The Coming Dollar Crisis?

As is often the case, the most interesting things I learned at last August's round of conferences came not in the formal conference sessions but in the informal small-group conversations before, around, in the interstices of, and after the conference.

Take the Federal Reserve Bank of Kansas City's "Greenspan Era" conference. It was held in Jackson Hole, at the Jackson Lake Lodge in Grand Teton National Park, in the shadow of the Grand Tetons, which are perhaps the most impressive mountain range in North America. ("Perhaps" because the Canadian central bankers present pointed out the Canadian Rockies from Lake Louise to Jasper, while Federal Reserve Bank of San Francisco president Janet Yellen sang the praises of the mountains of her own Federal Reserve District: the east face of the Sierra Nevada as seen from the Owens Valley, to be specific.) You spend the mornings in windowless conference rooms, and the afternoons outside--on the Snake River, hiking, climbing, looking for moose, looking for elk, hoping that bear are not looking for you.

But the afternoons--and the formal and informal breaks in the mornings when you flee the windowless conference room for the fresh air of the west lawn of the lodge to stare at Mount Moran and company across the lake--are filled with arguments. Go with Federal Reserve Governor Don Kohn on an afternoon hike up Cascade Canyon, I am told, and expect to gain 3000 feet in two hours while being quizzed intently about technical details of monetary policy. Try to keep from grounding yourself on sand bars in the Snake River, and you will hear ex-senior executive branch officials of both political parties give their assessments of why neither of the Bush II Treasury Secretaries has been able to make effective use of the thousand or so people who work directly for him.

This time the most interesting rounds of break-and-afternoon conversations I heard were sparked by Sebastian Edwards's paper about the U.S. current account deficit. My conversations quickly exposed a deep fault among the conference attendees. Those who analyzed or forecast the U.S. domestic macroeconomy agreed that a steep decline in the value of the dollar sometime in the next five years was overwhelmingly likely, but by and large they did not think that such a decline would pose a big problem for the U.S. economy. (They agreed that it might well pose a very big problem for some of America's trading partners.) By contrast, those who analyzed or forecast the international economy as a whole were typically terrified by the prospect of a steep (30% or more, perhaps much more) decline in the value of the dollar: they thought a severe U.S. recession was a definite possibility, and that the situation would require exceptionally skillful handling to keep from becoming a serious economic problem.

Why this disjunction?

The domestic macroeconomists would typically argue more or less like this:

Yes, the dollar is likely to decline steeply either when foreign central banks stop buying dollar-denominated assets to keep the values of their currencies down or when international speculators lose confidence or both. But so what? The fall in the value of the dollar will boost foreign demand for U.S. exports. Workers will be pulled out of other sectors into the export sector. The effects of the dollar decline are much more likely to be a plus for employment rather than a minus, a boom rather than a recession.

To this, the international economists would respond more-or-less like this:

When foreign central banks stop buying or international speculators lose confidence in the value of the dollar and thus stop buying U.S. long-term bonds, two things happen: the value of the dollar falls, and the rate of interest on dollar-denominated long-term bonds spikes. The spike in long-term interest rates discourages investment spending directly, and also discourages consumption spending because higher interest rates mean lower housing and stock prices and thus lower consumer wealth. The fall in domestic spending happens now. The rise in exports as the falling dollar makes U.S.-made products more attractive to foreigners happens two years from now. In between, a lot of people are unemployed--and as they are unemployed, they cut back further on their spending. Plus there is the risk that the fall in the value of the dollar and the fall in long-term asset prices generated by the interest rate spike will cause enough bankruptcies among financial institutions to cause a flight to quality--which will further raise non-safe interest rates, and further discourage investment and consumption spending

This then puzzled the domestic economists:

Why should interest rates spike? The Federal Reserve controls American interest rates. If it wants to keep the price of the ten-year Treasury bond high, it can simply start buying bonds until the price of ten-year Treasuries is what the Fed wants it to be. There's no reason for employment in construction and other interest rate-sensitive sectors to fall before employment in exports and related sectors rises--at least not unless the Federal Reserve makes a big mistake and allows rising interest rates to shoot the economy in the head.

And at this point the response of the international economists fragmented:

1. Some said that the falling dollar would create inflation--with imports at 1/6 of GDP, a 40% fall in the dollar would, if fully passed through to import prices, add 6% to the U.S. price level. The Federal Reserve would feel honor-bound to maintain its reputation as an inflation-fighter, and so would allow interest rates to go high enough to produce enough unemployment to push nominal wages down far enough to offset this rise in import prices. Thus the Federal Reserve would welcome the spike in interest rates as appropriate, and take no steps to offset it.
2. Others said that the adjustment to the fall in the dollar would require that ten million workers shift out of construction, retail, and consumer services occupations and into export and import-competing manufacturing industries. You cannot move ten million American workers from one sector to another in a matter of a year or two without creating lots of structural unemployment.
3. Still others said that financial stress would be the key: perhaps some major Wall Street firms would discover big unhedged risks in their derivative books; perhaps perhaps others would find that the values of their portfolios were more responsive to changes in long term interest rates than they had thought. In either case, it is financial distress and chaos that really triggers the recession.

And the domestic side had rebuttals to each of these three points:

1. If the Federal Reserve announces now that it is targeting a measure of inflation that is not grossly affected by import prices--that it is targeting nominal wage growth, say--there is no need for the Federal Reserve to defend its credibility by attacking the economy. Just as the Federal Reserve has trained observers that it is more important to worry about 'core inflation' than 'headline inflation', so the Federal Reserve ought to be preparing observers to recognize that inflation produced by rising import prices is a one-time event, not an inflationary spiral that needs to be fought by triggering a deep recession.
2. A large structural shift will cause high unemployment only if the transition is quick and brutal, and only if workers are pushed out of job-losing rather than pulled into job-gaining sectors. Whether it is quick or gradual and whether it is push or pull depends, once again, on the path of interest rates. Only if the Federal Reserve fails to do its job and allows for a massive interest rate spike is there a problem.
3. Financial stress is something that can be managed: if the Federal Reserve keeps the path of interest rates smooth, great financial stress is unlikely.

And the domestic side of the argument pointed to the historical experience of the U.S. from 1986-1990:

Between 1985 and 1989 the value of the U.S. dollar declined by 40%. Between 1986 and 1990 the U.S. trade deficit declined from 4.0% of GDP to 0.5% of GDP--without a big recession, or significant macroeconomic distress.

Before dinner one evening I was lectured by a prominent Washington-area international finance economist about all the reasons that the 1986-1990 U.S. experience was likely to be a bad guide to the future:

1. 1986-90 began with a 50% decline in world oil prices, a powerful stimulus to the world economy. This time the process is beginning with a doubling of world oil prices.
2. 1986-90 saw Europe growing rapidly. Europe has a high propensity to buy U.S. exports, and the European boom meant that U.S. exports grew much faster in the late 1980s than anyone had expected. This time it is Asia that is booming, not Europe. And Asia has a relatively low appetite for U.S. exports.
3. The Japanese government was willing to buy very large amounts of dollar-denominated assets in the late 1980s to keep the decline in the value of the dollar "orderly." In so doing, it inflated its domestic credit base and touched off its own property bubble. No foreign government is going to risk this again just because the U.S. would rather that the decline in the dollar was slow and orderly.
4. The problem then was half as big relative to the size of the U.S. economy as is the problem now.

One way I found myself thinking of the argument is that the domestic-side economists look at the goods market and think of a decline in the value of the dollar as a supply shock, and as not that big a supply shock: if half of the adjustment in import prices is taken in reduced margins by producers abroad, and if the shock is spread out over four years, then 40% / 2 x 16% / 4 = 0.8% increase in inflation relative to baseline over three consecutive years. The Federal Reserve could easily allow that to happen without--providing it explained its causes well--running any risk of damaging the credibility of its commitment to effective price stability. No big deal. International finance economists, by contrast, look at the asset markets. A 40% decline in the dollar over four years is a decline at the rate of 10% per year. Once financial markets convince themselves that such a decline is coming and that they need to be compensated for it, that ought to drive a 400 basis point wedge between U.S. and foreign long-bond expected returns. And that is a very big deal.

Martin Feldstein said something very smart just after we had both taken off our shoes at Jackson Hole airport. He said that the domestic-side economists were keying off the past experience of the U.S. after 1985 and of Britain after 1982, and so were saying "no big deal"; while the international finance economists were keying off of the experiences of developing countries that had run large current-account deficits--Mexico 1994, East Asia 1997, Argentina 2001. Each side had its own preferred models that functioned very well at explaining the past historical cases that they focused on. But there was no way right now of settling, empirically, whether a model built to explain the U.S. in 1985 or Korea in 1998 was more applicable to the U.S. in 2006--you had to make a bet, either that continuities in U.S. economic structure were important, or that financial globalization was important, in choosing your model and your terms of analysis.

It was very interesting. And very disturbing. Brilliant economists, thinking hard, unable to reach even the beginnings of analytical agreement about how to model the distribution of possible futures.

Comments

[Saheli]

Since so much of this analysis, or at least the various counter arguments of the domestic-side, depends on the dependability of the Fed, is there any reason to believe that the Fed is substantially less or more able to react properly than in 1986-1990? Just wondering since we've been talking about the importance of considering changes in personnel lately anyway. . .

[robert waldmann]

I wonder why the international economists didn't stress the yield curve. The FED can control short term interest rates. Why does this imply that they can control long term interest rates ?

I also think the economists might actually agree. A collapse of the dollar implies an unusual challenge for monetary policy makers. If they are smart, all will be well (for the USA). Domestic economists are still in love with Alan Greenspan so the assume the US macroeconomy will be fine. The international economists might mention that he won't be around.

I'd ask the domestic economists if they have considered the possibility that Larry Lindsey will be fed chairman and if they are storing up on canned goods.

OK now the other side. The countries which suffered all listened to the evil IMF. The USA listens to nobody and so will be fine.

Less Stiglitzanly, the countries that suffered had dollar denominated debts all over the place to foreigners to each other etc. The US has dollar denominated debts. The collapse of the dollar is a collapse of US foreign liabilities. There is no balance sheet mismatch over there in the USA (over here sure I have dollar denominated assets and my consumption is gonna tank if I don't do something soon).

I think the basic story is that the domestic economists are saying "we're the USA. The normal rules don't apply to us. We make the rules."

[Norman]

History tells us we shouldn't get so up in arms about the dollar although it is fun to do. The FRB puts out a 'real' value of the dollar vs major currencies (which is what we should use to take into account respective inflation rates): http://www.federalreserve.gov/Releases/H10/Summary/indexnc_m.txt. FYI since 1972 it has averaged 95.6 and is now 90(so close to the average to make some wonder what the big deal is); the standard deviation is 2.8 or a measly 2.9% of the average so for 95% of the time the dollar is within a measly +/-6% of its average!!!. The peak was 131 in 1985 and the second peak was 117 on Feb 2002. The lows have hovered at 80, 16% below the average. So, what's to worry so much about?

[Brad DeLong]

Re: "I wonder why the international economists didn't stress the yield curve. The FED can control short term interest rates. Why does this imply that they can control long term interest rates ?"

Because Greg Mankiw said: "The problem is that the yield curve steepens because the Bank of China has stopped buying so many ten-year Treauries? OK. The Federal Reserve starts buying ten-year Treasuries and keeps doing so until the yield curve flattens again..."

[Andrew]

"The Federal Reserve starts buying ten-year Treasuries..." does this translate as "The Federal Reserve starts printing money..."?

[wcw]

Short answer to Andrew: yes. The fed is allowed to print money, you are not, and that's just the way it goes.

Brad, did you ask Greg whether the Fed was prepared for the attendant domestic inflation, or was that effect understood under the hypothetical to be a good thing?

[Katherine]

Some economists have pointed out that we have dismantled a considerable percentage of our export goods producing infrastructure. We might not be able to ramp up our production of exports quickly and easily when the dollar drops.

[STS]

Great post, Brad. I'm also puzzled by the domestic economists' complacency regarding inflation. If the long end of the curve is held down by helicopter money won't that lead to substantial inflation in domestic goods? So the inflationary effect wouldn't be isolated to our share of the increased dollar cost of imports.

And once the inflation gets going, doesn't the Fed have to start ramping up short rates again? Seems like the Fed would be deliberately inverting the curve (image of helicopter marked "FRB" spinning wildly out of control while pouring money overboard).

Once the dollar starts sliding, it looks to me like a one-way ticket to stagflation.

[bradsetser]

Prof. Delong -- Nice summary of the debate; it seems that the conversation among the great and good is not all the different than the conversation with the working stiffs in the bowels of the fed who occasionally chat with me. I think Feldstein's analysis of the source of the disconnect is right. And your point about the need for a large spread between US and asian bond yields to compensate for the risk of dollar depreciation also gets to the core of the problem, though market developments this year have shown that spread differentials can come about from falling yields abroad not just from rising yields here (See Bund v. treasuries). That is presumably part of the story -- and something that I wish I had considered more carefully a year ago.

I am a bit surprised that Mankiew is so interested in buying the ten year -- that is not quite the policy advice the US and the IMF gave emerging markets whose currencies were under pressure (tho perhaps it is the advice Stiglitz would have wanted ...). But emerging markets had to work about pesky balance sheet effects and the US does not.

In any case, I am pretty clearly on the same side of the debate as the prominent washington based international-finance expert -- though i would take issue with one point he/she made. It seems to me at least plausible that China will act much like Japan in the 1980s, buying $ like mad, damn the domestic consequences. At least I cannot rule that possibility out, particularly when the domestic consequences of chinese intervention currently seem more manageable that I expected.

I put a strong emphasis on the point Katherine emphasized -- the weakness of the US export infrastructure. It implies that a larger fall in the dollar is needed to do the job than was the case in the 80s -- the "deficit" relative to the US "tradeables production base" is bigger. Rogoff is right - also compare say korea's adjustment with Argentina's. After the dollar falls and the big profits are in the export sector, workers will need to move across sectors. and there may need to be changes in composition of the US capital stock, which takes time -- that may limit the United States' capacity to quickly respond to the stimulus offered by a falling dollar.

I certainly here the dollar fall = stronger demand for us goods, and there is no reason why it needs to lead to higher US rates so long as the Fed does its job argument all the time. A couple of questions though --

a) I see how that a sudden fall in the dollar might be consistent with low us rates after the dollar had fallen -- assuming that folks in the market were totally convinced the dollar had fallen as far as it needed to and thus its next move would be up. This is basically the jeff Sachs policy recommendation for Asia. Don't fight the depreciation/ keep rates low to support the domestic economy. But that is also the circumstance when the "gap" between the composition of the US labor force and US capital stock and the us labor force and capital stock that would be needed to respond to weaker dollar would be greatest. the adjustment in asia -- which had a solid export base -- still came mostly from a fall in imports, and i don't think a different interest rate path would have changed all that much. dollar debtors would still go bust. moreover, i suspect that it will be hard for many to know when the "move" is done --

b) perhaps because of my international background, I find the emphasis on domestic us inflation rates as the sole determinant of US interest rates a bit puzzling. foreign investors hold a larger and larger share of US debt securities, and they presumably care far more about the path of the dollar v. their home currency than about the path of CPI. That is not to say that inflation rates do not matter -- domestic investors still hold more of the stock of debt claims on the US than foreigners do, and at least some domestic investors could care less about the dollar (though they too would gain by shifting assets abroad prior to the dollar's fall ... ). But at some point, i would think fx market dynamics would start to cast a bigger shadow over the us fixed income market. the fact that the US has a larger gross liability position than a net liability position adds to this concern -- a decent share of the world's wealth hinges on real external value of the dollar.

the best counter to this comes from the Gagnon paper -- Australia had a large net and gross liability position in the 1990s, and was still able to carry off an external adjustment without a surge in domestic rates. i wish to find time to look into that episode more closely.

Finally, I recommend the appendix to chapter 1 of the WEO by Milesi-Ferretti and Laxton. it looks at this very set of questions. http://www.imf.org/external/pubs/ft/weo/2005/02/pdf/app1_2.pdf

[knzn]

As Robert Waldmann pointed out above, part of the reason the US is not like Mexico, Korea, or Argentina is that our debts are in our own currency. But another difference I think is even more important is that the US is “too big to fail” from the point of view of the rest of the world, particularly since most of the world either depends on demand from the US or competes with the US (or both). If Argentina’s currency collapses, it is of only minor interest to most of the world’s central banks. If the US currency collapses, much of the world is going to be screwed. If central banks care about employment and about avoiding deflation, they will be willing to spend quite a lot to keep the dollar from collapsing abruptly.

I am therefore puzzled at point 3 of the “prominent Washington-area international finance economist.” Japan in the late 80s had (what appeared to be) a very healthy economy. If they didn’t recognize the risks from supporting the dollar, they also had little to gain in the way of benefits. Today, foreign countries may be more aware of risks from supporting the dollar, but they are also surely aware of even bigger risks from allowing their currencies to appreciate too quickly against the dollar.

The underlying premise of this discussion is also a little puzzling: “the dollar is likely to decline steeply … when foreign central banks stop buying dollar-denominated assets to keep the values of their currencies down.” Why steeply? It will decline at whatever rate they want it to decline. If they want the dollar strong today, why would they make a sudden shift to wanting it weak (or to indifference)? Can anyone even imagine that the PBoC would continue its present regime for a few more years and then suddenly announce a free float?

[Ian D-B]

It seems like part of the issue is that there simply aren't many analytical models to deal with this. as you point out at the end, there's a good deal of model uncertainty, and within each model, there's a good deal of uncertainty over the specific parameters. Moreover, there just aren't good models for thins like central bank credibility. Sure, the fed managed to convince people that core inflation is the correct measure, but will that work for imports? Were they only sueccessful with core inflation because the rise in food and energy prices has been generally tolerable? There are big problems beyond just losses in credibility that come from high inflation. And the main point is that we simply don't know how credibility is gained or maintained.

one last thing about credibility and model uncertainty, it doesn't seem like people know very well exactly what it is about inflation that makes it so dependent on past values, and how many past values are actually important. If the bank really is so credible, then the slope of the Phillips curve should be flatter, and the effect of past inflation should be smaller. In the models I've worked with, neither of those things have happened.

And speaking of Mankiw, he seems to have this impression that interest rates are fully controlled by the fed. I find it difficult to believe that they can put rates exactly where they want. Although I will accept that they have a good deal of control nonetheless.

[Michael Cain]

"Some economists have pointed out that we have dismantled a considerable percentage of our export goods producing infrastructure. We might not be able to ramp up our production of exports quickly and easily when the dollar drops."

In addition, if the US is suffering a structural increase in unemployment over a couple of years as adjustments take place, countries which currently have large trade surpluses with us would be suffering somewhat the same problem. Will those countries suffer this gracefully, or is protectionism, either explicit or implicit, likely to occur? What are the consequences of that?

[Bear]

>You spend ... the afternoons outside ... hoping that bear are not looking for you.

Hope all you want... I AM looking for you.

[pat]

Brad,

Great post!

STS,

I think you are exactly right -- stagflation it is. The way I look at it, a 30% drop of dollar mainly due to foreigners' reduced demand for the currency is a combination of a negative supply shock (less fund to invest in the US) and a positive demand shock (more demand for US goods), so even with the best Fed response, a mini stagflation is what we should expect. And Mankiw's idea of using expansionary monetary policy to deal with a positive demand shock? That will give us a full blown stagflation.

[nate]

In upcoming year it will be interesting to see how U.S. economy (GDP growth, labor markets) hold up if the fed raises rates to 3.75% and beyond. If the U.S. economy does okay, and interest rates are higher in the U.S. than in other parts of the world, this might help prevent a dollar decline of the magnitude described (30%+).

it would be nice to see Prof DeLong post several interest rate parity math problems and scenarios-

[nate]

The annual % spending increases in fiscal spending for years 2006-2008 will be interesting as well-

[tjallen]

From above:
"Some economists have pointed out that we have dismantled a considerable percentage of our export goods producing infrastructure. We might not be able to ramp up our production of exports quickly and easily when the dollar drops."

Rather than spending large amounts of money building factories, for the old-style physical goods export market (old-economy picture), perhaps the US will be exporting intellectual goods (movies, music, computer games, Windows 2008, Photoshop 19, books, patents, etc) for the new economy picture.

Advantages - 1. The production of intellectual property for the export market does not require the same kind of capital investment in factories, raw metals, big labor force, that we remember from the old economy. If the dollar falls, we won't be seeing Ford export more autos, we'll see MacroMedia exporting more copies of DreamWeaver. 2. Intellectual goods cost less to export than old fashioned heaps of metal and plastic. We don't need to schedule a ship, a crane and a port of exit, rather we export software by mailing it FedEx!

Political comment: Maybe after BushCo has ruined the way the rest of the world looks at us, perhaps they won't want to import our ideas, entertainment and computer media.

A few weeks ago, Anne asked: with interest rates rising and choking off the housing boom, where will the economy get its next lift? Maybe the answer is, as the dollar falls, the economy will get an export-led boost from the overseas sale of our intellectual property. Maybe? Just speculating...

[nate]

Intangibles figure into this. I am reading Hayek's Road to Serfdom. In the first several chapters, what caught my eye was Hayek's discussion of "tolerance" (see page 18- paperback). It becomes important to ask: is the U.S. more or less tolerant today vs. 5-6 years ago? How does this affect currency?

Also, on exporting intellectual property: a lot of the world may not recognize intellectual property the same way the U.S. does. This is a challenge for exporters of IP, and to the expectation that IP will solve trade deficits.

[wiffle]

The dollar falls, export goods are lacking, so the available dollars chase real estate, keeping it high, or at least not collapsing.

[CapitalistImperialistPig]

This is pretty scary to the non-economist. You guys really don't know shit about the most crucial economic issue of our age.

This is like physicists setting off the atomic bomb while everybody was still arguing about whether or not it would ignite the entire atmosphere.

[Barry]

I have to add in my wonder at how the export sector could ramp up quickly. It's not just a matter of old vs new economy; moving large software-writing operations back into the US should take time, and that's *after* people were confident that lower US wage rates would hold.

And in many cases it would take well over a 50% drop in US wages even to bring it under consideration.

[Maynard Handley]

"
But another difference I think is even more important is that the US is “too big to fail” from the point of view of the rest of the world, particularly since most of the world either depends on demand from the US or competes with the US (or both).
"

I don't buy this. Too big to fail works for something like Citibank because those who land up supporting Citibank basically want Citibank to succeed. On the other hand, if the US gets into trouble you'll have 90% of the world's population dancing in the streets and ready to tell politicians that, sure, they're willing to suck it up for a year or so if necessary, they've done it before, just so long as their country does absolutely nothing to help the US out of its misery.

[João Carlos]

Let's me ask to you economists: what will happen with the federal budget defict if the dollar decline? I am sure that the GOP will not care and will want more tax cuts. You know, tax cuts are the cure for all economic problems....

So, IMHO we will have huge federal budget defict while the dollar decline and there are less international investors buying treasure bonds. IMHO it is not a good environment to the FED buy treasure bonds and inject new printed dollar at the domestic economy. I think that the inflation can lose control if the FED try it because the treasure will need print more treasure bonds to pay the federal budget deficit (that the FED will need buy...can you see the problem?). And any dollar inflation will make the dollar decline faster and it will make the federal budget deficti bigger. The crisis can simply lost control.

Maybe the true question to determine what model is more problable to happen if the dollar decline (if the 85-89 USA model or if the Argentina model) be verify how the federal budget behave then. If a (huge) federal budget deficit happened when the Argentina and other latin america countries had the financial crisis and if USA hadn't a (huge) federal budget deficit at 85-89 I can see a big crisis coming....

To make it worse, remember that now there is the Euro to compete with the dollar for the position as international trade currency. The USA economy can be severy dangered if the countires that produce oil start to sell the oil at Euros while the dollar decline. You can suddenly discover that you don't make the urles never more because the dollar is not more the coin that measure the debts that you make buying goods from other countries.

João Carlos

sorry the bad english, my native language is portuguese.

[AllenM]

Seignorage!!!!! WHAT ABOUT THE LOSS OF BEING THE NUMERAIRE!!!
That is what the international economists whisper in the dead of the moonlight glowing off of those mountains...what if we buy the ten year note and provide mountains of liquidity and the dollar still falls and interest rates still rise....argentinian, or something far worse? Is that not the fear that was beginning to play out in the late 70's before the coming of Volcker and the explicit targeting of the MONEY SUPPLY- and through impossible interest rates?

Fear. Fear. Fear. The FDR mantra is true when you have to close the banks and nationalize the gold supply ahead of a devaluation. In this era we have forgotten fear in our domestic markets, and all we have left is greed, total greed. Now we shall pay the price. The paradigm of the late 80's is toast. Now we shall remember the paradigms of the early to late 70's...
and fear shall return to the nights of wall streets mightiest creatures through their derivatives and through Herstatt...

[marquer]

Energy. Energy, energy, energy.

The US economy is, today, critically dependent upon imported supplies of energy.

My best guess is that even the (relatively modest!) energy price shock we are now experiencing may well give us a horrid round of stagflation for 2006.

If the dollar takes another serious nose dive, expect to hear the petroleum exporters begin to talk seriously again about contract settlement in euros. If you command supplies of an incredibly important trade good, why consent to sell it in exchange for an increasingly valueless currency?

[AllenM]

I suppose that my previous comments look a trifle doom and gloom. That is true. They are meant to be. How else does one begin to describe a situation where the last commodity based portion of our currency system is now subject to Gresham's Law? Yes, the lowly penny from before 1982 is now worth more as scrap metal than as currency. Have you looked at the metals markets lately? After all finished refined metals are the result of an energy intensive process and represent the peak of utilization before disappearing into the goods production process. Silver since 1999- 100% gain. Gold since 1999- 80%, platinum up over 100%, copper well over 100%, aluminum, tin, lead, etc etc etc. Now the costs of higher energy have not yet fully transmitted through the metals groups alone...now does this sound like low inflation is on the horizon?

[piotr]

1. Too big to fall.

I guess that money managers may have difficulty finding, say, a trillion dollars worth of atractive investments outside USA. There would be a considerable risk of getting hit by dollar drop, realizing the losses, and then getting hit again when, say, Euro drops from the peak value at which we performed the conversion.

When money runs away from, say, Argentina or Russia, it does not alter asset prices all over the world, or at least not as much. For this reason, withdrawal of assets from USA would have to be gradual.

2. Energy prices and impact on assets

What does it mean for the dollar to drop? Perhaps it would mean that oil goes up, in dollars. We are talkining about 100+ dollars per barrel, 4+ per gallon of gasoline etc. Affordability of long distance commuting in large cars and of heating/airconditioning Mansions may drop. Mind you, this happens together with a whack on interest payments on the interest-only mortgages that were so popular of late. Can we have a depression of property values, and thus of domestic demand etc.?

3. Can Fed print money?

I though that they can only force the banks to deposit funds with them. So saving deposits, money market accounts etc. could be converted into T-bonds and T-bills. So far so good, but the pool of savings in banks is limited and that can ricochet in the private credit market, like mortgages and credit cards.

Genuine printing of money, I thought, is a bit like using a nuclear weapon. Isn't it a way to produce hyperinflation?

[RMF]

Well, dear Brad, you finally seem to be getting a grip on what the big controversy is! Thank you for explaining it!

My impression is, the domestic economists have mostly it right:
The US has been a fantastic story of growth for many decades. Productivity is growing, society is open and makes generally good decisions, the Bush catastrophe is horrible but not so damaging after all, democrats will come back sooner or later. Therefore, the US makes the rules, the whole world wants to invest here, the dollar is used throughout, hundreds of people inmigrate here every day. The value of the bonds of the only empire left standing won't suddenly collapse. Investors will not loose confidence. And therefore, there's not too much to worry about.

(My impression is the Sebastian Edwards setup is a portafolio balance model. Is it? You really think there's a nearby bound to the amount of US debt people want?)

However, the US will have to go through a long, and
difficult adjustment one way or another. A 1% drop in GDP/consumption can make any society suffer greatly. If the US must reduce imports by 6% of GDP, that should be very painful, whether it is through higher prices, less credit, or high unemployment. That together with aging baby boomers worldwide, continuing engagements around the world and high oil suggests difficult times are ahead for this country, unless productivity rises even faster.

Finally, I think the International Economists have the policy implications and criticisms right, first because the longer bad fiscal policy is around the more pain will come in the end, but also because of the financial meltdown story. Global markets are not SEC controlled, NY fed analized, or even profit driven! ...and therefore the potential for a big decision from the Chinese or the japanese or a big hedgefund can probably change market prices quickly and bring many balance sheets to pieces. A 1% chance of a high rates, high mortgage default, bankrupt banks, dollar falls 75% scenario, financial wealth dissapears is worth paying a lot of attention to.

ok. sorry for the long post.

[christo]

This is a good attempt at a clear balanced summary where Prof. Delong is trying a corrective action to the panic that set in this week. Didn't things get crazy yesterday? Bush didn't mention Osama at all. The head poobah of our lower house of the peoples' deputies makes a fend to claim the mantel of Juan Peron. If the United States is a big rig 18 wheeler and we assume that all the wheels were still on on Aug. 25, we are now down to about 15 wheels still inflated and servicable.

What goes assumed here is the Federal Reserve and some bureaus of the Treasury are the last bastion of good government in the U. S. There will be no battle for Helm's Keep (sorry, what is the name of the citadel in Tolkien's The Two Towers?). We're not going there. Was Kudlow who yesterday called for a return of the sedition act there? It he was, was he avoided like a Thai chicken with the avian flu or was he listened to due to his TV audience? Were the flinty eyed right wing economists trying to act civilized not yet willing to wear the Delay sackcloth? Were the reality based ecnomists operating under the hope that one day they will get to return for a posting to the Treasury or the Federal Reserve?

We're already into stagflation which our current methods of counting the important econ statistics mask. Go ask one of the 10 percent unemployed what their daily bread and butter life is like. Ask some of the wait help.

Thanks for your help in trying to get us back to rationality. Unfortunately you are focusing on an area where we already have less control than the governors want to admit. Here's the whammy, Bush is going to pick Greenspan's replacement. And here are two questions that one in the know can explain, is Greenspan the head Fedster who has been most responsive to political pressure? How will his replacement differ?

[Anthony]

But another difference I think is even more important is that the US is “too big to fail” from the point of view of the rest of the world, particularly since most of the world either depends on demand from the US or competes with the US (or both).

Posted by: knzn | Sep 15, 2005 3:06:46 PM

heh. I don't buy that. Russia was "too big too fail' too for half the planet but it fails.

Let's put it this way. In an idiologically hostile world, why not brings US to its knee and buy the pieces on the cheap? Economist only think about this or that monetary. What if, a shrewed global investor play the game instead?

The question should be asked, then: what does it take to destroy US economy using currency exchange and what precious technology can other countries buy?

Money is just that 'carrier of value', If it worth more to destroy it by gaining a lot of technologie and institutions, why not?

eg. If China destroys 80% of US economy, will walmart suddenly stop importing cotton underwear or Saudi Oil?

I always find it rather cute how economists always forgetting that the value of money doesn't lie within money. It's how it moves.

[João Carlos]

piotr wrote:
"Genuine printing of money, I thought, is a bit like using a nuclear weapon. Isn't it a way to produce hyperinflation?"

Yes, it is a way to produce hiperinflation. I am from Brazil, so I know it... I saw hiperinflation start with huge federal budget deficts that were paid printing money.

The problem with "Too big to fall" is that USA federal budget deficit is going be "Too big to pay". If the budget deficit is too much big that USA economy cannot pay it (because the defict is greater than all USA GNP)or if became evident to external investors that the that the defict will be eternal and will be not payable at the future (for example if the GOP make the cut tax permanent) that can be a BIG HELL problem. If the international investors finally start to think that the USA budget defict cannot be paid the withdraw of USA's assets will be not an option and that will not happen gradually. Simply, no one will have other choice because the USA economy is "too much big" for its own good - no one can pay the huge federal budget that USA big economy can create....

And as I said it, printing money and hiperinflation will not make the federal budget defict go lower. Au contraire.

The loss of the "seignorage" will be an inevitable consequence from the federal budget deficit exploding under higher inflation and a hell to USA economy if it happens.

João Carlos

Sorry the bad english, my native language is portuguese.

[Anthony]

I don't buy this. Too big to fail works for something like Citibank because those who land up supporting Citibank basically want Citibank to succeed. On the other hand, if the US gets into trouble you'll have 90% of the world's population dancing in the streets

Posted by: Maynard Handley | Sep 15, 2005 5:25:26 PM

yeah. I always find the whole idea of 'we are too big' to fail, incredibally naive. It's similar to pentagon wishfull thinking 'Iran' won't retaliate cause they are too afraid of our weapons. In the meantime the Iranian already infiltrate Iraq and play the game.

Who says we are too big to fail. What if Russia and China play our game in the 80's. Let's bring down US and buy out the pieces. Make it beg. How much will it cost? $500B to $1T maybe? It's a good deal if you ask me. Weapons, relative large market, intelectual propterties.

The british empire was also thought to be too big to fail once.

Anybody who thinks The middle east, Russia, China, and India are so needing our market to survive is deluding themselves.

[christo]

Yes, our central planners manipulating their various chess pieces are ready to roll out the Donald Trump defense, "when you owe the bank $100 mil, the bank owns you. When you owe the bank $1 bil, you own the bank."

Ha, ha, Mr Kudlow and Seignorage Bernanke de Helicóptero Bendecido chuckle over a tequila with their feet up on the parapet of Helms Deep, "let's see how those brownies will manage if they make us pay. Let them eat their stinking IOUs. We still have our pistols."

Switching and mixing metaphors instantly as is customary in our current government, the democratic bankers fret and whine over on the side equivalent to the navigators in Frank Herbert's Dune, "will we ever be allowed to navigate the starships again?" Greenspan at the bridge looks over his shoulder while ship number three "Unioin Industrial Employment" crashes into a sun, "I'll let you control a dial, please turn the applause meter 0.011341 mm up. Those screams of the lupin at the gas pumps are drowning out my praise."

[shah8]

Dr. Delong, I think the people you talk to aren't really thinking very wholistically.

1) The domestic economist's chief weakness is the *speed* of decline of the dollar. If it isn't slow or cannot be controlled, most of their assumptions, I think, goes out of the window.

2) We are bumping into supply constraints. Printing money does no good if there is no more slack in resource extraction and processing into crucial economic materials...

3) We have social issues that are growing ever larger. The wealth and income gaps are widening, and if it continues, political unrest is probable. When you go walking into an urbane Borders and use the restroom, and read graffiti that talks about killing bush, and killing republicans, it really brings into mind that there is substantial discontent forming.

4) While the US would have its supporters in trying to keep the thing going, past history shows that other countries competing with a failing hegemon generally generally favor undermining it, even as its economic elite favor keeping the system. Politics simply will not allow accomodation.

5) It is extremely obvious to me that all the hope of Fed is a psychological punt, that they will do what needs to be done because they HAVE to. All you have to do is look at Nixon through Reagan to see what happened as people tried to cope with the disastrous guns 'n butter program. They have less control than they would ever admit. It is also odd to think that these people could think so little of Bush and his crew, and think that the Fed aren't just as subject to political pressures as other agencies...

[Matthew Saroff]

> This is pretty scary to the non-economist. You guys
> really don't know shit about the most crucial economic
> issue of our age.

> This is like physicists setting off the atomic bomb
> while everybody was still arguing about whether or not > it would ignite the entire atmosphere.

> Posted by: CapitalistImperialistPig | Sep 15, 2005 4:44:31 PM

No. The economists are more like the seizmologists who did not no whether or not the earthquake off Ache would cause a Tsunami.

They won't ignite the universe, but they may be unable to save people by warning them in time.

[me]

"We don't need to schedule a ship, a crane and a port of exit, rather we export software by mailing it FedEx!"

I guess you haven't heard. Software is made in India and China. Movie employement is being offshored - Canada, New Zealand, Canada.

We are in real trouble if we depend on your list for exports.

[Anthony]

Dr. Delong, I think the people you talk to aren't really thinking very wholistically.

Posted by: me | Sep 15, 2005 8:15:10 PM

Thinking? lol.

[christo]

Talk to Bill Gates about selling software in China. It's okay to spend a few hundred million dollars in research centers and tailoring the product to the central bureaucrats demands, but getting the bureaucrats to buy it, forget about it. For the other edutainment stuff, there are no moats around a DVD burner.

[bradsetser]

too big to fail, or too big to save (at a reasonable cost to those financing the rescue)? it the fiscal deficit heads toward $500 b plus next year, the current account deficit expands a bit too and the dollar hits another round of turbulence, it will be interesting to see how the big players now on the sidelines (Japan, europe) act -- and when china finds it a bit harder than it does now to "stabilize/ save" the US by supporting the $ and also to achieve its domestic goals.

[rod]

brilliant economists and among them is our friend brad. very grateful for this explanation. only: it leaves out the political scenario. all this cannot unfold without political intervention. what would that intervention be? it will tilt the scales toward the horrendous or toward the bearable. what would it be? our econofriends always leave this out. they praised greenspan and left out the savage attacks on the middle class standard of living that he launched. they brilliantly fail to come to consensus an effectively leave the outcome in the hands of financiers and politicians. then what happens?

[Movie Guy]

I appreciate your presentation, Brad.

And I applaud the many fine comments of the posters.

Your conclusion that intelligent "economists, thinking hard," are "unable to reach even the beginnings of analytical agreement about how to model the distribution of possible futures" confirms my conclusions and reinforces my low level of expectations from the majority of your professional field.

The collective failure of key economists to "reach even the beginnings of analytical agreement" is not so dissimilar from the failures of U.S. Federal Government DHS and FEMA that we have witnessed in the past weeks. Preparation time existed, but was misused. The scale of the pending natural disaster was obvious to all but the number crunchers and regulation enforcers.

Similarly, the mismanagement of the U.S. economy whether related to misjudged outcomes regarding the continued push for globalized trade or repeated fiscal budgetary abuses has set the United States on a collision course of sufficient magnitude that key economists should be working collaboratively around the clock on efforts to provide realistic plans of action to address each potential major emergency, or adverse global and domestic upset. But that level of dedication and cohesiveness does not exist in the professional ranks of American economists.

The American economists have no current national economic sustainability or recovery blueprints. None. They're just 'winging it'.

Welcome to DHS/FEMA-style economics.

[Fat Tails]

1. Who could have possibly predicted that someone would hijack a plane and fly it into a building?

2. Who could have possibly predicted that a hurricane of that scale would hit New Orleans and cause the levees to break?

3. Who could have possibly predicted that the rest of the world would eventually fail to support the US Dollar, the Petrodollar?

Gold is printing $458/oz as I type, up another $3/oz in overnight trading.

[Spectator]

Fat Tails has exposed the core of this entertaining but pointless discussion.

The US is openly running a confidence game, relying on past glory and the gullibility of the rest of the world. Well, you can't fool all the people all the time. Remains to be seen when those buyers/lenders will wake up - but wake up they will. Then it'll be an Argentina here, and we'll discover the value of intellectual property in a depression.

The tragedy here is that Economics is such a pathetic science, and fails to offer any real help with these giant blunders. Just a lot of fashionable speculation dressed up with fancy but baseless math.

[realist]

if the domestic economists' central arguement is that other countries must depend on investing their money in the u.s., then they have no arguement. bahrain, the united arab emirates, kuwait, oman, quatar and saudi arabia have pulled tens of billions of dollars out of the u.s. since 2001. in that time period their collective stock markets have soared 400%. their domestic markets are booming, while our economy, addicted to their oil, is on the verge of fragmenting. i believe that the large net exporting countries must know that the parts of the u.s. are worth far more than the whole.

--------------------------------------------------------------------------------

Name:

[glenn hefner]

One question - can the Fed pull it off, that is, buying enough 10 years to direct long term rates? I guess in theory, they can buy as much as they like, but with inflationary consequences. I'm wondering if there's any reasonable ballpark figure - how many billions worth would need to be bought. And I guess Bernanke believes that if the Fed were to just say that are doing so, is enough to shift rates down ...

[asiequana]

Sorry to nitpick Brad but a 40% decline over 4 years is not 10% a year. The math is ((1.40/1.00)^(1/4))-1 which is 8.78% a year.

[anne]

Brad Setser:

"It seems to me at least plausible that China will act much like Japan in the 1980s, buying $ like mad, damn the domestic consequences. At least I cannot rule that possibility out, particularly when the domestic consequences of chinese intervention currently seem more manageable that I expected."

No, no, never, think Chinese leaders and advisors ignore the domestic consequences of policy decisions. There is a reason China is gorwing in a way that can dramatically change the lives of 1.4 billion people. To underestimate the understanding of a leadership that prizes education is a little foolish :)

[anne]

Excellent and thought provoking post and comments :)

[Mr. Econotarian]

I think the uncertainty isn't the issue.

NO ECONOMIST can give a good ECONOMIC REASON why the U.S. federal government should be SPENDING SO MUCH now that it leads to the kind of deficits we are currently facing.

We can argue about fine points of tax rates and who pays them, but the point is that too much is being spent by government without seeing any real economic benefit. Infact a lot of spending may actually be hurting the economy (such as health care spending that distorts and inflates the health care market).

[knzn]

bradsetser: You make a good point that bigness also makes it harder for the rest of the world to save a country. I would argue, since it costs nothing (e.g. for China or Japan) to print money, zero times a trillion is the same as zero times a billion, so as a first approximation, it’s just as easy to save a big country as a small one. Of course there are indirect costs (mostly potential instability) to printing money, so it’s not quite so simple, but I have a hard time imagining that the indirect costs are as large as the costs of the alternative (passivity). (In my view, the indirect costs don’t include inflation, which will not be an issue for a currency that is starting to soar against the dollar.) And I should be clear, I’m not arguing that anyone will necessarily be trying to save the US. They will be trying to save their domestic economies (individually) by weakening their currencies.

[AD]

I would really appreciate it if somebody who knows more than I about economics would explain why Mankiw can say to Brad that the Fed can just buy Treasury bonds to raise long-term bond prices (and lower rates).

Wouldn't this be very inflationary?

[knzn]

AD: Bond buying by the Fed would tend to be inflationary in general but not necessarily in the particular situation where the US is facing a potential recession, as imagined in the dollar crisis scenario. If the dollar crashed, the Fed would want interest rates to go up a little bit, to prevent inflation. Some are arguing that long-term rates would go up more than what is necessary to prevent inflation, because the Fed can’t control long-term rates. Mankiw is just saying that the Fed can control long-term rates if it wants to.

[cynic]

Were are wealth effects in all this?

[AD]

Thank you knzn.

[Kevin Brennan]

"In my view, the indirect costs don’t include inflation, which will not be an issue for a currency that is starting to soar against the dollar."

knzn, you're forgetting that other countries buy goods that are not denominated in dollars. Inflation is most assuredly an issue, and a very serious one.

[morton e.]

Where are the deflationists with the argument that the dollar collapse triggers or is caused by the bursting of the real estate bubble and leads to cascading defaults?

[Patrick (G)]

If the currency collapses, it will be a golden opportunity for our entrepreneurial captains of industry to bring their manufacturing back to the U.S, where labor and parts are now dirt cheap compared to before...

Except:
1) They've already made their manufacturing investments elsewhere, and taking advantage of the new situation is going to require significant new investment.
2) With the U.S. savings rate gone from negligibly positive to negative in the past few years, there's very not enough investment money available after our debt-laden government sucks in what it can to run its day-to-day operations.
3) So our investment money has to come from abroad. Well, international investors with funds to invest after our currency's collapse AREN'T going to accept greenbacks after that. they'll want to be paid in either their own currency or a more stable international currency.
4) given our trade imbalances to date, earning that international currency in sufficient amounts is going to be significantly harder than when we could pay for everything using Uncle Sam's script.
5.) Intellectual products are largely cultural products. (A CD/DVD with Dreamweaver for win32 has as much appeal to someone running Chinese Linux as the latest AOL CD/DVD that was sent to you via postsl mail with 5000 FREE hours). Our cultural appeal has never been lower.
6.) Like any 3rd world country gone banana-republic unstable, our most significant export is likely to be our intellectuals/entrepreneurs who believe the key to the 'American Dream' is to be found anywhere but the US of A.

[realist]

the most valuable commodities the u.s. has to offer are it's real estate and energy producing companies. wouldn't a weaker dollar bring in more foreign investors? japan got burned doing this in the late eighties, but it paid too much. china already made a stab at buying one of your oil companies. our companies may be an even better buy in the future. aside from arms, i don't know what else we have left to export.

[JRossi]

The Tetons are a nice little range, but they're less impressive than the Canadian Rockies, the Eastern Sierra, the North Cascades, the Alaska Range, the mountains of the Alaska Peninsula, the
mountains of SE Alaska, the BC Coast Range. You should get out more.

[Ralph]

This is the new field of meta-economics. Create a futures market in theories versus outcomes, and the whole problem becomes much more tractable. Why simply bet that interest rates will rise, when you can bet on a whole scenario which naturally results in that rise?

Personally I am short 500 Krugmans.

[Chris R]

I'd personally put my money on a 1985 US scenario rather than a 1998 Korean scenario or indeed a 1973 US scenario. The reason: We have flexible exchange rates now and the Fed doesn't seem that interested in exchange rate targeting. If this changes, we're probably in for a world of hurt. Let's hope that GWB has more wisdom picking the next Fed chair than he has had picking (or not listening to) treasury secretaries.

[knzn]

Kevin Brennan: “…other countries buy goods that are not denominated in dollars.” My view is that the combination of cheaper dollar-denominated goods and the deflationary impact of dollar-good competition on the domestic economy of a given country would usually outweigh the impact of rising non-dollar prices. If this is true for most countries separately, it will be even more true in general equilibrium, because the other countries will not allow their currencies to rise so much against the dollar.

[camille roy]

"ten million workers shift out of construction, retail, and consumer services occupations and into export and import-competing manufacturing industries."

This ought to be something that could be investigated as to feasibility. Really. For example it is often inserted into discussions of oil exploration and new finds that it would take so many years to get the facilites and refineries up and productive.

How many years simply to get the infrastructure up and running? 10 million workers is ALOT.

The other factor OF COURSE is the devastating incompetence and corruption and cronyism of our Rethuglican oligarchy. If the voters don't take a sharp turn away from this crew, we can be SURE that any transition will be completely screwed up, in so far as the govt can screw it up.

Perhaps the deciding factor is really the American voter. If they remain under the sway of the Rethugs, kiss the good life goodbye.

[Barry]

Chris, that's a frightening comment to end a post on. I shudder to think of who Bush will appoint.

[Dean Baker]

Brad,

I think the domestic side of this argument needs to work on their arithmetic. The trade deficit in the eighties peaked at 3.1 percent in the 4th quarter of 1985 and had only fallen back to 1.5 percent of GDP in the first quarter of 1990 -- the last pre-recession quarter. That's a drop of 1.7 pp in 4 years, compared to a decline of close to 6 pp that we would be looking at today. And, of course the Fed did raise interest rates and bring on a recession to counter the inflation we were seeing at the time. (Maybe Greenspan's successor will be a more astute monetary manager than the Maestro.)

The second arithmetic point concerns the implied inflation. It's an increase of 0.8 pp in the inflation rate for FOUR years. I don't know any economists who believe that the core inflation rate can RISE by 3.2 pp (5.2-5.7 percent inflation) from current rates without prompting a response from the Fed and/or financial markets, but I didn't attend the conference.

[Simon L.]

"When you go walking into an urbane Borders and use the restroom, and read graffiti that talks about killing bush, and killing republicans, it really brings into mind that there is substantial discontent forming."

The type of left-wing people who hang out in Border's restrooms don't own any guns, since they lack testosterone. So they aren't killing anyone.

[jon livesey]

It may be worth reflecting that at one time it was the UK that ran the world's reserve currency, that it was "too big to fail" in the sense that too many other countries held Sterling in their reserves and depended on trade with the UK, that it did encounter imperial overstretch and that Sterling did undergo a decades-long slide from around four dollars to just above one dollar per pound, and that countries which had quite recently been part of the British Empire used that time to re-orient both their reserves and their trade away from the UK. There was no sudden collapse, no blood in the streets, but when the dust cleared the UK was no longer a world power.

[Barkley Rosser]

Really excellent post, Brad. Very informative to read about this deep debate on the fringes of Jackson Hole about something we do not have the answer to. We really are in an unprecedented and impossible to predict situation here.

Two points more points for the domestics beyond the "the debts are in our own currency," the "we're too big too fail," and "any devaluation will stimulate our exports and save us from a recession (plus the Fed will keep interest rates down)." One is that although we now have a total net foreign debt exceeding $3 trillion and growing rapidly, the income outflow on that is minimal still. We are under very little pressure on that front, which is a big deal for most countries with large foreign debts. The other is that our big creditors (Central Bank of Japan, Peoples' Bank of China, Central Bank of Taiwan) have such large reserves that they will not "panic sell" dollars if we decline over fear of their own capital losses ("just paper anyway"), a factoid I have from insiders in one of those institutions verbally.

However, there are some other points pushing the other way. First, the "too big to fail" depends on assuming that it would be bad if we failed. However, if the domestics are right, then this is a false argument, although maybe it still works if foreigners think it would be bad if we failed (hey, they might have trouble selling to us). So, they may not prop us up out of fear, if they listen to the domestics too closely.

Second, even though the net outflow of income is still trivial, the sheer size of our foreign indebtedness is quite unprecedented. It is more than ten times that of any other country, although still not all that bad as a percent of GDP. However, a simple projection shows us getting to 50% of GDP level in another decade or so if the trend is not reversed, which is in the range of the pathetically troubled basket cases that Sebastian Edwards worries about.

Finally, the very fact that there are all these reasons why we might just be able to go on and on without any adjustment, foreigners willing to lend to us so that we can buy their stuff so that they can avoid political explosions in their countrysides and cities and all that, means that the situation could get way beyond anything that is manageable before something is done about it. It could go so far that the inevitable adjustment could be a much larger crash than anyone has or can imagine, with completely unmanageable consequences. Can the Fed really keep interest rates down if the foreigners stop lending us money when the current account is 6% or more of GDP?

BTW, a further skuttlebutt from the Asian central bankers is that apparently it is widely felt that if the US current account deficit reaches 10% of GDP that would be a "meltdown point." Hopefully we can at least avoid that particularly disastrous possibility.

[Ronald Behling]

Brad - regarding the Feldstein anecdote at the end of the entry. Is it not true that the Int'l econ models of the 90s relating to the CAD crises of Mexico et al all concerned fixed exchange rates (and nearly all developing - rather than developed - countries)? Is this not a small detail that should not be omitted in a relay of the anecdote? Also, from a sorting/self-selection point of view, who tend (on average) to be brighter within the profession, macroeconomists or international economists? I think I know the answer to that one. I think you do too. So if we have to bet on which side is right, I know which side my money is on . . . .

[bradsetser]

I'll second Dean Baker's comments on the size of the adjustment. And remember, in the 80s, the distinction between the current account deficit and the trade deficit could be ignored. Not any more -- the trade deficit has to fall to by say 5% of GDP to bring the current account deficit by about 3% of GDP, making realistic assumptions about interest rates (see the income line of today's current account data) and future debt to GDP ratio. Long-term, the trade deficit needs to fall by say 6% of gdp to generate a long-term current account deficit of 2.5-3% of GDP ...

Barkley -- I suspect the time frame for a 50% external debt to GDP ratio is more like five years, not ten years. Look at the IMF's staff report on the US. 7% of GDP current account deficits add up. And your Asian central banker friends seem remarkably willing to define deviancy down. up to 10% of deficits are now ok off a 10% of GDP export base -- that puts any emerging market to shame. I am not as sanguine about central bank's willingness to take "paper" losses -- and it the losses are just paper, why not sell in a panic. No need to care about a bigger paper loss if it is just paper. setting that aside tho, the issue is whether or not central banks are willing to keep their current pace of reserve accumulation (roughly $600 b a year) and even increase it if the dollar comes under renewed pressure. remember, the current equilibrium is not a "no intervention" equilibrium, it is a heavy intervention equilibrium, and in a crisis, it would need to be an even heavier intervention equilibrium. So the c. banks would have to be willing to add to their capital losses ...

[maracucho]

Brad is no doubt tired of my complaints about his impeachment ranting. Just to show that I see both good and bad sides to his blog and arguments, I want to say that this essay is excellent. It points to the problem of extrapolation, which has never been satisfactorily treated- it's all well and good to cite what happens when Argentina goes too far in debt, but no other country has played the role that the US has; therefore, there is much uncertainty about what lies ahead as our government plunges further into Peronista politics. Good job, brad.

[e sciaroni]

Perhaps the massive deficit could be used as a weapon against us in time of crisis.

From "Unrestricted Warfare"
http://www.cryptome.org/cuw.htm#Chapter%206

if the attacking side secretly musters large amounts of capital without the enemy nation being aware of this at all and launches a sneak attack against its financial markets, then after causing a financial crisis, buries a computer virus and hacker detachment in the opponent's computer system in advance, while at the same time carrying out a network attack against the enemy so that the civilian electricity network, traffic dispatching network, financial transaction network, telephone communications network, and mass media network are completely paralyzed, this will cause the enemy nation to fall into social panic, street riots, and a political crisis. There is finally the forceful bearing down by the army, and military means are utilized in gradual stages until the enemy is forced to sign a dishonorable peace treaty.

For the Chinese one trillion dollars might do it.

[Stormy]

When two such irreconcilable, divergent views occur the problem, in all likelihood, is that the problem has not been framed--or asked--properly. We have two sets of economists, both using somewhat antiquated models, both assuming the world before us is the world mirrored in their models.

One model assumes a world identical to 1986-1990 (domestic) or the late 1990’s (international).

What significant events have happened since then that might invalidate both models:

Let’s look at a two:

NAFTA 1994
China enters WTO 1999

I would make a few observations here before proceeding:

(1) The dates, while seemingly falling within the international model, are misleading. Each of these events took time for their full effects to mature.
(2) Each of these events trigger what has been, at least among the uninitiated, the greatest exodus of jobs that the U.S. has ever known.
(3) Foreign Trade Zones have proliferated and become increasingly more sophisticated, offering advantages that have not been fully understood.
(4) Undeveloped countries, slowly, but in increasing numbers, have begun seriously bidding for western manufacturing and service sectors, holding as plums cheap labor and very juicy tax deferments, both of which simply cannot be matched in this world or the next.

NAFTA and China’s entry into the WTO were watersheds, changing the economic landscape in ways never considered by any economic model. I have yet to see one model that assumes capital is mobile.

So where are the economists in all this?

Stuck with the models they learned in school, I expect. Not one of them has seriously looked at how money and capital now moves or how labor is now used. Not one. Occasionally we have one will make a nod to outsourcing, but then leave it out of the model.

There were warnings that we were entering potentially dangerous uncharted waters, but they were ignored in the euphoria of globalization. Meanwhile, some hope, without any substantive reasoning or factual evidence, that China will suddenly become a consumer or that the dollar will be devalued, thereby making those companies that stayed in the U.S. suddenly competitive with those that left. Meanwhile the twin deficits soar—and economists like automatons repeat their favorite analyses again and again. Not a new thought in the group.

The world has changed, but their thinking has not.

I say all this at the end of this long discussion, fairly certain it will never be read or answered. Instead, we will move on to other more topical issues: Owls, Iraq, Chertoff, and heavens knows what else. But the economists will continue talk to one another over the head of the posters—who, in the final analysis, are merely Greek Choruses singing the praise of this or that post.

I ask again: Show me how any of your models allows for ANY of the following:

(1) Tax laws can be modified to attract manufacturing. (Use China’s tax inducements as a starting point.
(2) Capital is mobile. It can take advantage of cheap labor elsewhere, all other things being equal.
(3) Labor is cheap and plentiful and not mobile. Use the populations of China and India and the United States as starting points.
(4) Any firm can pick or choose among competing countries for its next manufacturing base with all the “bidding” that entails.
(5) A country can become a “tax haven.” (I add this one for spice. It does complicate matters.)

In short, capital is mobile, labor is cheap and plentiful elsewhere, and tax laws are not uniform across boundaries. In fact, tax laws are quite malleable, to put it quaintly.

If you cannot do this, then I humbly suggest the following: You stop talking to each other and start soliciting answers from the posters. For once, let us use a blog that attempts to solve an issue.

Brad Setser?
Brad DeLong?
Any economist?

[Ralph]

Stormy,

I concur with your complaint about models, but I don't believe there are any SIMPLE models adequate to the job.

Instead, how about a global finance and trade simulation, organized like a game?

The game software generates events like droughts, hurricanes, declining oil production, and so forth. These events could be fixed over several simulations, or re-randomized each time.

Put a human being (or small group) in charge of decisions for each significant actor in international finance.

The big challenge, then, is figuring out a set of significant actors which is neither too large to be workable, nor too small to be realistic. Central banks are obviously actors. What about commodity markets? Oil ministers? I don't pretend to know how to pick the actors, but I think reasonable guesses could be used as a start.

I'm guessing it would require a good number actors -- maybe 1000 or 1200.

Therefore enlist the help of a lot of volunteers. Run the thing over and over until participants start to get a feel for how the simulated world functions.

Unless and until something like the above is done, I'm afraid all this discussion is like arguing over the shapes of clouds: it's a sheep! No, it's a dragon! Maybe a turtle?

And I don't believe we can afford sheep versus dragon arguments now. The global stakes are too high. With all the "sim world" and role-playing systems that have been created, why not give this a try?

[Randolph Fritz]

The answer is no answer; so much change that outcomes cannot be predicted. I think you experts are thinking too small; political change is what we're going to see.

Fundamentals, fundamentals. Money isn't real; human activity, climate, physical resources--these are real. In the short term, the realities we are likely to be facing are a reduction in oil refining capability and a harsher global climate. Combined with a slide in the dollar, these seems to me likely to lead to a vast political realignment. I expect the emergence of other global economic and political hyper-powers. In other words, Western Europe goes to a Euro base, Japan and China duke it out over yuan and yen (I think actually the same word but "yen" is uniquely Japanese :-), the rupee in Southern Asia, and perhaps parts of African and the Islamic world, perhaps the riyal in the middle east (or some combination of Arabian riyal and Israeli lirot), something in Eastern Europe and Russia, but perhaps not the ruble, who knows what in Latin America--the peso?!

Or perhaps not. But it's not going to be a simple thing, and it's not going to be just a shuffling of money.

[piotr]

A little observation:

1. wise economists agree that there is a huge gulf of uncertainty concerning the outcome of our huge deficit (prelude to another period of stable growth, just without such deficits or a depression or stagnation).

2. hack economists agree that making current tax cuts permanent and refraining from any program of energy conservation are two pillars of our unending prosperity; to complete this edifice we just need to privatise Social Security (or slash benefits), abolish even private health insurance for large groups (to eliminate moral hazard) etc.

3. semi-related question: if interest rates will not extinguish housing boom, can high prices alone extinguish it?

[Anthony]

Instead, how about a global finance and trade simulation, organized like a game?

Posted by: Ralph | Sep 16, 2005 10:28:11 PM

A game of simulation might provide some insight. Afterall, essentialy the market is just a sophisticated game, where each player tries to maximize his goal and competing/cooperating against each other.

but if there is a gigantic global trade war, I am putting my bet on China/Russia combo with India orbitting near it.

Anybody keep track last time bleep when dollar reaches 1.35 EU? what happen then? There was a lot of talk about diversification. (Russia, Norway, China, Asian Bellagio group. etc.)

[realist]

piotr is right on the money.

*Bernanke said the White House intends to continue pursuing policies that make the economy able to withstand shocks and that will keep growth on track.*

"These policies include making tax relief permanent, reducing the budget deficit by limiting spending, strengthening retirement and health security through efforts like Social Security reform ... and enhancing energy security," Bernanke said.

after making bernanke the administration's chief economic apologist, elevating him to greenspan's post becomes a strong possibility. this is the guy who once talked about monetizing the bond market. wouldn't he do everything he could to keep long term interest rates down, at least until the next congressional elections?

[Stormy]

Ralph, Antony:

Agree entirely!

I made that suggestion 2 months ago. No takers. Hire some top-notch game programmers; put the game on the Internet; let 10,000 people play. Let some people run companies, others are investors, set up a FED, banking, tax havens, all the elements.

Or start simple, as simple as some of the present models are.

Set the rules. Set up countries. I could easily outline the way such a game would be run, tweaked to discover how people make decisions. Set up a virtual newspaper that not only declares new policy but describes how others are playing. Behind the scenes would be a group of economists, instructing the programmers how to shift rules slightly, add new elements, change tax laws…you name it.

Right now some games on the net are interactively played with many thousands of people.

Be bloody imaginative. Stop sucking your thumbs and use IT in ways that give some answers.

The paucity of imagination among economists astounds me.

Again, I have made this suggestion quite a number of times; at first hesitantly because I knew I would be thought an idiot. But I am getting tired of this crap. I have read all their models—toy ducks in a bathtub. Then they try to extrapolate. Not a clue.

Hell, there is a company that is starting to use this approach with the environment. Imagine all the posters that would be eager to try their hand in such a virtual world.

And, frankly, I would put this project right up there in importance as the Manhattan Project. Imagine all the posters that would be eager to try their hand in such a virtual world.

Now, I am willing to bet that not one economist is willing to consider this idea seriously. Not one. And not one will even respond to it. They talk only to themselves.

[Daniel]

A fascinating article. My tendency is to side with the international economists simply because the US macro rebuttal that the 1986-1990 experience shows that we can withstand rapid devaluation of the dollar is not applicable today for two reasons.

First, by 1986, the Reagan Administration had essentially junked supply side economics and rediscovered fiscal conservatism, and, by signing off on the Packwood-Bradley tax reform, they were moving towards saner pastures which were built upon by the 1990 and 1993 budget deals and the Clinton-Gingrich spending cuts. The Bush-DeLay Republicans seem to be charging ever harder toward fiscal insanity.

Second, in the 1980s, we were proportionally much less exposed to foreign investment. The dollar peak in 1985 was truly exceptional -- remember pound-dollar parity? -- while the dollar "peak" now isn't anything to write home about at all. A fall from dollar levels in 1985 was a correction. A fall from dollar levels today means trouble.

[Mans]

A 30% decline in the value of the $ on top of the decline of the past few years is not just another linear event that can be modelled and analysed.

At some point these linear models breakdown. A good chunk of the global population is going to lose 30% of their investment in the reserve currency of the world. I don't think they just go about trusting other monies and forget about what happened to them.

And when the confidence of enough people is shaken it will take much higher interest rates to induce people to hold on to cash again. They will spend their money as soon as they get it because they won't trust the money as a store of value. Money demand will collapse and it will not matter one iota what the Fed does with money supply. And the value of the Dollar and probably all other currencies in the world will continue going down.

Non-linear events can't be modelled.

[gordon]

Maybe the analysis should take into account two extra things: (1) as long as countries need to buy oil for US dollars there is a huge baseline foreign demand for US dollars - and the oil price (and so the level of this baseline demand) has been rising of late, and (2) the US Govt. has shown a strong interest in using accumulated savings in the Social Security system to cushion stocks against any rise in interest rates - a sort of Govt. guarantee to Wall St. These factors might be interpreted as preparations which would cushion a fall in the US dollar exchange rate.

[Jay C]

Pardon the ignorant question from the non-economist lurker out here in Outer Blogistan: but what, exactly, do the "internationalist" economists assume it that all the rest of the world is going to want to buy from the US with all those suddenly-cheap Dollars?
IIRC, the USA has gradually moved a huge portion of its manufacturing base overseas over the last couple of decades: the main American exports, as far as I recall are either high-end specialty manufacture (like commercial aircraft), bulk agricultural products (wheat, corn, soy, etc); and computer technology (not the computers themselves, but the basics to run them).
And, in the meantime, we have converted a great deal of our domestic economy to either service-oriented industries, or those dependent on specific economic conditions to thrive (like homebuilding). And pace tjallen, somehow I don't think cultural/intellectual property is going to take up the slack. I wonder, in 2005-6, just what we can export - at all?

[Barkley Rosser]

Brad Setser,
The decaden projection was based on the somewhat smaller current accout/GDP ratio we had a couple of years ago. Five years is too soon, but it is now less than a decade to net foreign debt/GDP > 50% at current trends.

Rudolph Fritz,
"Yen" and "yuan" are virtually the same word, spelled with exactly the same Chinese ideogram, just pronounced differently. The difference is that "yuan" is simply money as a unit of account, with the Chinese money itself being called "renmimbi," peoples' money (RMB). The People's bank of China (central bank)is Zhongguo Renmin Yihang. In Japan, yen is money in all its forms. In Taiwan, they have the "New Taiwan dollar," but it is still informally called the "yuan."

Mans,
Nonlinear systems can be and have been modeled. It is just a lot harder to do than for linear systems.

JayC,
It is the "domestics," not the "international finances" who are all optimistic that a dollar devaluation will bring a boom of exports.

[Randolph Fritz]

"Non-linear events can't be modelled."

Gah! Of course they can be. Problem is, we don't have a deep enough understanding of the system to model this one.

[DuckedApe]

I totally support the gaming proposal; I would love to help get it going, where do I sign up?

In particular, I suspect that it will reveal, as has been said, that the dollar adjustment is nothing like the post-1985 adjustment--the level vs EU currencies (GBP, EUR) is no where near what it was, and agricultural prices are already unfairly low (thanks to subsidies), just ask Brazil and African cotton producers.

Instead of considering the scenarios in currency terms, with the technical manoeuvering to absorb higher import prices and diddle with interest rates, how about thinking of it as a price cut--buy two get one free-- one US exports. What exports can the US afford to discount so steeply (Windows and Office, as we've seen in Thailand, but what else)? And would a such price cut generate demand?

Who would the buyers be, and where does their money come from? IMHO, the two main possibilities would be transfer of demand from other suppliers, and reduced savings. In the first case, the other suppliers will cut price, too, resulting in global deflation (and possibly misery). In the second, the deficit spending would become harder, and more expensive, to finance.

If we consider the USA as a consolidated enterprise, sales (exports) are not covering purchases (imports), while perks and bonuses (government spending and tax cuts and consumer debt) are rising, rather than being cut. More bonds (T-bills) are being issued to cover the losses. Now if the rest of the world is to continue to save (T-bills) and at the same time buy more from the US, where does their money come from?

The game could help to find this out. Overall, I think it would demonstrate that no such devaluation is possible.

P.S. Dark thoughts on why China is buying T-bills: while moderating its own development rate to safely manageable levels, it enables the US to squander its resources on war-making and at the same time demonstrate just what US military capabilities are. Silver lining: they see clearly that the US has very limited conventional capabilities, and would have to resort to nukes, so deterence is intact.

[Mans]

I would appreciate further information on modelling discontinuous events like people losing confidence in a currency. TIA

From what I can see, modeling is done for risk assessment, not to examine first principles or to explore complex economic behavior and consequences.

Too bad.

Mans,

The following is the kind of thing that is out there: gotta pay. But I do not think it is worth it.

http://mlq.sagepub.com/cgi/content/refs/34/4/429

Or,

http://ww