A Community College Dean Looks at the Macroeconomic Situation, and Panics

Here we have yet another unhappy camper:

Confessions of a Community College Dean: In Which I Get a Little Panicky: I'm not an economist. Readers who actually understand economics are invited to explain why I'm off my rocker on this one.... [T]he U.S. is running nasty and increasing deficits at the government level, the household level, and the international level. We owe more to other countries than we ever have, and much of that debt comes from selling government securities to foreign central banks (esp. in Asia). Household debt is skyrocketing, and the interest rate increases of the last year or two are poised to nab anybody stupid enough to have taken out an adjustable-rate mortgage in the great housing boom of the last five or six years. The national debt grows apace, and has been refinanced over the last few years to progressively shorter-term loans, meaning that higher interest rates will hurt badly and quickly. Think of it as putting the national debt on an ARM, then watching interest rates go up.

Since we import most of our oil, and the price of oil keeps going up, our trade deficit is likely to keep increasing.... Plus we don't manufacture very much, so we don't export very much. We also borrow money for wars of choice, which themselves actually interrupt the flow of oil.... China is keeping its currency artificially low, to keep its exports cheap. Then it lends us the money to buy those exports. It underpays its own workers so that we can have cheap stuff. How long its own workers will stand for that is anybody's guess.... Since there are so many U.S. dollars flowing out of the country, their value is dropping on the world market.... The only way to entice foreigners to keep buying a depreciating currency is to raise interest rates to compensate for the depreciation. Raising interest rates kills the folks with ARMs, increases our national debt payments, and hurts the business climate....

Although productivity has been going up, real wages haven't. I know it's gauche to talk about income distribution, but there's no other way to explain....

So my question to my economics-literate readers: how are we not screwed? (That's the technical term.) If China lets the yuan float, we get inflation. If the Euro starts to displace the dollar as the denomination for international trade, demand for dollars drops and we get higher interest rates, eventually tipping us into a nasty recession.... If somebody manages to blow up a key pipeline or refinery, the sky's the limit.... I'm thinking I must be missing something really basic and wonderful that will reduce these concerns to nothing more than blips on the screen.... Please tell me why I'm wrong. I'll sleep much better if I can dismiss this as the ravings of someone who just needs a vacation.

No. You're not wrong. You're not raving. Nevertheless, the most likely scenario is one in which we come out of all of this OK.

What is this most likely scenario? It is of (a) gradual inflation in China and elsewhere (maybe 5% per year for five years), (b) gradual reductions in the value of the dollar (maybe 5% per year for five years), accompanied by (c) gradual interest rate increases in the U.S. so that the dollar decline never turns into a (d) sudden dollar crash.

If that is the case, then--gradually--U.S. housing prices deflate, construction and consumer spending fall, and imports drop. U.S.-made products become more competitive at home, and so manufacturing production and employment for domestic uses rises. The falling real value of the dollar leads to an export boom, which causes export manufacturing to boom as well. Over five years or so, we see a net of eight million jobs (relative to trend) in construction and consumer services (and supporting occupations) vanish, and eight million jobs (relative to trend) in manufacturing (and supporting occupations) appear. If the expanding sectors expand fast enough, we see a tight labor market that brings real wages back to their normal share of production. And moving an average of 1.6 million jobs a year from sector to sector--the U.S. economy can do that without any sort of uproar.

Of course, people are still likely to be unhappy with the process. Rising interest rates and rising import prices will make people feel poor--something in this process has to reduce Americans' total spending on consumption, investment goods, and government purchases from 107% of income to 100% of income, and whatever it is will crimp spending by making Americans feel poorer. But even so it is a "soft landing."

As I said, that's the most likely scenario. But there are other scenarios--the ones that you fear: stagflation, recession, financial crisis, oil shock, global depression, panic, revulsion, and discredit. The other scenarios become more probable every day.

You see, to achieve a soft landing requires that a huge number of people around the world watch the real value of their dollar-denominated assets melt away slowly for half a decade without ever being impelled to sell off the dollar-denominated positions in their portfolios. It could happen. It happened in the late 1980s, thanks to the Japanese central bank and the collected investors of Japan. It will probably happen again. It requires mammoth irrationality on the part of investors, and an extraordinary eagerness on the part of central banks to eat enormous losses on their dollar reserves. It is not a rational-expectations equilibrium. But it will probably happen.

But if it doesn't happen again--if there comes a day when the world's central banks and investors all decide that it is time to sell their dollar-denominated assets, then... Well, then we get to see how good a central banker Ben Bernanke really is. There is a really bad global equilibrium out there, which the world economy might jump to at any moment.

Comments

[monkyboy]

Poor Dean has never heard of Dark Matter!

I know I sleep better knowing it's out there working its magic for America!

[derrida derider]

So even in your best case the average American has falling consumption for 5-7 years. Plus one way or the other taxes will have to rise substantially at some stage to avoid a very hard landing.

Think through the politics of that. Maybe the 2008 election would be a good one to lose.

And of course Dubya, like Reagan (and indeed Brezhnev in Russia), will be looked back at as presiding over a golden age rather than being the cause of the decline.

[dryfly]

I don't know why he's panicky - what better place to be than working at a community college... after all according to shrub that's where we'll train & retrain & reretrain our future workforce.

[save the rustbelt]

Recession, third quarter of 2007 - mark it down.

The chances of any sort of manufacturing resurgence (as least enough to create jobs) is roughly equal to the odds of me starting at wide receiver for the Steelers.

[allinola]

3rd quarter of 2007? fantastic. right after i graduate from college.

looks like my plan b of "move back to india asap" may jump up to plan a....

[dryfly]

allinola - can my kid go with, she graduates about the same time and her other choice would be 'move back to Dad's couch'. LOL.

[Ian Whitchurch]

There's another circuit breaker - GM and Ford commercial paper going to 'junk' status.

Someone also has to be short on all those oil contracts - we might have something similar to LTCM happen, if someone was short enough, and leveraged enough on crude.

[shah8]

yo. One point in all this.

wages.

the structure of the economy in which very few people can make it without incurring personal debt that seeks permanent streams of cash from their incomes. People literally cannot afford to have children and maintain economic status...

Do you really see any slowdown occuring gracefully without wage-push inflation, and large scale defaults?

[knzn]

“It requires mammoth irrationality on the part of investors”

Presumably, any scenario that begins from where we are now requires a great deal of irrationality on the part of investors. But I don’t think the soft landing requires more irrationality than the other possibilities. The phrase “gradual reductions in the value of the dollar” might be a bit misleading. The dollar doesn’t need to drop against all currencies at the same time. Investors could come to their senses and bid the dollar down rapidly against the very few major currencies (mostly the euro) that both float freely against the dollar and don’t have problems of their own. Such a drop could be very big in terms of quoted exchange rates but still not huge on a trade-weighted basis. After that everything depends on central banks. In general, they will probably want to reduce their dollar reserves, but it’s unlikely that they will want to do so quickly, given the likely macroeconomic effects on their home economies. I expect the PBoC and the BoJ would be willing to take quite huge paper losses before letting their economies go into depression. My soft landing scenario also does not require rising interest rates in the US, because I’m willing to let the dollar crash against the euro. Of course, it wouldn’t be a soft landing from Europe’s point of view.

[bad Jim]

I like DeLong's lullaby so much that I'd like to hear something in the same vein concerning global warming.

The part about the resurgence of American manufacturing I simply can't quite believe. In the few years since I left that field, the trend to having everything made in China, even prototypes, makes me worry that too much infrastructure has been lost.

Even were a currency correction to level the playing field a little, I'm not sure we could just pick up where we left off, particularly with energy expensive in a society predicated upon its being cheap.

[anon]

The global strategic situation shouldn't be ignored here. If the US does something to really upset the Chinese, they could dump their US dollar holdings as an act of economic warfare. In the event of a real threat of cool, warm or hot war, the Chinese aren't going to mind the short and medium term damage to their own economy from dumping US dollars if it means wiping the US off the world stage.

[sglover]

"The global strategic situation shouldn't be ignored here. If the US does something to really upset the Chinese, they could dump their US dollar holdings as an act of economic warfare. In the event of a real threat of cool, warm or hot war, the Chinese aren't going to mind the short and medium term damage to their own economy from dumping US dollars if it means wiping the US off the world stage."

My understanding is that China's walking a socio-economic tightrope of its own. They're likely at least as interested in a stable globe as we are. I suppose fuckwits like Bush and Cheney and Rumsfeld could screw up enough to provoke the Chinese into doing something awful, but right now they're too preoccupied with holding post-November investigations and subpoenas at bay.....

[Movie Guy]

Brad - "What is this most likely scenario? It is of (a) gradual inflation in China and elsewhere (maybe 5% per year for five years), (b) gradual reductions in the value of the dollar (maybe 5% per year for five years), accompanied by (c) gradual interest rate increases in the U.S. so that the dollar decline never turns into a (d) sudden dollar crash."

"If that is the case, then--gradually--U.S. housing prices deflate, construction and consumer spending fall, and imports drop. U.S.-made products become more competitive at home, and so manufacturing production and employment for domestic uses rises. The falling real value of the dollar leads to an export boom, which causes export manufacturing to boom as well."

A few of the issues overlooked in your "likely scenario":

1. U.S. imports will not necessarily decrease in Dollar terms if the U.S. Dollar is devalued. Even with a recession, the ratio of imports to exports and GDP level may remain fairly consistent. Greenspan understood this point when many other economists missed it.

2. Consumer and business product imports will not decline significantly in Dollar terms absent a major recession. Declining valuations in the U.S. Dollar would affect the import volume of such goods perhaps, but not significantly decrease the Dollar value of such imports. The majority of U.S. consumer and business goods are now manufactured abroad. People will still buy such consumer goods, regardless of volume levels of purchases.

3. Crude oil, Ethanol, and natural gas imports will probably increase, not decrease. No help here unless we enter a recession while the rest of world economy cruises along without interruption. Otherwise, economic shrinkage is a shared consideration globally that will not help U.S. exports absent a crowding out expectation.

4. Raw materials imports will decline or increase based on economic growth factors, whether for domestic consumption or input for export goods. If raw material imports decline, it should be a safe bet that the U.S. exports market and U.S. economy are declining. It's a double edged sword.

5. Food product imports could decrease due to a U.S. Dollar devaluation while a limited range of U.S. food product exports could rise. But considering that the U.S. is presently a net importer of food and ag products, it's unlikely that the current mix of U.S.-produced food and ag products will have much of an impact on the U.S. trade deficit. Corn production gains, for example, will likely flow to ethanol production as opposed to export markets.

6. Production sourcers, including trade economists who prepare analysis for decision makers, have put us on an offshore production course. Those corporate funds, contracts, and equipment are already committed. Reversing the offshore sourcing course will take many years and significant additional funding, and many of the offshore production facilities serve the dual purpose of supporting foreign markets as well as U.S. markets. Those facilities are not coming back.

7. China will initiate many actions to protect its export base. It has plenty of potential options which will allow its domestic and foreign export sources to remain competitive globally. China and other countries have the ability to provide financial incentives to keep their export markets operating within a given range of performance; exporters and supporting national governments will not sit by and watch their export production dry up. Ask Dave Stanley.

8. It helps to understand the full scope of Economic Hydrology Theory and applied global practices. The old thinking of simplistic U.S. economic adjustments will not measure up in the advanced global trade model. The imbalances created by U.S. and WTO trade policies are too large to be tamed easily.

[Movie Guy]

Brad - "If the expanding sectors expand fast enough, we see a tight labor market that brings real wages back to their normal share of production."

Real wages and particularly real compensation (including pension benefits and health coverage) are not going to regain previous percentage shares of production costs.

Not a chance. None.

[reason]

I don't understand how markets can gradually deflate. They have always gradually inflated and suddenly deflated as far as I can remember. The reason is obvious, the total amount of investable funds is (nearly) always rising. This gradually drives up the nominal price of financial assets. The general price level of these assets only falls as a result of a loss of confidence (i.e. flight to quality) and deleveraging. And this loss of confidence is contageous because of risk aversion. The secret is to have these drops occuring often and keeping the amplitude small (a bit like fire-fighting). That is why I am pessimistic about the current situation there is just too much damn inflamable material out there.

Brad has concentrated on the real economy here, but the danger lies in the financial economy. The erosion of risk premiums is the lurking dragon.

[walkingtheline]

The Bank of China is expecting 3% currency appreciation per year for the next few years.

[vtcodger]

Mostly what I read here -- article and comments seems fine. A couple of questions if I may.

1. Won't a Yuan floated to a more realistic level exert pressures for both inflation and recession in the US -- the dreaded stagflation? Inflation as the cost of goods the US really needs increases. Recession as the cost of stuff that we don't so much need as want like DVR players, HDTVs, etc increases, sales drop, and retailing takes a hit?

2. Economists tell us that a devalued dollar will increase US exports. What, exactly, is it that the US manufactures that anyone outside the US actually wants to buy? Aircraft? Yes -- but surely aircraft sales depend mostly on a robust world economy and low petroleum prices. Maybe the dollar-Euro exchange rate is a factor as the principle competitor is Aerobus. Weapons systems? Sure. But the demand for those is more a function of the quality of governance overseas than of exchange rates? Agricultural products? Is the highly mechanized US agricultural system likely to provide many jobs? Software? ... Maybe. Color me skeptical. Maybe a decrease in outsourcing and a return of some services to the US? Tourism? Yes -- a plus for Vermont and California. Maybe not for Kansas. Has anyone looked at the specifics of what work a devalued dollar is likely to bring to the US? Who exactly are the winners and how much do they win?

3. Just how leveraged is the World Economy? If the answer is "not very" then a gradual decline of the US dollar seems plausible. If, on the other hand, the present relative prosperity in Europe, North America, and the Pacific Rim is based on a lot of paper hanging ... well, it's a small door and it's unlikely that everyone can get out through it simultaneously.

[glenn]

Be VERY afraid. Doesn't it seem so likely and obvious, that maybe the Administration is doing this on purpose? Of course, I've got to believe they realize a very weak US dollar is in America's best interests right now - becoming more competitive (but only against floating currencies) and reducing future liabilities - but it certainly doesn't seem like only that would be enough to help?

But the administration seems to be acting so recklessly, could it be engineering a (very bad) recession in order to reduce demand for oil, or for any other reason? Would a moderate or severe global recession hurt China and/or others worse than the US? ...doubtful.

[anne]

A gradual change in value of the dollar and Euro and Yen and Yuan will present no interest rate or growth problems the Federal Reserve will not be able to readily counter. We have a fairly robust highly diverse economy and production capability, making us easily able to increase exports. American products are noticeable everywhere in Asia and Europe. Debt worriers have been worrying forever, but to worry about debt everywhere when economy after economy is growing fairly robustly has made no sense to me. Watch long term interest rates now and then, and we will find what worries we should attend most to :)

[anne]

http://www.project-syndicate.org/commentary/delong36

May, 2006

Economists' New World Order
By J. Bradford DeLong

Most academic economics rely on concepts laid down at the beginning of the twentieth century by the British economist Alfred Marshall, who said that "nature does not make leaps." Yet we economists find ourselves increasingly disturbed by the apparent inadequacy of the neo-Marshallian toolkit that we have built to explain our world.

The central bias of this toolkit is that we should trust the market to solve the problems we set it, and that we should not expect small (or even large) changes to have huge effects. A technological leap that raises the wages of the skilled and educated will induce others to become skilled and educated, restoring balance so that inequality does not grow too much.

So a country where labor productivity is low will become an attractive location for foreign direct investment, and the resulting increase in the capital-labor ratio will raise productivity. Wherever one looks, using Marshall's toolkit, one sees economic equilibrium pulling things back to normal, compensating for and attenuating the effects of shocks and disturbances.

Marshall's economics has had a marvelous run, and has helped economists make sense of the world. Yet there is a sense that progress and understanding will require something new – an economics of virtuous circles, thresholds, and butterfly effects, in which small changes have very large effects.

Perhaps this has always been so. By the standards of centuries ago, we live in a world of unbelievable wealth. Within two generations human literacy will be nearly universal.

Yet three centuries ago there was also technological progress, from the mechanical clock and the watermill to the cannon and the caravel, and on to strains of rice that can be cropped three times a year in Guangzhou and the breeding of merino sheep that can flourish in the hills of Spain. But these innovations served only to increase the human population, not raise median standards of living.

Today, if we divided up equally what we produce worldwide, would it give us a standard of living ten times that of our pre-industrial ancestors? Twenty times? A hundred times? Does the question even have meaning?

David Landes likes to tell the story of Nathan Meyer Rothschild, the richest man in the world in the first half of the nineteenth century, dead in his fifties of an infected abscess. If you gave him the choice of the life he led as the finance-prince of Europe or a life today low-down in the income distribution but with thirty extra years to see his great-grandchildren, which would he choose?

No doubt, we live today in an extraordinarily unequal world. There are families today near Xian, in what was the heartland of the Tang Dynasty Empire, with two-acre dry wheat farms and a single goat. There are other families throughout the world that could buy that wheat farm with one day's wages.

Marshall's economics – the equilibrium economics of comparative statics, of shifts in supply and demand curves, and of accommodating responses – is of almost no help in accounting for this. Why, worldwide, did median standards of living stagnate for so long? Why has the rate of growth undergone an acceleration that is extraordinarily rapid over so short a period? Where is the economics of invention, innovation, adaptation, and diffusion? Not in Marshall. And why is today's world so unequal that it is hard to find any measures of global distribution that do not show divergence at least up until the 1980's?

It has been generations since economists Robert Solow and Moses Abramovitz pointed out that Marshall's toolkit is a poor aid for understanding modern economic growth....

[Cranky Observer]

> then--gradually--U.S. housing prices
> deflate, construction and consumer spending
> fall, and imports drop. U.S.-made products
> become more competitive at home, and so
> manufacturing production and employment for
> domestic uses rises.

Two minor problems that I see:

1) IMHO most analysts massively underestimate the extent to which our economy has been driven by house-building over the last 10 years. We are literally keeping our economy afloat by building McMansions for each other. If this process slows down, we fall off the unicycle.

2) US-based manufacturing can't "rebound", as there is no there there to re-anything. Yes, there is still some manufacturing base. Yes, some very good companies have kept at least a portion of their base in the US (Koehler comes to mind). And a few high-value assemblers, such as BMW, have built new plants here. But the _vast_ majority of US manufacturing capability has been sent to China and India since 1995. It just ain't there to rebound, and there are no manufacturing employees or engineers to man it if it were.

Sorry.

Cranky

[Barry]

I just gotta pile on, when such a deserving 'analysis' presents itself. Brad: "Over five years or so, we see a net of eight million jobs (relative to trend) in construction and consumer services (and supporting occupations) vanish,"

Easy enough - we can do job destruction on a mass scale better than any other industrialized country.

" and eight million jobs (relative to trend) in manufacturing (and supporting occupations) appear. "

In other words, if the trends of the past 30 years reverse themselves (turning pretty much on a dime) and start working very strongly in reverse.

[anne]

The real estate market is more than just the housing market, and real estate in general is in fine health, while the housing market is only slowing leaving much work about the home and grounds to be done. Houses are still be built and sold. There has been no developed country in which housing has slowed these last 5 years which has suffered a recession. There is no reason to believe we are running out of fine work to be done, or jobs that will be created as long as economic growth warrants.

[anne]

The guess is that the Federal Reserve is quite near an end to the tightening sequence and with a reversal of monetary policy I would expect a limit to any housing slowing or to a slowing of the economy. A healthy economy should easily find the 1.6 million jobs created each year that Brad DeLong would hold necessary, though I would count on more service sector employment. Further employment creation could easily come from infrastructure development.

[stunster]

What on earth would induce foreign central bankers to care about losses on dollar-denominated financial assets?

[stunster]

What on earth would induce foreign central bankers to care about losses on dollar-denominated financial assets?

[They've borrowed in their home currencies to buy the dollar-denominated assets. If they take big losses on their foreign exchange portfolios, they have to raise taxes by amounts that may be large.]

[Tim]

So every trend of the last 20 years is magically going to reverse itself in the next few years, and this is the most probable outcome? In most mathematical systems that would qualify as the least probable.

[anne]

Ah, but why not just soften Brad DeLong's argument? Rather than a reversal of trends, we just need a continuation and hopefully periodic increases in service sector and real estate and infrastructure job development :)

[save_the_rustbelt]

"...and eight million jobs (relative to trend) in manufacturing (and supporting occupations) appear..."

Come to think of it, I will be the Steelers quarterback before this happens (I'm old, fat slow and clumsy).

[stunster]

"What on earth would induce foreign central bankers to care about losses on dollar-denominated financial assets?

[They've borrowed in their home currencies to buy the dollar-denominated assets. If they take big losses on their foreign exchange portfolios, they have to raise taxes by amounts that may be large.]"

I see. Foreign central bankers have control over tax rates, do they?

(Incidentally, I don't know who wrote the comment in square brackets, but it wasn't me.)

[Eddie]

No wonder the right wing's attack on the ivory tower of academia has such traction! This everything is going to be "OK" story sounds pretty crappy if you are in the bottom 75% of wage earners in this country. Disaster for the country as a whole is obviously not "OK", but you are talking about countless individual disasters as if this somehow is. We are heading towards disaster pure and simple, it is only the relative strength of the disaster that should be questioned.

Of course why those discussing the trends get most of the blame while those who actually screwed us with their policies get reelected I guess can only be blamed on the poor quality of education by those in the ivory tower of academia. ;) You bastards!

[glenn]

Anne - just curious, aside from McDonalds, what American products are noticable in Europe? I see the odd Ford every once in a while, and I always do a double take, becasue American cars are that rare.

Secondly, I agree the Fed will reverse course once housing prices start declining on a year over year basis (should happen later this year), which should cause consumers to finally reign it in. But won't this cause a big air pocket for the dollar, increasing inflation, and rising interest rates? (at the same time risking OTHER asset bubbles)

I'll be the Cassandra to your Pollyanna...

[Matt]

Things could go on as they have been for 20 more years, without putting the U.S. in an untenable position. As a very rough calculation, just 18 percent of the rest of the world's holdings of foreign assets involves claims on the U.S. Perhaps 6 percent of total foreign financial wealth involves claims on the U.S. Why is either figure too high? We simply don't know how close to a balanced global portfolio the rest of the world we eventually desire to hold. (The concentration of U.S. deficit financing in fixed income assets is a bit more worrying, though.)

More factoids. Last year, total gross financial outflows from the rest of the world to other countries came to roughly $4.5 trillion. (This doesn't count intra-EMU flows.) Roughly $1.3 trillion of that came to the U.S. Why is this out of line with what a reasonable investor would do?

Another often ignored point. A weaker dollar, or lower U.S. asset prices, should induce additional inflows to the U.S., to keep the dollar share in global portfolios from fallling too low.

Of course, if the rest of the world decides not to accumulate more in U.S. assets, things we be bad for the U.S. But arguments of this sort so often base their conclusion on their premise.

[anne]

Glenn, your concerns are sensible and there is much to argue and I must answer in parts for I am soon off for a short campus bird walk :) Looking for hawklets.

[knzn]

"What on earth would induce foreign central bankers to care about losses on dollar-denominated financial assets?

[They've borrowed in their home currencies to buy the dollar-denominated assets. If they take big losses on their foreign exchange portfolios, they have to raise taxes by amounts that may be large.]"

This doesn’t sound right to me. Central banks can print money to cover their home-currency borrowings. The only reason they would not do so is if they are worried about inflation. Inflation isn’t likely if their currency is appreciating significantly against the dollar.

Also, these are countries with huge domestic savings rates that show no signs of declining. If their trade surpluses moved toward balance (as presumably they would if their currencies appreciated), then they would have huge amounts of domestic savings available to refinance the debt. A scenario where China and Japan really “have to raise taxes” would require a dramatic change in behavior. (Saudi Arabia is maybe a different story, if oil prices collapse, but a falling dollar accompanied by falling oil prices, based on what I recall from 20 years ago, would probably be a very soft landing for the US.)

[G-One]

"No wonder the right wing's attack on the ivory tower of academia has such traction! This everything is going to be "OK" story sounds pretty crappy if you are in the bottom 75% of wage earners in this country. Disaster for the country as a whole is obviously not "OK", but you are talking about countless individual disasters as if this somehow is. We are heading towards disaster pure and simple, it is only the relative strength of the disaster that should be questioned.

Of course why those discussing the trends get most of the blame while those who actually screwed us with their policies get reelected I guess can only be blamed on the poor quality of education by those in the ivory tower of academia. ;) You bastards!"

I wish to endorse eddie's comments.
IS the VEil lfting from your dreamworld yet ?

[dearieme]

"that's the most likely scenario": which branch of Economics lets one assess that probability?

[anne]

Developed country currencies appear to be increasingly valued according to projections of economic strength. Interest rates matter little or actually work against what was once logic. New Zealand, which has a curious central bank, continually has raised short term interest rates forever worried about inflation that is never there. The result is slow economic growth, among the weakest of stock markets for a decade, and a weak currency.

When the Federal Reserve is ready to end the tightening sequence, the stock and bond markets should strengthen along with the dollar. This brings us to an important export to Europe and Asia, an export that is easily overlooked. A few days ago, a friend from Hong Kong came by with his parents. The family had come to Boston to buy a medical office building. International investors buy American stocks and real estate, and no matter the dollar, bonds. We export capital, and there is no reason this will not continue.

[anne]

Brad DeLong:

"What on earth would induce foreign central bankers to care about losses on dollar-denominated financial assets?"

"[They've borrowed in their home currencies to buy the dollar-denominated assets. If they take big losses on their foreign exchange portfolios, they have to raise taxes by amounts that may be large.]"

Hmmm.... Japanese companies sell camers for dollars and trade dollars for Yen through the Bank of Japan. The Bank of Japan has Yen because of debt that was issued in Japan. So, a steep loss in the value of the dollar could cost the Japanese bank quite a lot.

[Bruce Wilder]

I see 36+ comments and I don't want to bother adding to the blather, but I think I will.

"narrative analysis" undisciplined by math, of the type offered by Brad, is subject to narrative error.

One is an error of proportion. Just how big is U.S. trade with China or the U.S. deficit relative to the total national income? This matters, and it can get lost in the emotive language of narrative.

Another error is one of logic relation: how is America going to create 8 million manufacturing jobs, while constraining investment spending? If China is apparently willing to sustain an exchange rate, which simultaneously reduces its own income from exports to the U.S. and holds down U.S. borrowing costs, there must be a reason. Oh wait, they are pushing extraordinarily high rates of manufacturing investment, while U.S. rates of investment in manufacturing is severely depressed, investment pressure from low interest rates has instead created a housing bubble. So, why do we think U.S. manufacturing investment is going to "recover" under a future regime of high interest rates? Something in this aspect of Brad's scenario does not compute.

One last thing: Americans will not just "feel poorer" they will be poorer. Since 1973, America has been engaged in a massive redistribution of wealth. To compensate for the increasing drain of petro-dollars to Dubai and the like, we have made our own billionaire class massively richer; the alternative would have been to sell all of our business assets to the oil sheiks, instead of just our Ports and the Indiana Toll Road. But, it is not enough, and some way MUST be found to crack the Social Security piggy bank. Brad will be helping with this project, I fear. And, then America will really know what it feels like to be poor.

That's what you get for voting for Nixon, Reagan and Bush II. Screwed. (That's the technical term, as the CC Prez said.)

[anne]

Interestingly, there has been no recession in any developed country since the energy price increases began. Nor has housing weakness in any developed country led to a recession even with energy price increases. There seems to be an increased flexibility in these economies, that is allowing for continually easier adjustment. Also, there are ways in which we personally should have been and evidently have been insulating ourselves against rising energy prices. With Brad DeLong, the sense I have is that we are faring reasonably well through what 15 and 25 years ago would have been a more difficult period.

[shargash]

Wow, Brad! You definitely deserve a pony. I can't imagine how we're going to dance through the economic minefields to come out smelling as sweet as you think the "most likely" scenario is, and that is without adding peak oil, disruptions from global warming, or a war with Iran and/or North Korea.

In order to spare Republicans embarrassment in an election year, the Fed dropped interest rates to 1%, fueling a housing boom that pumped 1.5 trillion out of thin air into the economy. We either have to destroy that airy wealth or suffer its inflationary effects. Furthermore, a declining dollar is a form of inflation, especially considering we don't manufacture anything any more and must buy it from foreigners.

You seem to think the declining dollar will fuel an export boom. But Bush isn't the first president to trash the dollar to address the trade deficit. It has never worked before. The trade deficity has been trending depressingly upwards for decades. There's no reason to think trashing the dollar will work this time, unless we really trash it, Brazilian style.

Add high oil prices to that. They aren't going down significantly. In fact, they are going to go up, possibly by a lot, especially if we start another war in the Middle East. High oil prices will slow the economy.

These are basically the same factors that caused stagflation in the 70s. And that's what I think the most likely scenario is.

And that assumes we avoid the many landmines out there. One of the biggest one of these is the huge foreign debt. Our international creditors are really sorry they have so much US debt. But if they dump it, the dollar will go down and cost them a lot of money, so they can't. It is like China, Japan, and Kora are holding grenades whose pins have already been pulled. They can't let go or they explode. But, if a run on the dollar starts, the last person still holding dollars will be the big loser. Because there are no safeguards built into the international system (c.f. collapse of the bhat), once a decline of the dollar starts, it will be hard to stop.

Then there is the fact that much of Asia's economy is propped up by the glut of exports financed by credit card spending in the US. If there is a slow-down in the US economy, what will the effect be on Asia?

There is more, too. The Reagan debt will need to be refinanced starting in 2010, about the same time we'll need to refinance the Bush debt. The likelihood of global warming induced economic disruption is quite high (q.v. Katrina or the borer beetles in Alaska). Both Iran and North Korea could become future wars. What will the national debt look like, if the US economy slows, reducing government revenues? And will the Fed be able to cut interest rates to end a recession, if the US is trying to finance, not just Bush's enormous deficit, but Bush's deficit fueled by a recession-induced decline in receipts?

IMO, the best case is long-term stagflation with a gradually declining standard of living in the US. The worst case is so ugly, I'm glad I have no children to worry about.

[failingeconomist]

There’s only one error that I can see in Brad’s analysis and that’s one of emphasis more than anything else. It’s his statement about creating 8 million jobs in manufacturing (and supporting services).
Err, do we actually need the new jobs to be in manufacturing? Or do we just need them to be in import substituting areas? Of, even, in areas that contribute to exports?

OK, OK, I realise that we all think of manufactures as the only things that get exported but that isn’t really true. Isn’t Hollywood one of the US’s largest net exporters? Certainly in the UK the largest net exporter (as a sector) is financial services with The City taking the lead. An expansion of Wall Street’s share of international finance would do just as much to reduce the current account deficit, wouldn’t it?

So why the emphasis only upon manufacturing?

[anne]

Oh, the loss in dollar value relative to the developed markets index is only 4.53% over the last decade, while the long term Treasury rate is a low 5.1%.

[Michael Cain]

"Interestingly, there has been no recession in any developed country since the energy price increases began... the sense I have is that we are faring reasonably well through what 15 and 25 years ago would have been a more difficult period."

One of the long-term energy trends of the past 25 years that is not given enough attention has been a shift towards electricity and away from direct use of fuels in all of the end-use sectors except transportation. This trend, I believe, helps insulate most developed countries from some of the effects of changes in fuel prices. If natural gas prices increase, generating companies shift away from gas towards other sources. The effect as seen by the end user is much smaller than if they were using gas directly. Worldwide, demonstrations and riots related to energy that I have read about this year seem to be more often about disruptions in the electrical supply and its effect on the local economy than about high oil costs.

Nano-scale materials science seems to be on the verge of making increased electrification of personal transportation feasible as well, and of decreasing the costs of solar electricity. I would feel more comfortable about the long-term prospects if our national policies on energy were focused on growing the supply of electricity and finding ways to use it to move a car or plow a field.

[anne]

Nicely done, Michael :)

[stunster]

I'm glad others have noted that central bankers are the ultimate in not having to deal with 'hard budget constraints'.

So I ask again, what would actually induce foreign central bankers, holding a lot of dollar-denominated financial assets, to care one way or the other about a falling dollar?

Relative demand for non-dollar currencies would rise, and the foreign central bankers would be faced with the choice of meeting that demand by purchasing, using their own currencies, dollar-denominated financial instruments, thus increasing their respective money supplies, or else not meeting it by not engaging in such purchases.

The former course might well be viewed as inflationary, but would also have the effect of stemming the fall in the relative value of the dollar. Problem solved.

The latter course would exacerbate the dollar's fall. This would cause US demand for foreign goods in turn to fall, triggering a world recession. It would also mean falling prices for US government securities, implying a rise in US interest rates, which would contribute mightily to that world recession.

Central bankers don't care about 'losses' on their dollar portfolios. But some of them might care about a world recession. Those that do will keep buying Treasury bonds. The alternative is a major downturn in the global economy (which would also solve the problem, though more painfully all round).

Foreign central bankers will keep the dollar from sinking too much not because they're worried about capital losses on their dollar portfolios, but because the alternative is a less-than-comfortable global 'structural adjustment'.

Inflation (with respect to goods, services, and assets priced in dollars), no matter how hawkish the rhetoric of central bankers on the subject, looks the easier course.

Of course, in the long run, it's not really. But, as a wise man once said, by then we'll all be dead.

[anne]

Brad DeLong answered the question. Central banks gain foreign currency as they exchange domestic currency for foreign. They gain the domestic currency by borrowing. The Bank of Japan borrows Yen and exchanges the Yen for dollars. The borrowing costs for the Bank of Japan will have risen if the value of the dollar declines relative to the Yen.

However, the charge of central banks in development countries is to limit inflation and betting that a central bank will not do just that is a foolish bet indeed as bond investors understand.

[dale]

"I know it's gauche to talk about income distribution..." says our Dean friend.

No it's not gauche, crude, improper to talk about income distribution. It should be a most natural, moral part of our everyday political discourse. Only those who benefit from a social stigma on such conversations would find it gauche- which is a class laden term to begin with.

[stunster]

"The borrowing costs for the Bank of Japan will have risen if the value of the dollar declines relative to the Yen."

They need fewer yen to buy dollars if the dollar falls relative to the yen.

Also, if a foreign central bank borrows its own currency, it will have no problem paying it back. If it needs to increase the money supply to do so, that in turn will tend to stem or reverse the fall in the dollar.

Also, if the dollar is falling relative to the yen, that implies a fall in the price of imports to Japan from the US, which would tend to be disinflationary in Japan. So increasing the money supply of Japan so as to support a falling dollar ought, in fact, to be neutral as regards inflation in Japan the medium term.

[Easter Lemming]

Brad, you are more optimistic than me.

[anne]

No; the dollar reserves held by the Bank of Japan, or any other central bank, will be worth less as the dollar loses value. A loss in value of foreign reserve even though it is a central bank loss is real.

[Cranky Observer]

I am just a humble citizen, not the economics experts that you guys are, but it does occur to me that many of these deep discussions of how central banks work and currency flows are based on an assumed structure of the world economy - one which has the United States at the center and which has been in place since at least Bretton Woods if not 1890.

But the situation that the essayist and Brad are describing is one in which no player would or could necessarily accept the stability of the US economy. That strikes me as a situation which hasn't occured for a very long time (there having been an economic actor of last resort since at least 1600) and one which would not necessarily work they way you expect.

Cranky

[shah8]

as I have posted earlier...

what about wages?

Thing is, the losses in productivity has to be made back.

because if you all haven't noticed, good faith is what makes society run. Not central bankers. China isn't the only one that has to pay attention to social harmony. It's just that US policy holders are much more complacent (overtly...all the NSA stuff seems mostly prep for what some beaurocrats are anticipating) about the need for this. You can't feed people with pride forever...

How much longer do you think relative domestic tranquility will last without heavy wage gains?

When people cannot make basic promises to each other, they get really, really nasty.

[Barry]

"Isn’t Hollywood one of the US’s largest net exporters? Certainly in the UK the largest net exporter (as a sector) is financial services with The City taking the lead. An expansion of Wall Street’s share of international finance would do just as much to reduce the current account deficit, wouldn’t it?

So why the emphasis only upon manufacturing? "

Posted by: failingeconomist

Good point, but similar things apply - the financial industry has been seriously off-shoring back-office operations for several years now; 'Hollywood' means Vancouver or Toronto for many shows.

For employers to engage in prolonged, significant hiring of Americans means that (a) US wage costs (relative to the world) have drastically declined *and* employers believe that that's a long-term situation, or
(b) the work is such that it can't practically be done offshore (or remotely from lower-wage areas of the USA).

[Neil']

Well, I hope you are right Brad, that the landing will probably be soft enough. And, it seems Bush can pick at least a few good leaders (even if one hasn't learned to talk softly yet....) But the current power structure needs to be swept out in 2006 and 2008. - and in the absence of popular and convincing third alternatives, that means the lesser of two evils...

[christo]

Brad Delong:

Was there kool-aid at the John Creative Law Yoo's welcoming party?

[anne]

Actually, simply judging by international investment flows, government, institutional and private investors find the American economy remarkably attractive. The American dollar has lost a mere 4.53% against the currencies of the index of developed economies in the course of the last decade. The sky may fall tomorrow, but today was blue above :)

[anne]

A question that should be asked however by every investor is how to organize a portfolio looking forward.
As investors we have had years to prepare for worries about the economy, yet continue to invest :)

[anne]

http://flagship2.vanguard.com/VGApp/hnw/FundsByName

Vanguard Fund Returns
12/31/05 to 7/7/06

S&P Index is 2.3
Large Cap Growth Index is -2.1
Large Cap Value Index is 6.8

Mid Cap Index is 3.1

Small Cap Index is 5.0
Small Cap Value Index is 6.9

Europe Index is 13.8
Pacific Index is 2.7
Emerging Markets Index is 5.8

Energy is 16.0
Health Care is 2.9
Precious Metals is 28.3
REIT Index is 14.4

High Yield Corporate Bond Fund is 1.4
Long Term Corporate Bond Fund is -5.1

[Bill]

I can't list all the things we manufacture, but I do believe that 14,000,000 American jobs are still classified as manufacturing - down from 17,000,000 5 years ago. 8mm will be a lot to add - but it won't be just in aircraft and farming.

Not sure if they count as manufacturing, but I'm sure some export jobs will come from biotech and pharma. Oil services, tourism, consulting services, financial services, and so on.
We have our problems, but we are still an economic power.
And I'm sure China believes it has more to lose from dollar depreciation than we do. That's why they keep fighting against it. So they will not be dumping dollars to spite us.

[Atul]

Great post. I think the standard of living in the U.S. has nowhere to go but down until the global standard of living equalizes (long term). The only way to fight these trends is to save save save and take advantage of the rising interest rates. One could also invest internationally as other emerging markets boom, you'll profit. And one last thing... We can all help lower the price of gas by using less of it.

[Robert Sneddon]

Some commentators have mentioned tourism as a minor revenue earner for America. It should be pointed out that the numbers of foreign tourists to the US has approximately halved since 9/11. Unless the US becomes more welcoming to foreign nationals instead of treating them all as potential terrorists (photographing and fingerprinting them at point of entry), this decline will not reverse.

[Delusional Andy]

That is THE worst prediction EVER...jeebus.

1. OIL price stability. $75 and going up. I am not sure which planet economists are living, but here in reality, everytime Dubya making stupid moves (Iran, Korea, Palestine/Middle east. Every brokers are smiling and betting up. Hence $2)

2. Every other countries, specially Asia and Europe are ready to match whatever interest rate we are raising. Imagine Japan Raising .25-.50% ... THERE goes Fed. (nevermind europe going .50%)

China inflation? Haven't the economist made prediction about collapsing Chinese economy since...oh...last decade? Newsflash: China is on the growth path that Taiwan and Korea has in the 90's (Korea was double digits for nearly two decades)

So far China is able to create relatively balance export/import and able to recycle collar quite cleverly. They don't need us, we need them. (eg. what? you think all those flat panel TV growth is going to walmart only? guess where all those are going? guess where cellphone growth are at? computer growth. etc etc. Global consumer market increasingly isn't propped up by US consumers.)

[Delusional Andy]

Posted by: Robert Sneddon | July 08, 2006 at 02:43 AM

Yep. Tourism in US? ya got to be kidding. finger print scan, retinal scan, computer database, airport detention, body search.

And people going to pay for that?

[Delusional Andy]

2) US-based manufacturing can't "rebound", as there is no there there to re-anything. Yes, there is still some manufacturing base. Yes, some very good companies have kept at least a portion of their base in the US (Koehler comes to mind). And a few high-value assemblers, such as BMW, have built new plants here. But the _vast_ majority of US manufacturing capability has been sent to China and India since 1995. It just ain't there to rebound, and there are no manufacturing employees or engineers to man it if it were.

Posted by: Cranky Observer | July 07, 2006 at 04:18 AM

Exactly. That is THE MOST delusional assessment EVER.

it assume "manufacturing" skill is constant. (eg. well garment industry and TV manufacturing line will pop up tomorrow when price go down enough)

Guess what! once we lost TV manufacturing and move to china, the innovation cycle is moving there. We are not going to be able to suddenly "build" a 7G flat pannel fab at $5B a pop because dollar price is down.

Once an industry is lost. It's LOST...

that mean we just have to move on to next big thing. (fuel cell car, biotechnology product, fashion, entertainment, etc etc)

we are not gonna be able to restart "auto manufacturing, Iron smelting, garment industry, etc..."

[knzn]

anne: “No; the dollar reserves held by the Bank of Japan, or any other central bank, will be worth less as the dollar loses value. A loss in value of foreign reserve even though it is a central bank loss is real.”

Changes in the value of an asset don’t matter unless someone is contemplating selling the asset. I own a house in the Northeast. I expect it to depreciate, but I don’t care, because I plan to keep living in it. Similarly, the BoJ plans to live in its exchange reserves, given that it has no prospect of ever having to use them to defend the yen.

You might say, what if I lose my job and can’t make the mortgage payments? Then I would have to sell. But the BoJ owns its house straight out. Far from borrowing to buy dollars, it has until recently been lending aggressively even as it buys dollars. There is a slight risk that the Japanese treasury will need a bailout someday (someday very much unlike today, someday when inflationary risks prevent bailing out the treasury by seignorage), so there is an opportunity cost to holding dollars. But if you want to talk about opportunity cost, then central banks should be investing in high-return assets like equity to maximize their chances of being able to conduct a bailout. That’s just not the way they operate (although, if Larry Summers is right, maybe it should be).

China is a slightly different story. The government has an ongoing surplus, so it’s even less likely that it will ever need a bailout. However, the PBoC doesn’t quite own the house outright. But once they stop pegging to the dollar, it is to be expected that they will retire their debt in the normal course of managing an expanding economy. Monetizing debt is, after all, the main business of a central bank under normal circumstances.

[anne]

http://www.calvorn.com/gallery/photo.php?photo=5375&u=17|15|...

House Wren Singing at Dawn
New York City--Central Park, Belvedere Castle.

KNZN, agreed, a fine response that leads me to feel more secure :)

[anne]

The idea of Japan having in time to defend the Yen, has always struck me as amusing when Japan after the surge in value of the Yen from 1985 worries only about a strong Yen :) So too, China noticed the problems caused by the central bank weakening of the dollar after 1985.

[farrar]

" it assume "manufacturing" skill is constant. (eg. well garment industry and TV manufacturing line will pop up tomorrow when price go down enough)

Guess what! once we lost TV manufacturing and move to china, the innovation cycle is moving there. We are not going to be able to suddenly "build" a 7G flat pannel fab at $5B a pop because dollar price is down.

Once an industry is lost. It's LOST..."

Don't worry so much - when the Dollar falls low enough, the Chinese can send us capital,engineers, technicians, and CEO's to help us get things going again ;-)

[anne]

The point for China then becomes supporting the dollar is of no consequence against against economic. Japan lost a decade of development, I am increasingly persuaded, by allowing the Yen to radically appreciate. This will not happen again. Europe too would have no interest in a radical appreciation of the Euro.

[a different chris]

>[summarizing] China...Japan....Europe... have have no interest in a radical appreciation of [their currency]

Ummm, OK. But how does that all work? How does every country keep it's currency down, especially when the player comprising more than 1/3 of this triumvirate insists on borrowing wealth from the other two?

[a different chris]

Er, not a triumvirate, in my mind I was kindof lumping China and Japan together in something called "Asia" and then adding US and Europe.

But that's not really a strong grouping...and reading Anne's comment again I'm not sure what she's saying about China.

But let it stand, somebody can figure out what I meant I'm sure.

[Ninjaplease]

In 5 years I will be 33 years old, an hopefully still an electronics engineer.

Please tell which fields are going to experience a growth of 8 Million manufacturing jobs. If you have no idea, then please don't purport such things. Doing so makes people vote for bad presidents.

[anne]

Chris is always interesting :)

What I think is the question is, against continued borrowing by America how can China and Japan keep the Yen and Yuan from rising in value? The simple answer is, if international debt grows only as fast as borrowing and lending economies grow there is no reason for debt to stop growing.

China and Japan can lend more as they grow, and we can borrow more. What the problem would be is growth in debt beyond our growth, but where is such a limit to come in?

[anne]

By the way, we are adept at invention and production of health care products and should not underestimate what drug production and medical equipment production mean for the economy and for trade. We have a thriving and wildly profitable health care sector and there is every reason this sector will continue to grow faster than the economy.

[andres]

anne: "Japan lost a decade of development, I am increasingly persuaded, by allowing the Yen to radically appreciate."

Hmm. I'm not so sure. imo, Japan lost a decade of _growth_ not by allowing the Yen to appreciate (it still made barely a dent in its large trade surplus), but by failing to properly monitor its financial system, leading to a decade of uncertainty in financial markets and business investment.

However, Japan, as far as I can tell, did not lose its technological edge, at least not in the tradeable goods sectors, so once Japan finishes reforming its financial system (including if necessary reducing the portion of the pie claimed by its growing senior population) and devotes some much-needed investment to services, its economy should come out all right.

Similarly, the US has lost at least a decade's worth of manufacturing competitiveness both due to an overvalued dollar and due to low developing country wages. A large if gradual depreciation of the dollar will help to change that though admittedly with some painful transition costs. Here's a slight suggestion: if some of the pain were to be absorbed by the pharmaceutical industry in the form of relaxing its patents, the US could substantially increase its exports of medicines and other health care products as mentioned by anne. Yes, this is only one branch in the garden of forking paths, but it's worth looking at more closely.

[anne]

Andres:

"Here's a slight suggestion: if some of the pain were to be absorbed by the pharmaceutical industry in the form of relaxing its patents, the US could substantially increase its exports of medicines and other health care products as mentioned by anne. Yes, this is only one branch in the garden of forking paths, but it's worth looking at more closely."

Excellent comment, within an excellent comment :)

[James Wimberley]

I thought Miss Rosy Scenario was an intern for Jerry Rubin and Larry Summers and quit the Treasury with Brad. If things turn sour in the next 17 months, what chance have Bernanke and Paulson got to prevent disaster? "Mr. President, I need an announcement about tax increases by midnight on Sunday, or I can't hold the run on the dollar when the Tokyo market opens"?

[anne]

The dollar goes up, the dollar goes down, but there will be no harming the American economy for the sake of protecting the dollar, as there was no harming the British economy to protect the Pound. Last year, there was a fairly sharp decline in the value of the Euro and European stock and real estate markets grew as though in compensation and European economies, gasp, were fine :)

[anne]

These last years developed market asset values have moved, or appeared to move, in compensation for declines in currency value. Investors have noticed :)

[anne]

There are important economic problems in America, as increaing corporate profits and income and wealth for the wealthiest while wage and benefit growth is limited and income and wealth disparity is growing. Still, this is a dominant economy and I find no reason at all to worry about an international crisis. Moreover, fear of a crisis is being used to harmful ends. Educational television stations wishing to raise money are suddenly directing us to watch analysts will tell how how to thrive after Social Security collapses. Nonsense.

[Barry]

Bill: "Not sure if they count as manufacturing, but I'm sure some export jobs will come from biotech and pharma. Oil services, tourism, consulting services, financial services, and so on. "

IIRC, biotech, pharmaceuticals, consulting and financial services are being offshored as fast as US companies are able. It's *sweet* to hire Ph.D.'s at $10K US/years.

[Bill]

Lots of jobs have been outsourced. Even more jobs have been created here in the US. Don't lose the forest for the trees.

[DOR]

"What is this most likely scenario? It is of (a) gradual inflation in China and elsewhere (maybe 5% per year for five years), (b) gradual reductions in the value of the dollar (maybe 5% per year for five years), accompanied by (c) gradual interest rate increases in the U.S. so that the dollar decline never turns into a (d) sudden dollar crash."

I missed the part about the fiscal fix, you know, where the federal government has to go back to living within its means.

As for the consumer side, enjoy the toys because there aren't going to be too many more in the future.
.

[Gaston Sanchez]

Just what is the US going to manufacture to compete globally? Get real!

[Per Kurowski]

No friends. The problem has to do with environmental fundamentals. Global warming has displaced toward the north the parallel of the Banana Republics, which we explains the current enormous fiscal and commercial deficits that currently thrive in the United States.
And so if you want to fix it, you might have to call Mr Gore.

[thebizofknowledge]

I would just like to thank you for a very stimulating post. The college dean's assessment was interesting, but I thought your comments in response were right on target and presented a much more accurate view of the situation and the economic implications.