Hard Landings II...

When I look at the galleys of the new edition of my Macroeconomics textbook, I am struck by a sense of disappointment. Don't get me wrong--I do think that it is better than every other macro textbook out there, being clearer (though less comprehensive) than Abel-Bernanke, more comprehensive (at the cost of only a little bit of additional difficulty) than Mankiw, and much more approachable (though not as theoretically sophisticated) than Blanchard. But I wish that people who read through or take a course based on the book could then have the tools needed to analyze things like, say, the current debate over the dangers to the U.S. economy from a "hard landing" of the international monetary system.

And the textbook doesn't quite get you there. The amount of material needed to bring students truly up-to-speed on the major issues of the day seems to be a little bit more than I can dare demand.

If I were teaching intermediate macro right now, I would be very tempted to push the envelope and try to get the students to that spot right now. So here are my thoughts on the possibility of a "hard landing," crafted so that they can make sense to students who are only 3/4 of the way through intermediate macroeconomics.

Briefly, the model and the argument teach us that a hard landing is more likely:

• The greater the size and speed of the interest rate and exchange rate movements that take place when foreign central banks stop buying dollars to keep the value of their currencies low.
• The more rigid is the U.S. labor market and the harder it is to move workers and capital from construction and consumption to export and import-competing industries.
• The greater is the pass-through to import prices, and thus the more does a fall in the value of the dollar put upward pressure on U.S. inflation.
• And (this is the big one), whether enough Wall Street firms are exposed and leveraged enough to be bankrupted by large exchange rate or interest rate changes. (Parenthetically, the fact that the U.S. can and so far has borrowed in dollars makes this a much smaller worry than it would be if things were otherwise.)

Anyone who feels like making use of this, please feel free to do so--and, most important, tell me if it works.

Comments

[n00b]

Is the only difference between a medium landing and a hard landing a few NYC hedge funds? On the one hand, this is somewhat reassuring... hopefully all this talk about a hard landing would wise them up to reduce some of their exposure. On the other hand, if that is the case, someone should be able to wind this up just a little more tightly by taking highly leveraged bets against the dollar, cornering those very leveraged funds, making the fall considerably worse. What happens in the model if the dollar starts to fall or even start showing a lot of volatility outside of the actions of the banks (i.e. because of a trading imbalance?) I'm too much of a n00b here... is this even a reasonable question?

[Movie Guy]

A very good read.

On page 12, you outlined four central banker considerations.

I question whether they can "avoid allowing rising import prices to produce expectations of general inflation, and thus of an inflationary spiral."

My reasoning is based on the high percentage of finished goods including clothing sold in the U.S. that are presently manufactured overseas, particularly in Asia.

The average household earning less than $100-200K is loaded with these goods which make up a reasonably large share of their non-food budgets.

I don't believe it can be done this time. The inflation psychology kicks in quickly with gasoline and retail price increases.

Far too many retail items are being imported to avoid this probability in my judgment.

[Michael Robinson]

Apropos of this analysis, what would you say about a macroeconomic expert who would write, in May 2003:

"China's been lucky: they've been anxious to slow down industrial development to keep the social problems associated with rapid industrialization manageable. Hence the cost (in keeping their exchange rate overvalued) has seemed to the government to be a benefit..."

[Guan Yang]

You should get a copy of the Intermediate Macro textbook that my macro professors, Peter Birch Sørensen and Hans Jørgen Whitta-Jacobsen, have recently published:
http://novella.mhhe.com/sites/0077104250/information_center_view0/

It's currently used in a 2nd year undergraduate course; we used Mankiw's book in the corresponding 1st year course.

Guan

[kharris]

Write an accompanying "readings" book, and write two or three of the readings yourself, aiming at providing the tools for analyzing two or three important issues. Sell readings book, make bucks, teach important issues, feel good.

[knut wicksell]

On the textbook. I used it this year for the first time for majors students (the ones who don't have to do the calculus and linear algebra required of our honours students). It was fine. I much prefer it to Blanchard, which I thought was just a lot of hand-waving at the critical points of an argument. I wasn't crazy about Bernanke/Abel or Mankiew, though they were competent. The last book I really liked teaching from before yours was Hall and Taylor before they dumbed it down.

Short summary: you can push the envelope on students at elite schools like Berkeley and my place. It took a bit of time to get used to the notation, but once mastered, everything sailed through. The last chapter on Mundell-Fleming gets a bit too compact and foggy once you go from the short term to the long term. One of the problems is that the time period is very unclear. It takes a lot of time for PPP to assert itself outside of highly inflationary situations. I couldn't follow the argument and neither could my students.

Other than that a fabulous piece of work. The students learned a lot of real macro from it. I'm not teaching the course next year, but I'm recommending it to my successor.

[David A. Spitzley]

I may be wrong, but I believe in the clause "and on the sensitivity-of-the-exchange-rate to-
interest rates parameter", you want the parameter expressed as epsilon [subscript r], not r [subscript epsilon].

[Elizabeth]

I think you have a typo in the first paragraph. You say r-sub-epsilon, and then in equation (1) you write epsilon-sub-r.

[Ken Houghton]

The last two comments almost lead me to take up the "there's too much math" argument that seems to be a significant portion of the battlepanda how-to-teach-econ debate.

Then I double-taked the "intermediate" portion, so ignore that.

You probably do need to go into a bit more specifics on the hedge-fund risk; it's the heavy-domino/multiplier effect of any number between one (e.g., LTCM, which took a couple weeks and a major capital infusion in an isolated case) and infinity that requires capital and reserves that cannot then be used for investment at precisely the time they will be needed (i.e., when others are selling in size).

[Crab Nebula]

I am trying hard to pick Macro up by reading blogs, but it just doesn't stick. I took micro in college.

I need a narrative approach with examples for an educated lay reader. Does one exist? Will Krugman's book be the one that will shine the light?

[chris]

Considering many of the punters in hedge funds borrowed to speculate, and the hedge funds leveraged up, when that pyramid starts to crumble things should start taking on water fast. The Fed is going to have to step in to start bailing. The problem is going to be too big to chain gang the bankers that made the lending mistakes to make the save. This will be another example of Bush/Greenspam's economic policies being carried on the backs of the middle class.

"The more rigid is the U.S. labor market and the harder it is to move workers and capital from construction and consumption to export and import-competing industries."

Other readers on this blog, DOR for one, seem to be saying fat chance of that movement happening. I'd like to see clowns like Bolton and Kudlow move from the tv commentariot and think fantasy tank land to dishwasher at burger king land. Another aspect of the U.S.'s lost of soft power will be buzz for cool American products. Do you really like there is going to a surge of U.S. made GM cars in Germany or China? We can't see around corners but take some guesses what these export competing industries are going to be. All I can see is wall.

Good news in product land is hard to find for the U.S. brand. The iPod is exceptional, on the other hand it's designed in the U.S. and assembled in Asia. The NYTimes reported that Boeing is enjoying an up draft in sales for one of their new planes. When do you think you'll see an American Apparel store on the streets of Beijing, Shanghai, and Bangkok? As an aside that company seems to have lost some of their soft porn product photos and going with more anonymous straighter product shots on their on-line store catalog.

I'll print out the hard landing reading tonight and read it over the weekend. I won't be able to follow the epsilon math.

[verbal]

Yet another reader trying to learn econ by reading blogs... no econ in college-- they call me "verbal" for a reason and it's not my math skills-- Anyway:

* p2: "come do" should be "come due."

* "Suppose that [delta]R drops to zero suddenly-- is this really possible/likely? Wouldn't there be a gradual easing-off?

* p5: "but when the exchange rate is rising: [equation, chart]" -- perhaps explain what that means more clearly. I mean, the equation is good but can you put that into a sentence too for the Lit majors in the audience? "but when the exchange rate is rising, y* drops away from the fundamental potential output of the economy as suggested here:" something like that.

Anyway, I *think* I'm learning stuff from this, and I appreciate the effort you go to to explain things to everyone without dumbing it down for the people who have studied this in greater depth.

[jim.arrowsmith]

Good stuff. As a business economist--not a right wing propagandist, but an analyst for people who want to understand how the world works--I always find your writing useful