from Follow the Money

Robert Rubin still worries about the risk of a hard landing …

January 24, 2006

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From Rubin's Wall Street Journal oped:

The effects of these fiscal conditions are exacerbated because they occur, uniquely in the U.S. amongst the developed nations, in combination with a very low personal savings rates, high levels of personal debt and enormous current account deficits (currently in excess of 6% of GDP, and caused at least in part by our fiscal deficits).

....  And the far greater danger is that these various imbalances could at some point lead to fear of fiscal disarray and concern about our currency, causing sharply higher interest rates in our bond markets and the risk of a sharp exchange-rate decline. ....  The adverse impact on interest and currency rates has not yet occurred, partly because business has had relatively low levels of demand for capital -- but most importantly because of vast capital inflows from abroad (until recently, predominantly from central banks supporting the dollar to subsidize their exports). This is not indefinitely sustainable; at some point, which could be near in time or still some years out, continued imbalances, increasing fiscal debt levels and ever-greater overweighting of dollar holdings abroad are highly likely to lead to loss of confidence, and trouble.

There are lots of reason to worry about this scenario.  But one is that any reduction in foreign confidence in the US would undermine one the economy's key shock absorbers: the tendency of interest rates to fall as US economic activity slows, helping to moderate the fall in economy activity.

A savings "supply shock" that reduced the flow of global savings to the US could imply that US interest rates would rise even as the US economy slows.  The Fed would cut short-term rates in response to the slowdown, but foreign investors would not be willing to add to their dollar balances at those low rates.

The market would find an equilibrium:  policy rates might fall, but market (long-term) interest rates might not.  So a US slump might not lead to lower US rates.  Or in the worst case scenario, might be accompanied by higher long-term rates.

Remember, the US will still run a very large current account deficit even if the economy slows.   It will still need to attract very large flows of savings from abroad.   The price the US has to pay (the interest rate) to attract that saving matters.

There is an obvious analogy to an oil supply shock.   If higher demand leads to higher oil prices, that's one thing.  If demand falls, price should fall.   Rising oil acts as a brake on the expansion, and falling oil prices help soften any contraction.  Not so with a supply shock.   A supply shock can drive up price even as demand and activity are falling.   Or more precisely, a supply shock prices up the price, leading to a fall in demand and activity.

Thomas Palley is right:  "Foreign flight" (a shock to the United States ability to borrow savings from abroad) is very different from "Consumer burnout" (a slowdown in US demand growth).   In both the foreign flight and the consumer burnout scenarios, the US economy slows and the dollar falls.  But in the foreign flight scenario, as Palley notes, the fall in the dollar and rise in US (market) interest rates triggers the US slowdown, while in the consumer burnout scenario, the US slump triggers dollar weakness.    Foreign flight would combine dollar weakness with higher US (market) interest rates, consumer burnout combines dollar weakness with lower interest rates.   

Bill Gross sure seems to be betting on consumer burnout - driven by a slowdown in .home froth and home equity withdrawal.  

Actually, he seems to be betting that consumer burnout won't give rise to foreign flight.  Consider the following scenario.  Consumer burnout could cause the US economy to slow and the Fed to start cutting rates.  But as US rates start to fall, foreign investors lose interest in lending even more to the US.  Rather than adding $1 trillion or so to their portfolio of dollar denominated bonds at 4.5%, they want to add only say $600 billion or so ... Reduced foreign demand for US dollar assets ends up pushing US interest rates up. 

At least those interest rates that are set in the market.  The Fed's response to consumer burnout could trigger foreign flight. 

That is a bad scenario. It implies that the US economy wouldn't benefit from some of the stabilizers that normally buffer the US from really bad (economic) outcomes.  

The risk of an oil supply shock that would keep oil prices from falling as US demand slows sure seems to be rising.  And underneath the surface, I suspect that the risk of a "savings" supply shock that would keep interest rates from falling even as the US economy slows are rising as well.

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