Tuesday, September 16, 2003

Endgame for the $ 

Semi-Daily Journal: The Endgame for the U.S. Current-Account Deficit
Kevin Drum interviews Paul Krugman, and in the course of the interview Krugman thinks about the end of the U.S. trade deficit:

CalPundit: An Interview With Paul Krugman: What happens if these foreign countries do stop buying U.S. bonds? Is this a real concern, or a tinfoil hat kind of thing? Oh, I don't think China is going to [stop buying U.S. bonds in order] to pressure us. You can just barely conceive of a situation where they're mad at us because we're keeping them from invading Taiwan or something, but more likely they just start to wonder if this is really a good place to be putting their money. So what happens is a plunge in the dollar when they decide to stop buying and start cashing in, and a spike in U.S. interest rates. But you might also get in a situation where the interest rates the government has to pay to roll over its debt become so high that you get an accelerating problem, which is what happened in Argentina. What happened was that suddenly no one would buy Argentine debt unless they paid a twenty something percent interest rate, and everybody says, but if they have to roll over their debt at a twenty percent interest rate, there's no way they can pay that back. So the whole thing grinds to a halt and the cash flow just dries up.

And do you think that's a serious possibility for the United States? Yeah, just take the numbers as they now look, and that's where it heads. And you might say, OK, we can easily handle it. U.S. taxes are 26 percent of GDP in the U.S., in Canada they're 38 percent of GDP. If you raise U.S. taxes to Canadian levels there's plenty of money to cope with all of this. But politically we've got a deadlock, and it's hard to imagine that happening. So you say, but this can't happen, this is America, and I guess my answer is, is it? Is this the same country that we had in 1970? I think we have a much more polarized political system, a much more polarized social climate. We certainly aren't the country of Franklin Roosevelt, and we're probably not the country of Richard Nixon either, so I think we have to take seriously the possibility that things won't work out this time...

The U.S. current account deficit is unsustainable, and as Herb Stein used to like to say, if things are unsustainable they will stop. I used to think it would stop as demand in the rest of the world grew and demand for U.S. exports grew along with it. That's becoming less and less likely. So I have to agree with Paul that the current-account deficit will end one day when foreigners decide that the U.S. is not a good place to put their money, and the dollar falls in value by somewhere between 25% and 50% in a relatively short period of time. If Bush is reelected and continues his feckless fiscal policies, my bet is that this dollar crisis comes between three and five years from now.

What consequences does such a shift in capital flows and a collapse in the dollar entail? I do find myself much more optimistic than Paul Krugman. A large chunk of the U.S. net foreign indebtedness is nominal and is denominated in dollars. The end of confidence in the American economy and the drying-up of the capital inflow leads to a very rapid and steep decline in the dollar, yes. It leads to a rapid fall-off in imports, yes (and to a slower expansion of exports). But the further the dollar falls, the more U.S. gross indebtedness to foreigners shrinks. So I think (unless New York banks' derivative positions are such as to bankrupt them all if the dollar collapses) the landing is a relatively soft one, as opposed to the brutal hard landings of Argentina at the start of this decade or East Asia and Mexico at the middle of the last one.

My bet is that interest rates spike for a little while in response to the dollar collapse, and that the U.S. undergoes a small recession, but that within a couple of years the macroeconomy stabilizes and unemployment never goes very high.

The real disaster scenarios for the U.S. economy are further out: they come when politicians try to tell the baby boomers that the combination of the tax cuts of the 2000s and the failure to address entitlement spending growth means that they don't get their Medicare, their Medicaid, and their Social Security.

Posted by DeLong at 01:23 PM

Erasmus comments:
I think both De Long and Krugman are right about the fundamentals. THe crucial question is about timing. As theirs is still a minority view and the FED/FOMC just said (Sept 16) that they will keep rates low for some time, one can enjoy the ride for a while.
Usually however the markets wake up quite suddenly, like it happened in 1994 (T-Bonds) and in July this year, when rates on 10 year Treasuries rose 140 bp in a month. Much more will happen when the international credit markets will lose confidence in US Treasuries. SO it is reasonable to say that it will take time, but how much? WHat are the indicators that the flow is reversing? Alas the best indicator are long term interest rates themselves; I do not know of a reliable leading indicator of Long Term rates. So the thing to watch is the trend in interest rates, relative to Japan and Europe. In the meantime it is hard to stay just in cash, but one should keep some siginifcant reserves, in my opinion.

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