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March 30, 2005

The "Hard Landing" Scenario...

Kash at Angry Bear sets out what the "hard landing" scenario is, and then why he is skeptical about it:

Angry Bear: [A]t some point those Asian central banks will decide to stop lending additional funds to the US. They do not have to dump their current dollar assets to cause a crisis; simply stopping the accumulation of new dollar assets will suffice to cause difficulties. When that happens, the US current-account deficit must necessarily fall by a (roughly) similar amount over a short period of time. The only way that that can happen, particularly given continued US government deficits, is for a sharp fall in the dollar, a sharp rise in interest rates, a sharp fall in asset values, a sharp fall in consumption, and a large rise in US saving...

And here's why he is skeptical:

Assuming that Asian CB lending to the US is indeed a crucial determinant of the US's CA deficit (see #1 above), will it be in the best interest of Asian CBs to stop lending additional funds to the US any time soon? The costs to those CBs of additional lending to the US are large: enormous potential capital losses when the dollar depreciates, growing inflationary pressures in their home countries (perhaps particularly in asset markets), and heightened protectionist pressures in the US.

But the costs that Asian CBs will incur if they stop lending to the US could be even greater: the sharp fall in exports to the US that would surely happen, a likely sudden rise in domestic interest rates, the crash in asset prices that would probably follow... all of which would make a recession -- possibly a rather severe one -- quite likely. Right now these costs are apparently greater than that aforementioned costs of continued lending to the US.

Is it likely that this calculus will ever change? I've generally been in the hard landing camp on this issue, but on this last question I'm not so sure. It seems entirely possible to me that the enormous downside risk of recession, asset price depreciation, and domestic economic dislocation could well outweigh any other consideration for a long time to come. If so, then Asian CBs will have every reason to only very gradually taper off their additional lending to the US -- gradually enough to ensure that the hard landing scenario never happens...

What this leaves out is that the associated central banks may lose control of the situation. As long as they all act in concert, things continue to work (at least in the short run). But suppose that one decides to hedge its reserve position against the risk that the dollar will decline. What happens then? The other central banks will have to step in to take up the slack--to buy its dollar holdings, and then to take up its share of new dollar holdings. The first central bank to decide that the game is up wins and escapes all risk. The rest are left holding the rotting hot potatoes. As the stakes at risk rise, the strains on the dollar-buying cartel that is the associated central banks of Asia rise. And when those strains become too great and the first one decides to try to get out the door first...

And what this also leaves out is the other actors in the game. As long as the dollar-buying cartel continues, you can move your assets from dollars into other currencies, wait for the dollar to fall, move them back, and thus have made 30% or more on your money. At the moment Americans are doing this at a rate of $600 billion a year as they trade bonds for net imports. There are about $30 trillion of dollar-denominated financial assets in the world economy. If their holders decide to convert only 2% of these from dollars into other currencies this year, that means that the central bank cartel will have to eat not $50 billion of new dollar holdings next month but $100 billion of new dollar holdings this year; if they decide to convert 6% this year than the central bank cartel will have to eat $200 billion of new dollar holdings next month. When the associated investors of the world who hold dollar-denominated assets decide on any significant scale that it's time to try to grab the 30% gain from the coming fall in the dollar, the game is over that very week.

If either of these happen--either a move by a couple of central banks to abandon the dollar-purchase cartel, or a decision by a significant number of investors to try to grasp the 30% profit from the forthcoming dollar decline--then things get wild immediately. Karen Johnson at the Federal Reserve, Kristen Forbes at the CEA, and Randal Quarles and Tim Adams at the Treasury will know what to try to do--or at least guess at what the least-bad course of action will be. But will anybody in the White House listen to them?

Posted by DeLong at March 30, 2005 10:23 AM