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Friday, January 09, 2004

Current Trends Are Unsustainable

Economist for Dean Steve Kyle had a post on the dollar as a reserve currency issue the other day, and I put up a couple of comments. In particular I was infuriated because I discovered inadvertently what I consider to be a scandalously irresponsible piece by Paul Krugman where he simply side-steps the whole question of the structural problem of having a given reserve currency in a continually changing world, and reduces it to a paying in dollars or paying in euros issue Steve subsequently wrote to me, and I am now posting his mail. He seems to have understood the problem, the danger is the hard landing, not the fact of the transition itself. There is a problem of 'money illusion' here: the US is obviously richer than most European economies, but not as much richer as they felt themselves to be. That was an illusion brought on by the exaggeratedly high value of the dollar, and that is the reason why Stephen Roach was constantly going on about the proprtion of global growth being due to the US economy, this was a kind of statistical illusion brought on by the reserve currency status, and if the US was not as rich, then India was not as poor, and the complicated unwinding of this illusion is where the problem is. Incidentally, like everyone else I've been watching US films for years, and it has alwasy puzzled me why, if they were so rich, the US worker didn't appear to be more different from the German one, why, for eample, the characters are forever in these two-bit diners which always seem so seedy, and why when you watch the people working you can't see more evidence of all that extra productivity being generated just in the way they work and the technology they use.

It is indeed a complicated set of issues, and I dont claim to have perfect understanding of what will happen, but that is precisely the problem. To make this clear, a couple of points:

1. I certainly dont agree with Krugman that the only problem is what bills drug dealers have in their pockets. That is small potatoes, though there ARE serious issues of psychology in the long run regarding which is the preferred currency to have in the world - an issue not limited to drug dealers. The issue is what happens on the way to that situation and it is this that makes me nervous.

2. It is this very uncertainty - we dont know what will happen - that is the most reckless part of this economic adventure of ours - that we can even be IMAGINING a global financial crisis brought on by the US is in itself a very scary thing.

3. We know that the current trends are unsustainable - The US government is spending money it doesnt have at the rate of half a trillion a year and climbing as far as the eye can see. We arent even spending the money on investment - it is going to guns, bombs, transfers, and tax breaks to people who, if they are like me, have put all available personal assets into Euro denominated instruments. Our current account more or less mirrors this, since private sector savings are negligible.

My fear (not yet a likelihood, but a visible and positive chance of occurence) is that we will suffer a very hard landing. At the moment foreign central banks seems to be soaking up a large share of what we are emitting. This cannot go on forever though, of course, there is no natural limit to the amount of their own currency these governments (China,
Japan, etc.) can print. Sooner or later, if the supply of dollars keeps growing and there is no reasonable expectation that this flow will cease (on the contrary, it seems to be scheduled to grow indefinitely) even central banks will stop buying dollar assets and the game will be over. What will happen then?

It is somewhat analogous to Triffin's dilemma backin the 50's and 60's - I wrote a paper touching on this a while ago, but the basic problem is more apparent today - How will the transition from a dollar standard (or gold as in Triffin's day) be managed?

You may be right that a deflationary scenario is better and will solve the problem of foreign banks' unwillingness to hold dollar reserves. Certainly they would remain happy if deflation raised the value of those reserves. But the real problem in this scenario is a major depression. And finding our debts to the rest of the world increased in
value while we are going through high interest rates (real rates are bound to be high in any deflationary scenario - perhaps very high) is a recipe for a depression along the lines of some of the adjustments suffered by e.g. Argentina within recent memory. It is one thing for Argentina to do this, but quite another for the US - Were we to lose, e.g. 20% of GDP in a very bad scenario, the consequences for the rest of the world would be pretty awful. (Again, I am not predicting this will happen but the fact that it is within the realm of possibility is not a good thing)

It is certainly the case that reasonable people from all of the important interested parties need to get around a table and figure this out. However, my estimate of the chances for this are much lower than yours. I DONT think that Alan Greenspan is the puppeteer here. Sure, he controls monetary policy, but the Administration cares ONLY about
political advantage. They neither know nor care what will happen beyond the next election. Just look at the caliber of the Treasury secretary now (and the one before) and compare them to Rubin. These guys simply dont
understand international finance. Not even a little bit. There is nobody in the White House who does either. Greg Mankiw certainly is no dummy, but he is out there making statements we all know he doesn't believe, so he is
obviously being a puppet, not a puppeteer.

What I hope is that nothing bad will happen before November and that sanity will return after that point. Even here, though, there is room for doubt. The Republicans (if they win) have demonstrated a complete lack of interest in or understanding of the need for responsible economic management. The Democrats (if they win) might do better but at the moment their posture is one of wanting to spend on DIFFERENT things but not LESS of them. And they will have a very hard time getting a repeal of the tax cuts through Congress, which is very likely to remain Republican (and
perhaps more so).

Well, that is all I have at the moment. - Feel free to post this on your site if you like - Perhaps we could continue the discussion there - I would be interested in hearing what others say. Also, you can look at stuff I have written in the past on my own website

By the way: note the "even central banks will stop buying dollar assets ", this is my endgame to, and if nothing is done before we get there the outcome may well not be pretty.

Incidentally: "a deflationary scenario is better". I'm not really saying this. I'm saying this is what we have. It may be relatively acceptable to those with savings (which is why political change is so slow in Japan, and always imagining that the impact in the equity markets and on the banks isn't too dramatic) but it won't be any fun for the young people who have just accumulated all that debt. There are lots of silly little details I would quibble about here, but in general I think Steve is talking a lot of sense.

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