Continuing today's theme of current debates between economists, we have the lastest WSJ Econoblog installment. It's free, so read it!
David's opening line summarizes my thoughts exactly.
I truly do enjoy reading and listening to Nouriel discuss these issues -- much like I enjoy a good horror movie. It's a frightening ride while you are experiencing it, and I can't say that I don't sometimes get the willies in the dark of the night. But the whole thing just doesn't seem so scary to me in the light of day.
I'm not going to detail all the components of Roubini's disaster scenario. You can read them at his blog or at today's Econoblog. Imagine all of the bad things that you have heard about our current fiscal/financial position and multiply them by 2 or 3. Of course, as Roubini points out, many top economists join the chorus of voices repeating one or more aspects of the scenario in varying degrees. It can't just be dismissed out of hand.
While I would side with Altig on the big picture, I worry about just how bumpy the ride will be. Topping my list of things to worry about is inflation, and not just in the near term. If the fiscal imbalances in Social Security and Medicare are not fixed (not to mention the general fund imbalance), there will be considerable inflationary pressure (or downward pressure on the dollar--in an increasingly global economy the results will be similar and just as bad).
But I always am struck by the fact that the U.S. economy is probably in the best long term condition of the big three (which consists of the U.S., Japan, and Europe as a whole). The pension system in Europe makes ours look easy to solve, and Japan is aging very rapidly. (See The Coming Generational Storm by Kotlikoff and Burns--I plan an extended commentary on this book in a future post.) This is why Altig writes:
So that naturally leads to this question: If they flee from the dollar, to where are they going to run? Your "hot potato" metaphor is not apt, I think. In a game of hot potato you throw the offending spud to your neighbor, and your hands are empty. Not so in dumping dollars -- you have to end up with something else, and hope it's not a flaming carrot. Right now, perhaps investors are thinking that bet looks less than obvious.
Admittedly, being a hot potato in a world of flaming carrots is nothing to be proud of. I do think, though, that it might stave off the disaster scenario. But there is a lot to worry about in a world in which the major three economies face generational fiscal imbalances. It might be bumpy, but I'm a little more confident than Roubini.
On this same theme, the NY Times chimes in.
There is indeed a volatile blend of risks surrounding the dollar. President Bush's new budget proposal would substantially expand the government's debt burden in the next decade, potentially raising doubts about the desirability of its i.o.u.'s. Some Asian central banks have declared that they will diversify their reserves away from dollar-denominated assets. If China decouples the yuan from the dollar, it will not need as many dollar-denominated assets to keep its currency from gaining value, nor will its competitors for export markets. In recent times, long-term interest rates have stayed stubbornly low, making it difficult for American companies to attract new investment from abroad.
These ingredients may just be waiting for the right catalyst. If enough people start thinking like those at Bridgewater Associates, the dollar will lose value rapidly. There's no point trading dollars today, after all, if everyone thinks that they will be worth less in the near future. Fundamental economic factors need not worsen any further; in currency crises, perception very quickly becomes reality.
Bridgewater says it believes that the dollar is already beyond the point of no return. To keep the currency at its current value, private investors will have to buy more American securities as central banks desert them, said Robert P. Prince, the firm's co-chief investment officer. Before private investors will act, they need to see a higher return from American assets, relative to assets carrying similar risks abroad.
Mr. Prince said that those higher returns had begun to arrive through lower prices for assets. If an asset comes with a fixed interest payment, say 4 percent, buying it at a lower price will offer a relatively higher return. But these higher returns could cause problems for the economy. Borrowers in the competitive market for credit will have to offer higher returns, too, and interest rates may rise. "The Fed doesn't want that, because too much of a rise in interest rates will choke off the economy," Mr. Prince said.
The alternative is for the assets' prices to remain the same while the dollar loses value. That way, foreigners will be able to buy assets at a discount, yielding a higher return, but without putting too much upward pressure on American interest rates. (The implicit assumption here is that the assets' future returns will not be harmed too much by today's lower dollar.)
So, instead of allowing the economy to adjust purely through higher interest rates, perhaps causing another recession, Alan Greenspan and his colleagues at the Federal Reserve will have the luxury of allowing the dollar to do some of the heavy lifting. The numbers? Bridgewater predicts a further decline in the dollar of 30 percent, especially against Asian currencies, and a rise in American long-term rates of one-half to one full percentage point.
Not everyone thinks that events will play out this way. "It's really too extreme to be talking about potential crises in the dollar," said Martin D. D. Evans, a professor of economics at Georgetown University in Washington. "Yes, we have seen a large movement in the dollar versus the euro in particular, but to say we're sort of on the edge of a precipice isn't really merited by the facts. The premise here, thinking that it's impossible for the dollar to come back, I also don't buy."
Professor Evans said the Fed's hand would be forced by the rising tide of inflation. "The Federal Reserve cares about inflation," he said, "and they're going to be very reluctant if they start seeing the inflationary effects of the decline in the dollar to just sit by and say, 'But we need low interest rates to support exports.' " He predicted that the Fed would put the clamps on credit, leading to interest rates high enough to attract foreign capital: "We are going to see quite a sharp tightening in the United States, perhaps tighter than people are expecting."
Needless to say, I think Evans is right on the mark.
Unfortunately, the Times finished with this.
Though action by the Fed and a clampdown on federal spending could spare the dollar's blushes, they would both be bad news for the economy. A cutback in federal spending will, at least in the short term, create slack in labor and product markets. And one of the surest forecasters of recession is a tightening of short-term credit by the Fed.
Not so in 1994. But more on that later.
UPDATE: Andrew Samwick has more.
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