from Follow the Money

DeLong: It will all be OK … unless it isn’t

July 7, 2006

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Weekend commentary on the forthcoming (we just don’t know when) process of external adjustment in the US has been outsourced to the left coast.  DeLong: 

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.

Only three additional points from me.

First, I keep waiting for that upsurge in inflation in China.  And waiting.  It just doesn't seem to happen.  Despite quite strong money growth from partially sterilized reserve growth.  And there is another possibility: Chinese over-investment leads to a Chinese bust that drags down prices and activity in China.   In the past, falls in investment in China have often led to falls in consumption growth too.

Second, before eight million new US jobs can appear in manufacturing (or service exports), someone has to make a lot of new investment in manufacturing capacity (or develop some non-traditional service exports).   Boeing assembly lines don’t spring up overnight.  There has to be a change in the composition of investment –not just the composition of employment.  And the change in the composition of investment needs to precede the change in the composition of employment.   

Some folks can go from building homes to building factories.  But I am not convinced that the US economy will prove as adept shifting workers back into tradables production as it has been as shifting workers out of tradables.  A European economist once quipped to me that the US has become the first economy in the world to specialize in producing non-tradable services … 

Third, I am in the process of updating my estimates for official financing of the US.   Counting oil investment funds, I suspect official investors bought at least $450b of the roughly $700b in debt the US placed abroad in 2005.   Remember, in 2005, the US needed to place a bit less debt abroad than usual because US firms brought profits back home to take advantage of the Homeland Investment act, so equity inflows helped finance the US deficit.   In 2006, the US likely will need to place around $900b in debt abroad.  And at least $500b will be placed with official investors.    Oil rose to $75 this week.  Folks in Abu Dhabi, Kuwait, Riyahd, Olso, Moscow and a few other places are gonna have a lot of money this year.     

Oil investment funds have become the new Asian central banks … but no one seems to have noticed.   

$450-500b, by the way, is the amount of official financing the US needed when interest differentials favor the US -- so Japanese money flowed into the US on its own accord.  If private demand for US debt were ever to drop, barring a pickup in demand for US equities (kind of unlikely if US consumption growth is sort of slow) central banks would have to do even more to keep the world economy from jumping to that bad equilibrium. 

But not so much that the US doesn’t adjust.

I suspect we will have ample cause to find out how good a central banker Bernanke is.   

And perhaps cause to see how good Paulson is as well.   I am not one who thinks it all hinges on the Fed.   There was a reason why Time included Rubin and Summers in its famous (at least in Treasury circles) Committee to Save the World cover shoot.    

Next time around, though, the committee won’t be all-American.

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