A reader sent this note by AIG’s Bernard Connolly, which is surprisingly blunt for a sell-side analyst:
In saying today that the housing price correction must be allowed to proceed, Paulson is in effect calling for a massively weaker dollar – athough he probably does not realise it.
Of course it is true, as Paulson is now prepared to say, that the housing boom was unsustainable in any fundamental sense. But, as we keep on stressing, all asset values, not just housing prices aer distorted upwards by the current level of real long rates at 1%. A fundamental equilibrium would involve real long rates close to 3%. That would devastate no just the housing market but all other US asset and credit markets. Domestic demand would crash, unemployment would soar, deflation would set in, there would be very widespread capital default and the financial system would be in very serious danger of collapse (that is, the US would face the problems that are more or less unavoidable in the euro-area cad countries). In such circumstances, the only possible source of sufficient offsetting support for the US economy would be a massively weaker dollar.
To us that means, quite simply, that fundamental equilibrium in now unattainable. And Paulson continues to intone that a strong dollar is in the interest of the US. If he believes that, he must attempt to restore a Ponzi game. But if he does that, it makes no sense to argue for “price discovery” in the housing market. Unless he is prepared to advocate 3% real long rates, a violent stock market crash and enormous dollar depreciation, he is being inconsistent in saying that the housing correction should be allowed to proceed.
Now I have always viewed strong dollar talk as just that, talk, which must annoy to our trade partners as we continue to debase our currency.
Connolly’s note in effect says that there is no pretty way out of our current conundrum. And I am not certain if a massive deprecation of the dollar would in fact stave off a very deep recession. The US is largely a service economy; we’ve ceded a great deal of our former manufacturing base to foreign competitors. Even if the dollar is trashed, I doubt that their are enough export opportunities to offset the loss of demand on other fronts. It isn’t as if the US can become the call center for India.
The other factor that makes the end game unclear is the dollar’s standing as reserve currency. A dollar collapse wipes out a lot of value in the hands of foreign central banks. Thus they won’t be too keen for this scenario to play out, but whether that makes any difference on a practical level is awfully hard to assess.
Finally, I don’t yet believe Paulson’s latest pronouncement. Just as with his palaver on the dollar, actions speak louder than words, and so far, his actions have been to prop up markets, as witness the rescue of Bear. This may simply be posturing before the upcoming Senate hearings on the JPM-Bear deal.