House of Paine

try gobblin this ......eve old girl

i'm posting 
mister DeLong's 
latest
bloviation
on the coming 
        "dollar crisis"

hoping to taunt
 the lady eve 

into some talmudic commentary ...


====================================





" the  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 fragments:

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.
 
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
 
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 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:

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
 
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
 
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.

but 

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
 
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
 
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. 

The problem then was half 
as big relative 
to the size of the U.S. economy
 as is the problem now

 
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 
that the domestic-side economists 
were keying off the past experience
 of the U.S. after 1985
 and of Britain after 1982,
 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"