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Politics : Idea Of The Day -- Ignore unavailable to you. Want to Upgrade?

To: IQBAL LATIF who wrote (44623)	9/18/2003 3:42:56 AM
From: IQBAL LATIF	Read Replies (2) \| Respond to of 50167

If Something Is Unsustainable, Then It Will Stop Up through 1997 the measured United States current account deficit was a relatively-small one percent of GDP. Since then the measured deficit has grown remarkably--to 2.7% of GDP in 1999, to 3.5% of GDP in 2001, to an estimated 4.7% of GDP this year, and with the U.S. economy currently forecast to grow significantly faster than most of its trading partners to 5.1% of GDP in 2004. How long will non-U.S. residents continue to embrace the large flows of capital to the United States needed to finance this deficit? And what will happen when they stop doing so? Clearly the United States's current account deficit is unsustainable. And, as the late Herb Stein used to say, if something is unsustainable then someday it will stop. I used to think that the United States current account deficit would stop when the rest of the world "balanced up"--when Japan recovered from its more than a decade-long stagnation, and when western Europe restructured its economy, boosted aggregate demand, and reduced its unemployment rate to some reasonable level. But as the years have passed "balancing up"--rapid growth in the rest of the world boosting demand for American exports--has become less and less likely. The other way the current account deficit could come to an end is if the inflow of capital into America comes to an end. As the late Rudi Dornbusch used to say, unsustainable capital inflows always last much longer than fundamentals-watching economists believe possible. The investors funding the capital inflow and the country receiving the money always think up reasons why this time the inflow is not unsustainable but is the result of permanently transformed fundamentals. That mass delusion, Rudi argued, keeps the inflow going long after it should come to an end. But when it does come to an end, the speed with which the capital flow turns around is much faster than anyone--even fundamentals-watching economists--believes possible. Whenever the capital inflow to the United States comes to an end, it is clear what happens to the value of the dollar: it declines by between 25% and 50%, depending on how rapidly Americans switch spending from imports to domestically-produced goods and how much of an expected dollar bounce-back is needed to induce investors to hold U.S. assets while the switching of spending takes place. In Mexico in 1995, in East Asia in 1997-1998, and in Argentina in 2002 the collapse of currency values caused enormous distress: as currency values fell, the local-currency value of debts owed to foreigners and linked in value to the dollar rose, and the danger of effective national bankruptcy grew. Deep recessions, high real interest rates, and financial chaos were all on the menu--although the skills of Robert Rubin, Michel Camdessus, Stanley Fischer, and many others including Mexico's and East Asia's politicians and central bankers kept the Mexican and East Asian crises much less destructive than they might have been. But should the value of the dollar collapse suddenly, the United States will follow a different course. Like Mexico, East Asia, and Argentina America's international debts are largely denominated in U.S. dollars. But unlike Mexico, East Asia, and Argentina, the dollar is America's currency. A decline in the real value of the dollar does not increase but instead reduces the real value of America's gross international debts. A fall in the value of the dollar reduces Americans' standard of living by 4% or so, but it does not cause the kind of liquidity and solvency crises that we have seen so often in the past decade. (At least, it does not do so if New York's major financial institutions have well-hedged derivative books: if their derivative books are not well-hedged, all bets may be off.) The ending of the inflow of capital to the United States should not set off the worries about solvency and the derangement of finance that generated recessions in Mexico and East Asia and deep depression in Argentina. The currency crises in Mexico, East Asia, and Argentina primarily impoverished workers who lost their jobs and those who found their hard-currency debts owed to the industrial core suddenly a much greater burden, and secondarily rich country investors who found themselves renegotiating terms with insolvent creditors. A rapid decline in the dollar is likely to have a very different pattern of impact: to primarily impoverish workers whose products are exported to America and investors in dollar-denominated assets who see their portfolio values melting away, and only secondarily affect Americans who heavily consume imported goods or who work distributing imports to consumers. But why, then, does the capital inflow continue? Investors outside the United States can see the magnitude of the trade deficit, calculate the likely decline in the dollar to eliminate it, recognize that the interest rate and equity return differentials from investing in the United States are insufficient to compensate for the risk that next month is the month that the capital inflow into the United States starts to fall. To this fundamentals-watching economist, the fact that so much of the risk of loss from a decline in the dollar falls on those investing in America means that the capital inflow has already gone on much longer than I would have believed possible. What stories are investors far from America telling one another to justify continuing to add to their exposure to dollar depreciation? And when will they stop believing these stories? Posted by DeLong at 10:59 AM \| Permanent Link