of other commodities and currencies. With currencies in crisis around the world, investors flocked to the dollar and US asset markets. As Johns Hopkins Professor Steve Hanke pointed out in testimony before the Senate Banking Committee, during the past 5 years the dollar has become the world’s “vehicle currency.” Ninety percent of all internationally traded commodities are invoiced and priced in dollars; the dollar is employed on one side of 90 percent of all foreign exchange transactions; and over 66 percent of all central bank reserves are denominated in dollars.

    Low expected inflation in the U.S., higher than average expected returns on U.S. assets, and currency crises around the world stoked demand for the dollar, but Treasury certainly played a role in the currency’s ascendance. When the US approached the statutory debt limit during the 1995-96 budget impasse, the Treasury was about to default on U.S. government obligations for the first time since the gold standard was abandoned. To avoid this outcome that would have undoubtedly undermined demand for Treasury securities and the dollars necessary to purchase them, Rubin replaced bonds held in two federal employee retirement accounts with IOUs and issued new debt to pay off bondholders when their Treasury bonds came due.

    During that same period, Rubin introduced 5, 10, and 30 year inflation-indexed Treasury bonds and began weekly meetings with Federal Reserve Chairman Alan Greenspan to better coordinate open market policy and international intervention. In addition, Rubin helped to orchestrate the bailout of Mexico and South Korea, and advised the International Monetary Fund (IMF) on the Russian, Brazilian, and Southeast Asian financial crises. All in all, an estimated $250 billion in international loans went to prop-up faltering currencies and restructure debts.

    While it is not immediately clear why bailouts would help prop up the dollar, as distinguished financial economist Allan Meltzer has noted, support for exchange rates “gives the people who want dollars a better price at which to buy them” as they have to pay less of their own currency for every dollar purchased. As Meltzer says, “Give people more opportunity to leave and on better terms, and more will leave.” As a result nearly all of these nations have larger international debts than before the bailout and the dollar appreciated following each intervention.

    In addition, the infusion of cash allowed the developing countries to continue to service the debt owed to international bankers like Banc of America, JP Morgan Chase, HSBC, and Citigroup. Often the loans were restructured, but this did not matter to the Wall Street speculators since they would charge banking fees and a commission for their troubles. Rubin was a hero to his former colleagues as IMF and Treasury bailouts attenuated the default risk on highly speculative loans. Bankers got the high-yields that accompany high-risk investments and very little of the actual risk.

    But the dollar’s dramatic appreciation cuts both ways. In addition to squeezing margins for exporters, it places all debtors on precarious footing. As George Gilder explains, “To comprehend the effect of a rapidly appreciating dollar, imagine taking out a loan with the expectation of paying back $1 billion. Then your bank calls and says, ‘You know, we'd like $1.4 billion instead.’” The record bankruptcies and defaults can be attributed, in part, to a rapidly appreciating currency.

    A strong dollar and huge trade deficit is sustainable only as long as foreign investors continue to invest in US assets in record numbers. As economic and financial consultant Henry Kaufman stated in early 2001, no time since World War II has “the well-being of the American economy and that of the rest of the world have been so dependent on the strength of the U.S. equity market.” But as the stock market slides, and corporate debt yields widen, it looks more and more unlikely that the US can continue to attract the necessary $1.2 billion in daily foreign investment to support its current account (trade plus balance of payments) deficit, potentially dragging the world economy into a prolonged period of stagnation.

    Economists will long debate the extent to which the dollar and stock market’s rise was a product of Treasury intervention, or a natural surge in demand for US assets, but that bubble has burst. No Treasury Secretary, no matter how masterful at personal politics, can do much to change that.

    Perhaps the Bush Administration will benefit politically from the Waco summit and from a new voice on economic affairs, but a return to Rubin’s policies are not only not viable, but probably unwise. As economic historians are sure to point out, it is far better to be Treasury Secretary during the formation of an asset price bubble than in its aftermath. Unfortunately, O’Neill probably won’t be around when sober retrospection recasts his first 18 months in a better light.